Sec. 304 and rev. rul. 99-6: fitting a triangular peg in a round hole.

• Author: Bodoh, Devon M.

There is little dispute that Subchapter C and Subchapter K of the Internal Revenue Code have difficulty coexisting in certain circumstances. Despite lawmakers' efforts to coordinate the subchapters' interaction, many areas of uncertainty remain. This item examines one such area: the potential application of Sec. 304 to transfers of interests in a partnership that owns corporate stock.

Overview of Sec. 304 Sec. 304 is intended to prevent the bailout of corporate earnings through a sale of the stock of one corporation (Issuing) to another corporation (Acquiring) in exchange for property.

Under Sec. 304(a)(1), if (1) one or more persons are in control of each of two corporations (Acquiring and Issuing), and (2) in return for property, one of the corporations (Acquiring) acquires stock in the other corporation (Issuing) from the person (or persons) in control, the exchange is treated as though Acquiring distributed the property in redemption of Acquiring's stock.

The tax consequences of the deemed redemption are determined by reference to Sec. 302. Specifically, if the deemed redemption satisfies any of the tests in Sec. 302(b) with respect to Issuing, then the deemed redemption qualifies for sale-or-exchange treatment under Sec. 302(a) (Secs. 304(b)(1) and 302(a)). If, however, the deemed redemption fails the tests in Sec. 302(b), then the deemed redemption is treated as a dividend to the extent of the earnings and profits (E&P) of Acquiring and Issuing (Secs. 304(a)(1), 302(d), and 304(b)(2)). Characterizing a transaction as a sale or exchange versus as a dividend distribution used to have greater significance (in the form of differing tax rates for capital gain and dividend income), but important reasons remain for preferring sale-or-exchange treatment. For example, dividend treatment defers basis recovery until E&P is exhausted, while sale-or-exchange treatment effectively front-loads basis recovery.

For purposes of Sec. 304, "control" of a corporation is defined as the ownership of stock representing at least 50% of the total combined voting power of all classes of stock entitled to vote or of the total value of all classes of stock (Sec. 304(c)(1)). Additionally, several special rules apply when determining control. First, the constructive ownership rules of Sec. 318 apply, with certain modifications (Sec. 304(c)(3)). Second, control of Acquiring is determined after taking into account stock of Acquiring received in exchange for stock of...