Selecting the right target basis calculation for your basis transfer transaction.

• Author: Keppler, Juliane L.

Corporate taxpayers undergoing certain tax-free transactions now have several more options to determine their tax basis in the acquired Target stock. Rev. Proc. 2011-35, which was issued by the Internal Revenue Service on May 31, 2011, and became effective June 20, 2011, updates 30 years of basis determination procedures for basis-transfer transactions.

If a company has engaged in a tax-free stock acquisition or if a transaction is in the planning stages, a tax executive should consider the shifting landscape of target tax basis determination guidelines. This article reviews the history of basis determination techniques and the evolution of guidance from Rev. Proc. 81-70 to Rev. Proc. 2011-35. It also explores the potential hazards of delaying basis determination and provides best practices for identifying the most appropriate method for determining target stock tax basis.

Evolution

Stock, a common vehicle for corporate acquisitions, has been the sole or part consideration in one third of all U.S. transactions since 1996. (1) When at least 80 percent of a company's stock is acquired by another company in an exchange solely for the Acquiring Company's voting stock the transaction may qualify as a type B reorganization (under section 368(a)(1)(B) of the Internal Revenue Code) and qualify as tax-free.

In a B reorganization, the acquirer's tax basis in the newly acquired Target stock is the surrendering transferor's basis in the stock (or carryover basis under section 362(b)). The basis is carried over from transferor to transferee; such is the case with a basis transfer transaction.

Another basis transfer transaction is the Section 351 merger, where typically an acquirer and target merge to form a "NewCo" company. To be considered tax-free, at least 80 percent ownership by vote and value of each of the target and acquirer's stock must be controlled by the NewCo after the merger.

An example of the determination of target stock tax basis in a basis transfer transaction is as follows: Assume Company T has five shareholders with 10 shares each and a tax basis of $10 per share, for an aggregate $500 in basis (5 x 10 x $10). In a B reorganization, Company A uses voting stock to acquire 100 percent or all 50 shares of Company T. Company A's basis is transferred from the surrendering holder, such that A's tax basis in the acquired T stock will be $500, or Company T shareholders' stock aggregate basis.

If target stock is publicly traded, ascertaining carryover basis can be quite complicated since a significant portion of the transferor shareholders may not be easily identified. The complexity behind target basis determination in basis transfer transactions is typically a function of these issues: (1) the number of issued and outstanding Target Company shares, (2) the number of transferor shareholders, and most critically (3) the degree the transferred shares are held in nominee name versus record name.

A significant trend over the past five decades is the change from primarily certificated share ownership to nominee-held shares. Fifty years ago, when investors purchased stock in a public company, in many cases stock certificates were issued and the shares were registered directly with the issuer's transfer agent. As shareholders became more active investors, and trade settlement changed from seven to three days, shareholders began to have their shares held in custody by a bank or broker to facilitate trading. Custodian-held shares are recorded in nominee name under the bank or broker holding the shares and are often called Street-held shares. The identity of the beneficial owners of these Street-held shares in many cases is not known to the issuing company. By 1990, the typical publicly-traded company had approximately 85 percent of its issued and outstanding common stock held in Street name.

Until 1980, there was little formal guidance for estimating carryover basis in B reorganizations, other than through direct shareholder inquiry (i.e., survey) or from the Target Company's books and records. Some companies adopted the "Cohan Rule," which provided the Taxpayer with a precedent in the event it did not have fully supportable basis data. In the absence of actual knowledge, an estimate of basis that was greater than zero (under the assumption that the stock price traded at greater than zero) could be considered reasonable. (2)

Seeking to formalize the basis determination process for B reorganizations and recognizing the burden of surveying 100 percent of the shareholders of a publicly traded company, in 1981 the IRS issued guidelines for determining target tax basis in B reorganizations. These guidelines, set forth in Rev. Proc. 81-70, primarily focused on using statistical sampling procedures to survey a subset of the Target Company shareholder base and extrapolating the basis data obtained from the sample group to all Company T's outstanding shares. The guidelines prescribed that the resulting basis estimate was to achieve a sample error of 10 percent (or less) at a 95-percent confidence interval. Rev. Proc. 81-70 also included procedures for estimating target stock basis in the absence of actual knowledge (i.e., non-responding sampled shareholders). For example, the Acquiring Company could look at the date a stock certificate was issued to the Target Company shareholder and assign the average trading price on the date of issuance as the estimated basis.

To sample and survey a public company's shareholders, you would first need to identify the shareholders and then randomly select a sample group of holders, both in Record and Street name. These steps may prove challenging because the majority of the publicly-held shares are held in Street name, which means the identities of a company's shareholders are not readily apparent and oftentimes not available. Bank and broker nominees will often not divulge shareholder account information to the Acquiring Company, let alone shareholder basis data, out of a fiduciary responsibility to their account holders. (3) Consequently, the Acquiring Company in some cases will encounter difficulty with ensuring statistical validity and obtaining sufficient Company T shareholder basis data to estimate the Company T shareholder's aggregate basis within the...