Significant recent developments.

• Author: Schneider, Mark A.
• Position: Regulations on reorganization

EXECUTIVE SUMMARY

* The Service issued proposed regulations that would excuse E and F reorganizations from the continuity requirements; establish a testing date for determining whether the COI requirement is met; and allow certain transfers or distributions of acquired assets or stock following a reorganization.

* Notice 2004-58 describes the basis-disconformity method for determining basis in subsidiary stock attributable to BIG; temporary regulations allow a limited opportunity to elect retroactive application of this method.

* The Service issued significant rulings on disregarded entities, spinoffs, transfers of debt instruments, Sec. 304 and partnership conversions to corporations.

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This article summarizes some of the more significant recent subchapter C and consolidated return developments, including the American Jobs Creation Act, proposed regulations on reorganization continuity requirements, guidance on subsidiary stock losses and various other significant rulings.

This article summarizes some recent, significant subchapter C and consolidated return developments. It addresses, among other things, (1) the American Jobs Creation Act of 2004 (AJCA); (2) proposed regulations on the continuity of interest (COI) and continuity of business enterprise (COBE) requirements in tax-free reorganizations; (3) guidance on how to determine allowable loss on subsidiary stock in a consolidated group setting; and (4) revenue rulings on the business purpose for spinoffs and on the tax effects of a state law conversion of a partnership to a corporation.

Legislation

The AJCA was signed into law by President Bush on Oct. 22, 2004. It contains several corporate tax provisions. First, AJCA Section 898(b) narrows the scope of Sec. 357(c) to apply only to Sec. 351 transfers and divisive D reorganizations (i.e., D reorganizations undertaken to affect a corporate spinoff). Under Sec. 357(c), the transferor corporation recognizes gain to the extent that liabilities assumed by the transferee exceed the aggregate adjusted basis of the assets received by the transferee. The AJCA makes clear that the provision no longer applies to acquisitive D reorganizations. This is a welcome change.

AJCA Section 899(a) clarifies the definition of nonqualified preferred stock, by providing under Sec. 351(g)(3) that stock shall not be treated as participating in corporate growth to any significant extent, unless there is a real and meaningful likelihood of the shareholder actually participating in corporate earnings and growth. In addition, AJCA Section 836 narrows the ability to transfer a built-in loss (BIL) in a Sec. 351 transaction. Finally, AJCA Section 839 provides that a qualified stock purchase for which an election is made under Sec. 338(h)(10) is subject to estimated taxes. The estimated tax is determined based on a stock sale, unless and until there is an agreement to make a Sec. 338(h)(10) election. (1)

Regulations

COI and COBE

To qualify as a Sec. 368(a) tax-free reorganization, a transaction generally must satisfy the COI and COBE requirements. For example, target corporation (T) merges into acquiring corporation (A), with A surviving the merger. Under the COI requirement in Regs. Sec. 1.368-1(e), the consideration issued to the T shareholders must consist of a certain amount of A stock. In addition, under the Regs. Sec. 1.368-1(d) COBE requirement, A must continue T's historic business or use a significant portion of the historic T assets in a business.

E and F reorganizations: Proposed regulations (2) would excuse two types of reorganizations--E and F reorganizations--from the continuity requirements. An E reorganization is a recapitalization, or a "reshuffling of the corporate deck." (3) A typical recapitalization involves the conversion of a corporation's debt into its stock. An F reorganization is a mere change in one corporation's identity, form or place of organization. For recapitalizations, the IRS has long held that the COI and COBE requirements do not apply to transactions involving only a single corporation. (4) F reorganizations, according to the preamble to the proposed regulations, effectively involve only one corporation, even though two corporations technically might be involved (e.g., a reincorporation in another state).

Testing date for COI requirement: In certain types of reorganizations, for example, when a target corporation merges into an acquiring corporation under Sec. 368(a)(l)(A), the acquirer may issue money or other property to the target's shareholders, in addition to the acquirer's stock. The amount of money or other property is limited, however, by the COI requirement under Regs. Sec. 1.368-1(e), which is designed to prevent transactions that resemble sales from qualifying as tax free. To satisfy the COI requirement, the acquirer must issue an amount of its stock to the target's shareholders that preserves a proprietary interest in the target. A transaction will meet the IRS'S safe harbor if the value of such stock is at least 50% of the value of the total consideration issued. (5)

This is a key factor. In light of potential shifts in the value of the acquirer's stock--such as a decrease during the interim period (between execution of the reorganization agreement and the transaction closing date)--the testing date for determining whether COI is met is critical. Against this backdrop, Prop. Kegs. Sec. 1.368-1 (e)(2)6 would provide that, in determining whether the COI requirement is satisfied, the consideration to be exchanged for the target's stock is valued as of the end of the last business day before the first date there is a binding contract to effect the transaction. The consideration must be fixed in the contract and include only stock and money. The value of any stock or money placed in escrow to secure the customary target representations and warranties would be fixed consideration, under the proposed regulations.

Push-Up Distributions

Under Sec. 368(a)(2)(C), an acquiring corporation in certain enumerated tax-free reorganizations may transfer all or a portion of the acquired assets or stock to a controlled corporation. However, this provision does not specifically sanction a distribution of assets (a push-up)...