Recent statutes, regulations, cases, revenue rulings, notices, letter rulings and FSAs in the C corporation area.

• Author: Schneider, Mark A.
• Position: IRS Field Service Advice

This article examines certain recent sub-chapter C and consolidated-return developments. Spanning the period from approximately July 1, 2000-June 30, 2001, it provides a review of statutes and regulations, court decisions, revenue rulings, notices, letter rulings and FSAs. The article does not purport to address every item of importance or interest during this period; rather, it attempts to review the most useful items to tax advisers.

Statutes

Certain Stock

Section 309 of the Community Tax Relief Act of 2000 enacted Sec. 358(h), effective for transactions after Oct. 18, 1999. Apparently designed to deny certain losses, Sec. 358(h) provides that if the basis of stock received in an exchange to which Sec. 358(a)(1) applies exceeds the fair market value (FMV) of such stock after the application of Sec. 358(d) (e.g., a Sec. 351 transfer of property to a corporation in exchange for its stock), the stock's basis in the transferor's hands is reduced (but not below FMV) by the liabilities assumed by the transferee corporation in the transaction. Sec. 358 (h) defines "liability" broadly to include not only fixed liabilities (already addressed by Sec. 358(d)), but also contingent obligations. (1)

Prior to Sec. 358(h)'s enactment, the Service had published guidance holding that contingent liabilities generally were not taken into account under Sec. 358(d). Rev. Rul. 95-74 (2) held that contingent liabilities (such as certain environmental remediation liabilities) were not liabilities for Sec. 358(d) purposes and, thus, did not reduce the basis of transferee stock received in a Sec. 351 transaction. In addition, the Service held that such liabilities generally could give rise to a deduction under either Sec. 162 or 263 on becoming fixed and determinable.

A transaction potentially affected by the new legislation involved a Sec. 351 transfer of a high-basis asset (i.e., a basis approximately equal to FMV) to a transferee corporation in exchange for its stock. The transferee corporation would assume a contingent liability (such as an environmental remediation liability that the transferor had not yet taken into account for Federal income tax purposes). The transferred asset's basis and FMV were generally only marginally greater than the assumed liability's present value; as a result, the transferee stock received had little value. However, under Rev. Rul. 95-74, the stock basis was not reduced by the contingent liability assumed by the transferee corporation under Sec. 358(d). Thus, the basis of the stock received in the transaction remained in excess of its FMV, generating a loss if the stock were sold.

Sec. 358(h), by contrast, would reduce the basis of the stock received by the transferor by the present value of the contingent liability assumed, effectively eliminating the loss on the subsequent stock sale. While Sec. 358(h) applies to transactions after Oct. 18, 1999, Notice 2001-17 (3) (discussed below) stated that the IRS may also attack transactions of this nature entered into before the Sec. 358(h) effective date on other grounds.

Regulations

During the period covered by this article, noteworthy regulatory developments included the issuance of final regulations under Sec. 355(d) and a second set of proposed regulations under 355(e) that was ultimately made temporary (the first set of proposed regulations was withdrawn). In addition, final regulations were issued under Secs. 338 and 1060.

Sec. 355(d) Final Regs.

Sec. 355(d) final regulations were issued on distributions of controlled corporation stock or securities. (4) In general, Sec. 355(d) requires a distributing corporation to recognize gain on the distribution of a controlled corporation's stock or securities in a "disqualified distribution" (defined generally as any Sec. 355 distribution if, immediately after the distribution, any person holds a 50%-or-greater disqualified stock interest in the distributing or controlled corporation and such stock was acquired by purchase after Oct. 9, 1990 and during the five-year period ending on the distribution date).

Sec. 355(d)'s purpose is to prevent taxpayers from using Sec. 355's tax-free spinoff provisions either to dispose of subsidiaries in sale-like transactions or to obtain a FMV stepped-up basis in a subsidiary for future dispositions, without incurring a corporate-level tax. The final regulations carry out this objective, as follows:

* Regs. Sec. 1.355-6(b)(2)(iii) modifies the definition of "disqualified stock," providing that stock of a distributing or controlled corporation acquired by purchase within the five-year period ceases to be treated as acquired by purchase if the basis resulting from the purchase is eliminated.

* Regs. Sec. 1.355-6(b)(3)(i) provides that a distribution is not a disqualified distribution if it does not violate the "purposes" of Sec. 355(d). The purposes of Sec. 355(d) are not violated if the effect of the distribution does not (1) increase a disqualified person's ownership in the distributing or controlled corporation or (2) provide a disqualified person with a purchased basis in the stock of any controlled corporation.

* As to the definition of "purchase" Regs. Sec. 1.355-6(d)(2)(iv) provides that a qualified stock purchase (QSP) for which a Sec. 338 election is made is not treated as a stock purchase under Sec. 355(d)(5)(A). However, any stock held by the old target treated as purchased by the new target is deemed acquired by purchase under Sec. 355(d)(5)(A) (unless a Sec. 338 or 338(h)(10) election is made).

Sec. 355(e) Temp. Regs.

Preliminarily, if Sec. 355(d) applies to a transaction, Sec. 355(e) does not apply. If Sec. 355(d) does not apply, the focus quickly shifts to Sec. 355(e). Indeed, many a tax adviser has spent time fretting over the potential application of this fairly broad provision.

In general, Sec. 355(e) requires gain recognition on the distribution of stock of a controlled corporation if such distribution is part of a plan (or a series of related transactions) under which one or more persons acquire 50% or more of the stock of either the distributing or controlled corporation. On Aug. 24, 1999, the Service issued proposed regulations under Sec. 355(e), which, for the most part, provided exclusive rebuttals for establishing that transactions were not part of a prohibited plan. (5) Under those rules, taxpayers generally had to prove, through "clear and convincing evidence," that transactions were not part of a plan (or a series of related transactions). These proposed regulations were criticized and ultimately withdrawn.

New regulations were proposed on Jan. 2, 2001, and apply a facts-and-circumstances approach to determine whether a distribution is part of a plan. (6) These regulations were ultimately made temporary, effective for transactions after Aug. 2, 2001. (7) The temporary regulations set forth a nonexclusive list of factors indicative of the presence or absence of a plan and provide several safe harbors and examples.

Temp. Regs. Sec. 1.355-7T(b) provides that whether a distribution and a stock acquisition in the distributing or controlled corporation are part of a plan is a facts-and-circumstances inquiry; no one factor is determinative. In the case of a stock acquisition in the distributing or controlled corporation after a distribution, the temporary rules generally provide that the acquisition and distribution are deemed part of a Sec. 355(e) plan if the distributing or controlled corporation (or any of their respective controlling shareholders) intended, on the distribution date, that the acquisition (or a similar acquisition) occur in connection with the distribution.

In the reverse case (i.e., the stock acquisition precedes the distribution), the temporary regulations generally provide that the acquisition and distribution are deemed part of a plan if the distributing or controlled corporation (or any of their respective controlling shareholders) intended, on the acquisition date, that a distribution occur in connection with the acquisition.

A full analysis of the temporary regulations' plan and nonplan factors, and the safe harbors and examples, is beyond the scope of this article. However, the temporary regulations' operating rules shed some light on the Service's priorities. Temp. Regs. Sec...