LTR 201203004 illustrates how to split up a public company’s two businesses, while monetizing the tax losses of one of the businesses so that it can have a better chance to survive.
The basic facts are that Distributing, the group parent, puts Business B into one subsidiary, Controlled, and spins it off tax free. Evidently Business B was the more successful business. Then Distributing exchanges all of its Business A subsidiaries with new Controlled 1 for its common and preferred stock, and sells the preferred stock to investors. The sale of the preferred stock caused the formation of Controlled 1 to fail to qualify for section 351 treatment. Therefore, Controlled 1 made a qualified stock purchase of the subsidiaries that operated Business A. Distributing and Controlled 1 made a section 338(h)(10) election, resulting in the Business A subsidiaries being deemed to sell their assets and recognize losses. The losses produced NOLs in the Distributing group, which is left owning the controlled stock of a subsidiary that has preferred stock outstanding held by investors. That subsidiary, Controlled 1, can remain in the Distributing consolidated group because the 80% test for section 351 control is different from the 80% test for affiliation.
Why was the loss recognition desirable? The clue may be in the terms of the preferred stock. It had a liquidation preference. It was sold to “Investors and Insiders.” Presumably Insiders were officers and directors, but Investors could have been corporations that would enjoy claiming a dividends received deduction on deemed dividends received on the preferred stock under section 305(c) due to the liquidation preference. Having excess NOLs allowed Distributing to forego the interest deduction it would have claimed if it had raised capital for Business B by borrowing.
The technical issues of greatest importance for the ruling were (1) the ability of Controlled 1 to make a qualified stock purchase and thus a section 338(h)(10) election; and (2) the recognition of losses in the deemed asset sales; and (3) the ability to apply section 197 amortization to intangibles. The sale of the preferred stock predominantly to unrelated persons made the QSP inevitable. The recognition of losses on the deemed asset sales was permitted by the rule under section 267 that tests relatedness after the transaction. In this case, Distributing and Controlled 1 were not related parties for section 267 purposes after the transaction. The section 197 anti-churning rules were avoided.
The taxpayer represented that a series of potentially applicable anti-abuse rules did not apply: section 269, 197, 267 and consolidated return intercompany sales. It also represented that it would have done the transactions even if losses had not been recognized. The latter representation might be hard to believe, but the IRS generally must accept such representations because it has no way to disprove them.
Conclusion: This taxpayer used a busted section 351 exchange to recognize built in losses and apparently to share the tax benefit of the loss recognition with investors in the preferred stock of a subsidiary.
