You will rely on section 355 for nonrecognition, but here you also must rely on section 332 to make the liquidations tax free, without any liquidation-reincorporation problem. It’s very clear that you can get the results you want, but not clear why.
LTR 201123022 describes these facts, in simplified form:
- FP owns Parent, which owns S1, which owns S2, which owns S3.
- Down under S3 is a whole collection of disregarded LLCs and a foreign sub, which FP likely wants the flexibility to sell without U.S. tax (foreign persons are not subject to U.S. tax on the sale of U.S. stock, unless it is a real property holding company). If the Parent group sold the lower tier subs, it would recognize taxable gain.
- S2 appears to be the banker for the entities below and so has given notes to them and also has lent some amount to S1.
- First, S3 checks the box to liquidate into S2, then S2 checks the box to liquidate into S1, then S1 liquidates into Parent. As a result, all of the intercompany debt is satisfied and eliminated for federal income tax purposes.
- Also, the liquidations enable S3, S2 and S1, respectively, to distribute assets up to Parent, tax free. These distributions are tax free because of the preceding liquidations; they are transfers between disregarded entities or their owners.
- Finally, Parent drops the LLCs to be distributed into Spinco, which Parent distributes to FP.
- Somewhere along the way FP “contributed” cash to Parent to be used to acquire an additional interest in a pre-existing business of Parent.
So at the end of the day, FP put cash into the Parent’s group, Parent put one of its reincorporated businesses into the hands of FP, intercompany debt was eliminated, and all of this was facilitated by the liquidations of three subsidiaries of Parent. The IRS rules these results were tax free due to section 332 and 355 and a D reorganization under section 368.
There is only one problem: part of the assets of the liquidated corporations were reincorporated in the Spinco (probably a big part). Not to worry, the taxpayer did not lie to the IRS: the taxpayer represented there was no reincorporation “except for” the reincorporation described in the ruling request.
Letter rulings have blinked at these reincorporations, going back into the early 1990s, still giving section 332 rulings. Rev. Proc. 2011-3 states that the IRS will not ordinarily rule under section 332 on “The tax effect of the liquidation of a corporation preceded or followed by the transfer of all or a part of the business assets to another corporation (1) that is the alter ego of the liquidating corporation, and (2) which, directly or indirectly, is owned more than 20 percent in value by persons holding directly or indirectly more than 20 percent in value of the liquidating corporation’s stock. For purposes of this section, ownership will be determined by application of the constructive ownership rules of § 318(a) as modified by § 304(c)(3).”
Rulings will not be issued on “Whether a transaction qualifies under § 332 for nonrecognition treatment,… unless the Service determines that there is a significant issue that must be resolved in order to decide those matters. If the Service determines that there is a significant issue, and to the extent the transaction is not described in another no-rule section, the Service will rule on the entire transaction, and not just the significant issue. However, the Service may rule on a significant issue in a transaction that occurs in the context of a § 355 distribution without ruling on the entire transaction.”
Presumably the IRS views these transactions as raising a “significant issue” in the context of a section 355 ruling and chooses to rule on the section 332 liquidation. In doing so it chooses to treat the reincorporation as not precluding the liquidation. Why, we don’t know. Perhaps the IRS views such reincorporations as benign. Perhaps it thinks that the transactions alternately could be treated as upstream C or F reorganizations and so it doesn’t matter. For now, we don’t know exactly why the IRS is willing to call off liquidation-reincorporation in section 332 cases related to section 355, but it is (but you need a ruling; don’t try this at home).
