Reorganization and Consolidated Rulings Issued

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The usual Friday release of a large number of letter rulings by the IRS included several rulings of interest on reorganizations and consolidated return issues.

Bankruptcy Reorganization: LTR 201208036 addresses the use of qualified settlement funds, disputed ownership funds and liquidating trusts (all referred to as trusts) to hold both some of the assets of the debtor and the securities of Newco, the corporation into which the debtor was reorganized. This debtor evidently was brought down in part by environmental liabilities. It is not clear what assets the debtor transferred to Newco in exchange for securities, but the debtor also transferred plant and equipment to one trust, other assets to another trust and Newco securities to two other trusts.

The principal issue was whether the section 368(a)(1)(G) reorganization was endangered by the fact that the three types trusts were used to administer the exchange of the Newco securities and other property for the debt claims against debtor. In other words, the debtor exchanged some of its assets with Newco for Newco securities and then transferred the Newco securities and other assets to two of the trusts for future distribution rather than transferring them directly to its creditors.

The ruling easily determined that this mechanism worked for reorganization purposes. Aside from the use of the trusts themselves, the other interesting part of the ruling was that the IRS relied on Court Holding Co., 324 U.S. 331 (1945), but only in connection with the transfer by debtor of Newco securities to the trust that was a disputed ownership find. That important, but very old ruling did not involve a reorganization but it did involve a corporation transferring its assets to its shareholders, who then purported to sell the assets to buyers. The Supreme Court ruled that the corporation sold the assets to the buyers for tax purposes.

The letter ruling obviously analogyzed the use of shareholders as agents in Court Holding with the use of the disputed ownership fund as an agent in the ruling. However, the methodology of using an agent to effect bankruptcy exchanges is so common that one wonders what was the concern. It must have been the status of the agent as a disputed ownership fund was not supported by clearly established authority, in contrast with the established rules governing qualified settlement funds and liquidating trusts.

Publicly Traded Personal Holding Company: LTR 201208025 reminds us that publicly traded corporations can be personal holding companies, although not in this case.

A personal holding company is a C corporation that is required to distribute its earnings or is taxed on undistributed earnings. Therefore, C corporations don’t want to be PHCs. However, the definition is easy to meet: a certain mix of passive income and more than half of the stock is owned by five or fewer individuals. The ownership threshold certainly can be met in the many cases of closely held corporations that go public to provide the original owners with a market for their stock. Usually the escape is provided by the passive income requirement.

The facts of this ruling stated that J owned a large amount of the stock directly, and in addition to the public, three entities that evidently were partnerships owned large blocks of stock. The partnerships had multiple owners, including individuals and four to five entities that were known to the taxpayer (possibly other partnerships). None of those owners of the partnerships overlapped, so far as taxpayer knew.

The IRS ruled that the ownership test was flunked and taxpayer was not a PHC. It is not clear exactly what the issue was, but it had to do with the unusual attribution rules in section 544. As readers will recall, there is no stock attribution for purposes of determining ownership unless a specific code rule requires attribution. Here section 455 attributes all stock owned by entities to their owners proportionately and also attributes all stock owned by partners to each other. There also is a limiter on reattribution, but it only applies to ownership caused by family attribution or attribution from another partner (not from a partnership).

This appears to mean that one partner can be deemed to own all of the stock owned by the partnership, by virtue of attribution first from the partnership to the partners proportionately, and then from partners to each other. If the partnerships owned enough stock it would be fairly easy for five or fewer individuals who are partners to own more than half of the stock. On the other hand the stock attributed from one partner to another cannot be reattributed to a third person.

It would seem that along with J, any individual member of the three partnerships could form a group of five or fewer individuals who own more than half of the stock. That was what the taxpayer was worried about. The fact that the IRS did not so rule and did not explain exactly how it reached this result suggests that the peculiar rules of section 544 attribution were at work, as explained in Rev. Rul. 89-20.

Unlike section 316 attribution, section 544 attribution whisks away ownership from shareholder X once its stock is attributed to shareholder Y. This can cause a highly complex process for identifying the five largest shareholders.

The takeaway for publicly traded corporations that have significant passive income (Berkshire Hathaway?) and large individual shareholders is to periodically make the PHC analysis, and seek a ruling when uncertain.

Consolidated Return Matching Rule: LTR 201208034 allows deferred gain arising in an earlier intercompany sale to remain deferred because the possibility of taking into account the deferred gain remains in successor property. Perhaps the more interesting aspect of the ruling is speculating on exactly what other benefits the taxpayer was getting through the domestication of a subsidiary.

Foreign Parent (FP) owns a US group, which owns Foreign Sub (FS). A group member sold FS to the common parent. The sale gain was deferred. Later FS domesticated and through merger became the owner of the rest of the group, just beneath the common parent. A possible key to the ruling is that FS issued a hybrid to the common parent that was equity for US purposes but debt for foreign country purposes.

The ruling and a required closing agreement assured the taxpayer that the series of transactions, which included two recaps of FS, would not trigger the deferred intercompany gain. This seems fairly obvious because the potential for later taking the deferred gain into account remained in replacement stock of FS. However, the IRS has not been consistent in its rulings on analogous cases and so the ruling is useful.