Since the repeal of the collapsible corporation rules, section 304 has been the most confusing corporate tax section in the domestic context. Its function is to convert a stock sale into a redemption for purposes of applying section 302 to determine whether the sale proceeds will be taxed as a dividend, or at least will be taxed under section 301 rather than section 1001.
But to accomplish this goal, the section has employed numerous deemings and hypothetical transactions. Every 10-15 years, either Congress or Treasury decides that these fictions require another tweak, and somehow they never quite get it right. Getting it right means writing the rules so that no taxpayer can find a way to use section 304 to obtain an advantage that Treasury thinks is inappropriate.
The latest example of a tax-advantaged use of section 304 may be LTR 201330004. Sub 3 owns all of the stock of Sub 6 and it has a built-in loss. It will sell 21 percent of Sub 6 to Sub 5 and then Sub 6 will liquidate. Subs 3 and 5 are sister corporations, but Sub 5 is not in the consolidated group with Subs 3 and 6. Reg. section 1.1502-36 will apply upon the deconsolidation of Sub 6.
The IRS ruled that section 304 applies to the sale to cause it to be taxed as a dividend. The liquidation of S will be taxed under section 331, not section 332, and section 267 will not apply to defer any loss. Obtaining an immediate recognition of loss on at least 79 percent of the stock of Sub 6 is a good enough result, but the taxpayer may have tried for more.
The ruling does not discuss what happened to Sub 3’s basis in its Sub 6 stock that was sold to Sub 5. However, commentators have asserted that the basis snaps back to Sub 3’s basis in the 79-percent block of Sub 6 stock it retained. If so, when Sub 6 liquidates, Sub 3 is treated as exchanging its entire stock basis for 79 percent of the value of Sub 6, thus, not only retaining the whole loss in Sub 6, but claiming more than its whole loss.
Whether this is possible depends on the application of Rev. Rul. 71-563. Whether this ruling is applicable is discussed below.
The standard section 302/301 basis rule is that the seller keeps the basis of the target stock redeemed, and adds it to other stock of the target held by the seller, which necessarily will produce a disproportion of basis to value, which will tend to produce loss recognition (or less gain) sometime later when the rest of the target stock is sold (or target liquidated). But that result is not improper, because the seller was denied the use of that basis when the redemption occurred, and its use later is a 2d best alternative. Also, in the redemption cases, no one is duplicating the use of the basis because the stock basis disappears inside the redeeming target.
In contrast, the standard section 304/301 basis rule is that the seller’s basis in the buyer stock (not in the target stock retained) is increased, which unlike the prior rule, keeps basis and value more properly aligned.
The alternative “proper adjustment” allowed in the section 301/301 case is for the basis to leap over from the seller to the related person whose stock ownership was attributed to the seller, which tends to have the good result of the 304/301 standard rule of keeping basis and value properly aligned.
Rev. Rul. 71-563 involved a father selling stock to a corporation owned only by his son. Section 301/301 applied, and because the father held no stock in the buyer to which the basis could be added under the normal rule, it was added to his basis in the stock of target that he retained. The ruling, in effect, applied to a 304/301 case the “proper adjustment” concept to vary the normal 304/301 rule, although that permission technically is found only in 302 authority, without citing any authority. It probably should have at least made a cf. cite to Reg. 1.302-2(c). The effect of the adjustment was to misalign basis and value; the ruling could have chosen to move the basis over to the son whose stock was attributed to the father to make section 304 apply, but did not. The resulting misalignment of basis and value looks bad when target is immediately liquidated and section 332 is thought not to apply, but aside from the quickness of the liquidation, it is no worse than the basic 302/301 rule that always misaligns basis and value.
However, in the Rev. Rul. 71-563 case there is a doubling up of basis because it is a section 304/301 transaction and not a simple redemption. Presumably 362(e)(2) would apply. But suppose that the buyer is foreign. Its loss of basis in a domestic target would have no significance.
So as long as Rev. Rul. 71-563 is on the books, and setting the liquidation of target aside, adding the basis of the 21-percent block of stock to the basis of the 79 percent of target stock retained by the seller seems to be supported. The 1997 amendment to section 304(a) does not affect this. It does give the seller momentary basis in hypothetical stock of the buyer, but that stock disappears and the basis is not used, and the only rule available to determine where the basis goes is Reg. section 1.302-2(c), which is consistent with Rev. Rul. 71-563.
If there is a problem here, it is the immediate liquidation and “use” of the retained basis to recognize a loss that could not have been recognized but for this ploy. The key to the ploy is the ability to say the step transaction doctrine does not apply to a decontrol of a wholly owned subsidiary in anticipation of its liquidation. Apparently, no one is willing to undo the decision that blessed turning off the step transaction doctrine in these cases—Granite Trust. As long as the Granite Trust rule exists, it will be applied very mechanically; i.e., you said you had not adopted the plan of liquidation and that controls . The piper may be paid to some extent in the future because value went into the buyer with no increase in stock basis to a U.S. taxpayer. Of course, the built-in gain may be less than the additional loss recognized by the seller on the liquidation.
Rev. Rul. 70-496 ruled on somewhat similar facts that the basis of the stock sold in the section 304 exchange disappears. Taxpayers did not like that ruling and it was revoked in 2003. As a policy matter, the revocation of Rev. Rul. 70-496 was correct because basis should not disappear in the world. The fact that the basis is duplicated in a section 304/301 case is the result of a code decision that is actually made more definite by the fact that the duplication may be partly turned off to the extent of loss in this very case by section 362(e).
As a policy matter in section 304(a)(1) cases, stock basis should follow value, and the 1997 amendment makes a good effort to see that that happens. However, it does not do so clearly enough to constitute an implicit revocation of Rev. Rul. 71-563. It should, however, be clear enough to cause Treasury to write some regulations carrying out that purpose. There is no good reason to separate basis from value when the sold stock lives on in the nonredemption cases. That key distinction between the 302 and the 304 cases justifies not having the basis snap back to other stock held by the stock seller.
Commentators also have wondered how section 301 can be found to apply when Sub 6 is planned to liquidate. The answer is the Granite Trust fiction. However, GCM 34601 (1971) supports the same conclusion. It involved a liquidation of target under section 332 after the section 304 sale and evaluated the section 302(b) ownership as if target continued to exist and post-sale ownership could be measured. That was probably why LTR 201330004, in effect, did the same.
Written by Jack Cummings, Partner, Tax | Alston & Bird LLP
