Category: Corporations Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com Re: D-Reorganization and Redemption Background Corporation N, a C corporation, is owned by three individuals as follows: 67.59% by N, 29.41% by J., and 3% by P. J is N's brother. P is J's son. The company consists of two divisions--Division CS and Division X--both actively operated for more than five years. The agreed-upon value of the company is $700,000. There is considerable friction between the shareholders and Mr. N wants out. He will receive a total of $473, 130 consisting of the $160,000 fair market value of Division CS plus cash of $313,130. It has been proposed that the transaction be cast as a complete redemption of Mr. N's stock. Alternatively, it has been proposed that Division CS be split off to Mr. N in conjunction with a complete redemption of his stock for $313,130 in cash. Discussion If the taxpayer, Corporation N, distributes the assets of CS division in redemption of the N's stock, the transaction would clearly be subject to Section 311(b). Gain (but not loss) would be recognized at the corporate level as if the taxpayer had sold each asset distributed at its fair market value. The statutory language is clear on its face, and there are no exceptions provided. There are no regulations for Section 311. In short, I think Section 311(b) gain is unavoidable. Regarding a D-reorganization combined with a redemption, I offer these thoughts. It appears from the information you have submitted and our conversations that it would be possible to incorporate the assets of CS division into a new, wholly-owned subsidiary, and then distribute the stock of that subsidiary to N on a tax free basis pursuant to Sections 355 and 368(a)(1)(D). This would be a so-called "split-off" transaction. The discussion that follows assumes that a valid D- reorganization is possible. If that is not the case, the following discussion is invalid. At the moment, I leave it to you to make the determination that a D-reorganization is indeed possible based on your full understanding of the facts. I stand ready to assist you with that determination if you so desire. Your letter, and my initial thinking, seemed to view this matter as being two separate transactions: a D-reorganization and then a redemption. On further reflection and after some research, I think it would be very difficult as a practical matter to bear the burden of proving that these two transactions are separate and independent. A D-reorganization--indeed any type of reorganization--requires a corporate business purpose. While there may be others in this case, the obvious and compelling corporate business purpose is the existence of significant friction between the various shareholders and the effect of that friction on the business. In this case, a D-reorganization in which only the stock of the newly incorporated CS subsidiary is distributed to N in exchange for a portion of his parent company stock would not achieve the desired business purpose of separating the antagonists. Something else is necessary, something that would entirely eliminate N from the picture. That can only be accomplished by giving N assets in addition to the CS subsidiary. With that background in mind, it seems to me difficult if not impossible to make a convincing case that the reorganization and the redemption are separate, independent events. Having so concluded, what would be the effect of distributing cash as part of the reorganization? A D-reorganization of this type allows only the stock of a controlled subsidiary to be distributed to a shareholder on a tax-free basis. See Sections 368(a)(1)(D) and 355(a)(1). Unlike some reorganizations (for example, type-B), presence of non-qualified property does not disqualify the transaction from tax-free status in its entirety. In this case, the nonqualified property is simply treated as boot which is then taxable to the recipient. See Section 356(a). The issue is how should the boot be characterized as an exchange of stock or as a dividend. Section 356(a)(2) provides if boot has the effect of the distribution of a dividend, then any gain recognized is treated as a dividend to the extent of the shareholder's ratable portion of post February 28, 1913 earnings and profits. There is no explicit definition of what is meant by "has the effect of the distribution of a dividend"; however, the phrase is reminiscent of the pre-1954 Internal Revenue Code cases dealing with redemptions of corporate stock and indeed is reminiscent of current Section 302(b)(1). Although there is no specific statutory link between Section 356(a)(2) and the redemption provisions, the courts and the IRS, through various published rulings, have in fact looked to those very provisions in making the determination of whether a boot distribution has the effect of the distribution of a dividend. With boot distributions in reorganizations in general, it matters whether the redemption tests are applied before the reorganization or after, particularly if the substantially disproportionate distribution rules of Section 302(b)(2) are in play. The Supreme Court in the case of Commissioner v. Clark, 489 U.S. 726 (1989), held that the redemption tests should be applied after the reorganization by comparing the stockholder's interest actually received in the acquiring corporation with the interest the taxpayer would have had solely if stock or securities in the acquiring corporation had been received in the reorganization exchange. Clark involved an acquisitive reorganization, a forward triangular A-merger, and thus is not directly comparable, at least in my view, with the present transaction which is a divisive reorganization. Prior to Clark, the Service issue Revenue Ruling 74-516, 1974-2 CB 121, which held that the redemption rules in a split-off with boot must be applied before the distribution of controlled stock. Subsequent to Clark, the Service issued Revenue Ruling 93-62, 1993-2 CB 118, which retained the pre-distribution redemption rule of Revenue Ruling 74-516 but changed the underlying reasoning to recognize the Clark decision and to attempt to distinguish a split-off with boot from an acquisitive reorganization with boot. The apparent reason for the Service's discomfort regarding a split-off with boot after the Clark decision is as follows. In a split-off, a shareholder exchanges stock in the distributing corporation for stock of the subsidiary. Generally, the shareholder terminates his entire interest in the distributing corporation. If the redemption standards set forth at Section 302(b) are applied to the transaction as a whole and after the transaction is completed (as Clark suggests), then the boot associated with any split-off that results in an complete termination of the shareholder's interest would be treated as a redemption under Section 302(b)(3) and not a dividend. If the redemption rules are applied before the qualifying distribution of controlled subsidiary stock, the boot transaction must be viewed in light of the substantially disproportionate distribution rules of Section 302(b)(2). Viewed in that light, many boot transactions would produce dividend treatment. Fortunately, in this case it does not seem to matter whether the redemption tests are applied before or after. It appears that the boot portion of this transaction is a redemption either under Clark as a complete termination of the shareholder's interest pursuant to Section 302(b)(3) or under the standard set forth in Revenue Ruling 93-62 as a substantially disproportionate distribution under Section 302(b)(2). As I understand it, the shareholder, N, owned 67.59% of the stock of the corporation prior to the transaction. The total value of the company is $700,000. The value of the division that will be incorporated and distributed to N is $160,000. N will get the stock of the CS division plus cash of $313,130. Looking at the distribution of cash alone, N would own 41.36% of the company after the boot distribution. Since N's ownership is less than 50% of the votes and value of the company after the distribution and N's ownership after the transaction is less than 80% of his ownership before the transaction, the substantially disproportionate test of Section 302(b)(2) is met. Thus, the boot distribution will be treated as a redemption and not a dividend. Note the other shareholders of the company are N's brother and nephew. The redemption provisions of Section 302 must be applied taking into account constructive ownership as defined under Section 318. While N is related by blood to the other shareholders, 318 does not include siblings or the children of siblings as related parties. Thus, the presence of blood relations between the shareholders is not taken into account in this case when determining ownership for purposes of Section 302(b). |
