IRS Releases Final Regulations on All Cash D ReorganizationsNovember 10, 2014
On November 10, the IRS released final regulations addressing the determination of basis in "all cash D reorganizations" in which no stock or securities of the issuing corporation are actually issued and distributed in the transaction. The final regulations provide that only a shareholder who actually owns shares in the issuing corporation in such a reorganization can designate the actual share of stock of the issuing corporation to which the basis of the stock or securities surrendered will attach. The final regulations will affect corporations that participate in all cash D reorganizations, and their shareholders.
A D reorganization is a transfer by a corporation (the "Transferor Corporation") of all or part of its assets to another corporation (the "Issuing Corporation") if, immediately after the transfer, the Transferor Corporation, or one or more of its shareholders, is in control of the Issuing Corporation, but only if, in pursuance of the plan, stock or securities of the Issuing Corporation are distributed in a transaction that qualifies under IRC Sections 354, 355, or 356.
All Cash D Reorganizations and the 2009 Final Regulations
Notwithstanding the explicit requirement in the Code, that stock or securities of the Issuing Corporation actually be distributed, neither the IRS nor the courts had required an actual issuance and distribution of stock or securities when doing so would be a "meaningless gesture" (i.e., where the same person(s) own, directly or indirectly, the stock of the Transferor Corporation and Issuing Corporation in identical proportions). Thus, it is possible to have an all cash D reorganization in which no stock or securities of the Issuing Corporation is issued. In December 2009, the IRS formalized its interpretation of the distribution requirement in the case of an all cash D reorganization in final regulations. Under the 2009 final regulations, if no actual shares of the Issuing Corporation are issued in an all cash D reorganization, the Issuing Corporation is deemed to issue a nominal share of stock to the Transferor Corporation in addition to the actual consideration exchanged for the Transferor Corporation's assets. The nominal share is then deemed distributed by the Transferor Corporation to its shareholder. If the shareholder does not own any shares of the Transferor Corporation, the nominal share is deemed to be distributed up through the chain of ownership, when appropriate, to reflect the actual ownership of the Issuing Corporation. Under the 2009 final regulations, the shareholder that is deemed to have received a nominal share of Issuing Corporation stock could, after adjusting the basis of the nominal share in accordance with regulations under IRC Section 358, designate a share of the Issuing Corporation's stock to which the basis, if any, of the nominal share would attach. The final regulations also amended Reg. 1.358-2(a)(2)(iii)(C) to provide that in the case of an all cash D reorganization, where the property received for the assets of the Transferor Corporation consists solely of non-qualifying property equal to the value of the assets transferred, the shareholder may designate the share of stock of the Issuing Corporation to which the basis, if any, of the stock or securities surrendered may attach.
The 2011 Temporary Regulations
The IRS issued temporary regulations in 2011 to address what it characterized as an inappropriate interpretation of the rules under the 2009 final regulations. The IRS illustrated the concern in the following example.
Corporation P owns all the stock of corporation S1 and corporation S2. S2 owns all of the stock of corporation S3. The assets of S3 have a net fair market value of $100x. S3 (the Transferor Corporation) transfers all of its assets to S2 (subject to liabilities) for $100x of cash. Under the 2009 final regulations, S2 (the Issuing Corporation) would be deemed to issue a nominal share of its stock to S3. S3 would be deemed to distribute the nominal S2 share to S1. Because S1 does not own any actual stock in S2, it would be deemed to have distributed the nominal share to P.
Under the 2009 regulations, any built-in loss in the shares of S3 were allocated to the nominal share. If the designation of and allocation of basis to the S2 shares actually owned by P was not made until after the deemed distribution of the nominal share by S1 to P, this built-in loss would be eliminated. S1 would not be entitled to recognize this loss on the deemed distribution of the nominal share to P because no loss may be recognized on such a distribution under IRC Section 311(b). Under IRC Section 301(d), P's basis in the nominal share would be equal to the fair market value of the nominal share and therefore would not have a built-in loss. Some taxpayers allegedly took the position that the designation and allocation of the basis of the nominal share could be made prior to the time the deemed distribution of the nominal share from S1 to P occurred. Under this interpretation, the built-in loss would be preserved in the S2 stock held by P to which the basis of the nominal share was allocated. P could then sell the share of S2's stock to which the nominal share's basis was allocated and recognize a loss or a reduced amount of gain.
The 2011 temporary regulations addressed this "incorrect interpretation" by providing that only a shareholder that owned actual shares of the Issuing Corporation could designate the share to which the basis of the nominal share would be allocated. Thus, in the above example, only P was permitted to designate its share of S2 stock to which the basis of the nominal share attached. Thus, the designation and allocation were permissible only after the deemed distribution of the nominal share by S1 to P. Under this approach, the built-in loss would not be preserved.
Impact of the Final Regulations Issued November 10, 2014
The 2011 temporary regulations would have expired on November 18, 2014. The IRS therefore issued final regulations on November 10, 2014, adopting the 2011 temporary regulations with some clarifying changes. The clarifying changes are not intended to make substantive changes to the rules in the 2011 temporary regulations. The new final regulations clarify that only a shareholder that owns actual shares in the Issuing Corporation can designate the actual share of stock of the Issuing Corporation to which the basis, if any, of the stock or securities surrendered will attach. The new final regulations also clarify the rules with respect to certain "bargain exchanges" (exchanges in which the consideration paid by the Issuing Corporation for the assets of the Transferor Corporation is less than the net fair market value of those assets). The final regulations generally are effective for exchanges and distributions of stock and securities occurring on or after January 23, 2006. Certain clarifying changes, however, are effective only for exchanges and distributions occurring on or after November 10, 2014.