CHAPTER SEVEN

Other Corporate Issues

§ 7.1 Introduction 426

§ 7.2 Earnings and Profits 426

(a) Introduction 426

(b) Account Adjustment 426

(i) Prior Law 427

(ii) Bankruptcy Tax Act 428

(iii) Discharge of Indebtedness Income 428

(iv) Reduction of Deficit When Shareholder’s Interest Is Terminated 428

(c) Earnings and Profit Carryover 430

§ 7.3 Incorporation 430

(a) Introduction 430

(b) I.R.C. Section 351(d) 431

(c) I.R.C. Section 351(e) 432

(d) I.R.C. Section 351(g) 432

(e) I.R.C. Section 362(e) 432

§ 7.4 Liquidation 434

(a) Old I.R.C. Section 337 434

(b) Distribution to Certain Related Parties 435

(c) Examples 435

(d) Loss Reduction 435

(e) I.R.C. Section 332 436

(f) Proposed I.R.C. Section 336(e) Regulations 439

§ 7.5 I.R.C. Section 338 440

(a) Reasons for I.R.C. Section 338 440

(b) Applicability of I.R.C. Section 338 441

(c) “Qualified Stock Purchase” 442

(d) 12-Month Acquisition Period 442

(e) Impact of a Section 338(g) Election 443

(f) Consistency Rules 444

(g) Elective Recognition of Gain or Loss by Target Corporation: I.R.C. Section 338(h)(10) 446

(h) Regulatory Evolution 448

(i) Acquisition Dates after February 13, 1997, and before February 6, 2000 448

(ii) Acquisition Dates on or after January 6, 2000 449

(iii) Current Final Regulations 450

(iv) T.D. 9071 452

(i) Election Procedures 453

(j) Summary of I.R.C. Section 338 453

§ 7.6 Limited Liability Corporation 454

§ 7.7 Other Tax Considerations 454

(a) I.R.C. Section 385 454

(b) Notice 94-47 456

(c) Codification of Economic Substance Doctrine and Imposition of Penalties 457

§ 7.8 Administrative Expenses 457

(a) Introduction 457

(b) Preregulatory Authorities 458

(i) Revenue Ruling 77-204 458

(ii) Placid Oil 458

(iii) Private Letter Ruling 9204001 459

(iv) Indopco and Related Authorities 460

(v) Abandoned Plans 462

(c) Final Indopco Regulations 463

§ 7.9 Other Administrative Issues 465

(a) Responsibility for Filing Corporate Tax Returns 465

(b) Liquidating Trusts 466

§ 7.1 INTRODUCTION

The objective of this chapter is to consider some of the miscellaneous tax topics not covered in the previous six chapters. Included here is a discussion of the impact of debt forgiveness on the earnings and profits account, limitations on the use of Internal Revenue Code (I.R.C.) section 351, corporate liquidation, application of I.R.C. section 338, exemption of bankruptcy or insolvency proceedings from personal holding company tax, impact of the establishment of a bankruptcy estate on S corporation status, and some problems encountered in determining whether an issue is debt or stock under I.R.C. section 385. This chapter also addresses a number of administrative issues not covered elsewhere.

§ 7.2 EARNINGS AND PROFITS

(a) Introduction

The earnings and profits of a corporation determine the extent to which corporate distributions are taxable at dividend rates. Earnings and profits must also be considered in determining the personal holding company tax and the accumulated earnings tax. There are two factors to be considered in analyzing the impact of bankruptcy proceedings on the earnings and profits account of a corporation. The first deals with the need to adjust the earnings and profits account by the amount that the canceled indebtedness exceeds the reduction in the basis of the assets. The second concerns the carryover of the earnings and profits balance—which is frequently a deficit—to the reorganized corporation.

(b) Account Adjustment

Prior to the passage of the Bankruptcy Tax Act of 1980, the procedures to follow in accounting for the impact of debt discharge on the earnings and profits of a corporation were unclear. The Bankruptcy Tax Act did clarify the procedures to follow in adjusting the account, but it failed to clarify the time period in which the adjustment should be made.

(i) Prior Law

Generally, the determination of the earnings and profits of a corporation for dividend purposes is based on generally accepted accounting principles that take into consideration economic realities of the transaction as well as the tax impact of a given transaction. Thus, nontaxable income items, such as interest on state and municipal bonds, increase the earnings and profits available for dividends. Similarly, losses and expenses disallowed for tax purposes reduce the earnings and profits.

Prior to the Bankruptcy Tax Act of 1980, the courts and the IRS considered the effect of debt cancellation on earnings and profit. The Tax Court, in Meyer v. Commissioner,1 reasoned that, to the extent there is a reduction in basis, there is a deferral of profit until the assets are sold. At that time, the gain will be realized and the earnings and profits will be increased by the amount of the gain. Earnings and profits, however, would never be increased by the amount that the cancellation of indebtedness exceeded the basis adjustment. Therefore, the Tax Court held that the earnings and profits should be increased by the excess.

The Eighth Circuit reversed the Tax Court decision and held that because section 395 of the Bankruptcy Act and Treasury Regulations (Treas. Reg.) section 1.61-12(b) provide that no income is realized on debt cancellation in Chapter XI proceedings, these sections preclude any adjustment to the earnings and profits account.

The IRS announced in Rev. Rul. 75-5152 that it would not follow the decision in Meyer in Chapter XI proceedings and that the deficit in earnings and profits would be reduced by the amount that the canceled debt exceeds the reduction of the basis in retained assets. Thus, there was no question regarding the nature of the adjustment to earnings and profits in prior-law Chapter XI proceedings as far as the IRS was concerned. If the earnings and profits account survives a prior-law Chapter X reorganization, it would appear that the provisions that applied to Chapter XI would also have applied to Chapter X.

In an out-of-court settlement under prior law, the debt forgiveness was considered taxable income only to the extent that the debtor was solvent after the cancellation. The taxpayer could have elected to reduce the basis by the amount subject to tax and not report the gain in gross income. The net effect was that earnings and profits, either now or at some future date, would have been increased due to the gain from debt cancellation to the extent the debtor was solvent. One question that remained unanswered under prior law was whether the earnings and profits were to be reduced by the amount of the debt forgiveness that was not subject to tax because of the debtor’s insolvency.

Treas. Reg. section 1.312-6(b) provides that among the items entering into the computation of corporate earnings and profits are income exempted by statute, income not taxable by the federal government under the Constitution, and items includable in gross income. This regulation, along with Revenue Ruling (Rev. Rul.) 75-515, provided evidence that an adjustment to earnings and profits was necessary when a gain on debt cancellation was not subject to tax. Although Rev. Rul. 75-515 dealt with bankruptcy proceedings, its application to out-of-court settlements was not necessarily precluded.

(ii) Bankruptcy Tax Act

I.R.C. section 312(l) provides two situations in which adjustments must be made to the earnings and profits account: when income is earned due to debt discharge and when stockholder interest is terminated as a result of a reorganization.

(iii) Discharge of Indebtedness Income

I.R.C. section 312(l)(1) provides that the earnings and profits of a corporation shall not include income from the discharge of indebtedness to the extent of the amount applied to reduce basis under I.R.C. section 1017. The implication is that excluded income from debt discharge under I.R.C. section 108 not used to reduce basis increases the earnings and profits of the corporation or reduces a deficit. Thus, the provision codifies the position the IRS took in Rev. Rul. 75-515.3

The year in which the adjustment is made may depend on the elections made by the debtor. For example, if the debtor elects first to reduce depreciable property, there is some question as to when to make the adjustment. The adjustments to basis are made at the beginning of the debtor’s first tax year immediately following the debt discharge. Thus, the amount of debt discharge income not available to reduce basis is not known until the next year. It has been argued that in such cases the adjustment should be made in the first tax year following discharge.4 However, if the income from debt discharge reduces the tax attributes, the earnings and profits would be reduced in the year of discharge.5

(iv) Reduction of Deficit When Shareholder’s Interest Is Terminated

I.R.C. section 312(l)(2) provides that a deficit in earnings and profits is to be reduced if the interest of any shareholder is terminated or extinguished in a title 11 or similar case under I.R.C. section 368(a)(3)(A). Note that for the reduction to take place, there must be a deficit, and the reduction is limited to the extent of the deficit. Also, the reduction may not exceed the paid-in capital allocated to the interest of the shareholder, which is terminated or extinguished.

The idea that the termination of the shareholder’s interest should be accompanied by the elimination of any deficit in the earnings and profits account attributable to the terminated interest seems to have a logical basis. However, at least one commentator suggests that it is not consistent with the concepts presented elsewhere, that the creditors generally should succeed to the interest formerly held by shareholders.6

One problem encountered in applying this provision is in determining the amount of paid-in capital. The code does not define paid-in capital. Paid-in capital is (or was previously) referred to in several I.R.C. and regulation sections:7

• I.R.C. section 382(c) (before amendment by the Tax Reform Act of 1986) used the term in one of several tests to identify stock not taken into account for purposes of the section’s reduction in tax attributes.
• I.R.C. sections 815(e)(1) and 819(b)(2) (before amendment by the Tax Reform Act of 1984) referred to paid-in capital in allocating life insurance company distributions pursuant to certain plans of mutualization.
• Treas. Reg. section 1.565-3(a) refers to paid-in-capital in describing the effect of consent dividends.
• Treas. Reg. section 1.857-7(b) illustrates distributions that are chargeable to capital rather than to accumulated earnings.
• Treas. Reg. section 1.964-1(e)(3) (prior to amendment) measured retained earnings for any year in part by reference to adjusted paid-in capital but provided no definition.
• Treas. Reg. section 20.2032-1(d)(4) refers to paid-in capital in illustrating unusual distributions of earnings to be taken into account for purposes of alternate valuations under the estate tax.

These references, however, provide little guidance. Even though the term “in capital” as used in this section relates more to a legal concept, its meaning should arguably be based on tax concepts, because the account being reduced—earnings and profits—has special tax meaning. The paid-in capital value as determined for corporate reporting purposes may be substantially different from the value used for tax purposes. For example, property contributed to form a corporation may be reported at market value at the time it is transferred to the corporation for corporate reporting purposes, but for tax purposes, generally the basis in the property must be used. Another example is a stock dividend that increases the paid-in capital for corporate reporting purposes but has no effect for tax purposes.

Under the tax concept, it has been suggested that the amount of the paid-in capital probably should be determined by reference to the tax basis to the shareholder as of the original issuance of the stock, adjusted only to reflect transactions between the corporation and the shareholder that are recognized for tax purposes.8 In other words, the amount should be computed disregarding any changes in the basis of the stock resulting from transactions with third parties, such as purchases of outstanding stock, or resulting from transactions not involving the corporation, such as the new market value basis acquired at death under I.R.C. section 1014.9

(c) Earnings and Profit Carryover

Prior to the introduction of I.R.C. section 381, the extent to which the earnings and profits account was carried over from a target corporation to an acquiring corporation following a bankruptcy settlement or reorganization was not clear. The important cases that deal with the subject all relate to the 1939 code. The decisions were based on the old law, which did not contain the provisions now found in I.R.C. section 381.

Current section 381 provides that in the case of a tax-free reorganization (including an acquisitive section 368(a)(1)(G) reorganization), the earnings and profits or deficit will carry over. However, deficits of one corporation cannot be used to reduce the amount of pre-reorganization earnings brought by any other corporation to the combination; they may be used only to offset future earnings. Again, these provisions would apply to chapter 11 and out-of-court proceedings.

§ 7.3 INCORPORATION

(a) Introduction

In general, I.R.C. section 351 provides that no gain or loss will be recognized if property is exchanged solely for stock10 of a controlled corporation. I.R.C. section 351(a) provides that no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and, immediately after the exchange, such person or persons are in control (as defined in I.R.C. section 368(c)) of such corporation. I.R.C. section 351(b) provides that if in addition to stock of the transferee, other property or money is received in exchange for property (i.e., “boot”), the transferor is required to recognize gain (not in excess of the amount of money received, plus the fair market value [FMV] of other property), but not loss. I.R.C. section 357(a) provides generally that the transferee corporation’s assumption of a liability is not treated as money or other property for purposes of I.R.C. section 351(b). I.R.C. section 357(c), however, requires a transferor in a section 351 exchange to recognize gain if the sum of the amount of the liabilities assumed by the transferee exceeds the adjusted basis of the property the transferor transfers to the transferee.11 Transactions are often structured to avoid this outcome, and thus the incorporation of property ordinarily qualifies as a tax-free transaction under I.R.C. section 351(a), even though the transferee corporation assumes liabilities in the exchange.12

As defined in I.R.C. section 368(c), “control” means stock constituting 80 percent of the aggregate voting power and 80 percent of the number of shares of each class of nonvoting stock.13 In determining “control,” all classes of voting stock are aggregated.

Note that at the outset of this description of section 351 transactions, the word “property” is italicized. In general, property includes the usual categories of tangible property as well as contract rights, leasehold interests, goodwill, employment contracts, patents, know-how, and so forth. If, however, the transferor’s “property” was a receivable owed to it by the transferee corporation, then an exchange of that receivable for stock of the transferee corporation could result in the recognition of gain or loss. Under prior law, the indebtedness of the transferee corporation that was not evidenced by a security was considered property.14 Also, a claim for accrued interest on the indebtedness of the transferee corporation was transferred property.15

(b) I.R.C. Section 351(d)

I.R.C. section 351(d), as amended by the Bankruptcy Tax Act of 1980, altered this nonrecognition provision by providing that stock issued for services, indebtedness of the transferee corporation that is not a security, and interest on this indebtedness is not considered stock issued in return for property. The net effect of this change is twofold:

Recall that control under I.R.C. section 351 means ownership of at least 80 percent of the combined voting power of all classes of voting stock and at least 80 percent of each other class of stock.16 Thus, if more than 20 percent of a debtor’s stock is issued in exchange for nonsecurity debt, the entire transaction may fail to qualify under I.R.C. section 351 and may be taxable. The usual definitional difficulties in determining what constitutes a security may, in fact, be increased because of the enactment of I.R.C. section 351(d). The changes will also affect the valuation process necessary to measure the worth of the debtor corporation’s consideration (stock).17

The changes to I.R.C. section 351 apply to transactions in both bankruptcy and nonbankruptcy situations.

(c) I.R.C. Section 351(e)

The Bankruptcy Tax Act contained another major revision to I.R.C. section 351: section 351(e)(2). I.R.C. section 351(e)(2) provides that section 351 will not apply in a bankruptcy or similar case to the extent the stock received by a transferor or debtor in exchange for the assets is used to satisfy the indebtedness of such debtor. In other words, gain or loss is recognized by the debtor upon the transfer of its assets to a controlled corporation to the extent the stock received is transferred to its creditors.18 The basis for the property, stock, or other securities received is adjusted to reflect the gain or loss recognized. The net effect of this rule is to treat the transaction in the same manner as if the property had been transferred to the creditors, who then transferred the property to a controlled corporation. Note that this restriction would not apply to contributions of capital if the stock received in return is not used to reduce outstanding debt.

The Senate Report indicates that the reason for imposing this limitation is to prevent the incorporation by a debtor of high-basis, low-value assets where a transfer of the assets directly to the creditors, followed by a transfer by the creditor to a controlled corporation, would result in an FMV basis to the corporation.19

(d) I.R.C. Section 351(g)

The Taxpayer Relief Act of 1997 amended I.R.C. section 351 to treat certain preferred stock (nonqualified preferred stock [NQPS]) as boot.20 The transferor receiving such stock is not afforded nonrecognition treatment to the extent NQPS is received. The Conference Report to the 1997 Act states that if NQPS is received, gain but not loss shall be recognized. The Internal Revenue Service Restructuring and Reform Act of 1998 further amended I.R.C. section 351 to clarify that NQPS is treated as boot in a section 351 exchange only if the transferor receives stock that is not treated as boot in addition to the NQPS. If a transferor receives solely NQPS and the transaction in the aggregate is treated as a section 351 exchange,21 the transferor could recognize a loss, and the basis of the NQPS in the hands of the transferor and the property in the hands of the transferee corporation is determined in the same manner as if the transferor received solely other property (i.e., as if the transaction were a taxable section 1001 exchange). The Conference Reports to both the 1997 and 1998 Acts confirm that the NQPS continues to be treated as stock received by the transferor for purposes of qualification of the transaction under I.R.C. section 351, unless Treasury issues regulations that provide otherwise.

(e) I.R.C. Section 362(e)

The American Jobs Creation Act of 2004 added new subsection (e) to I.R.C. section 362, imposing a limitation on the transfer or importation of built-in loss property. Under old law, the basis of property received by a corporation—whether from domestic or foreign transferors—in a tax-free I.R.C. section 351 exchange is the same as the adjusted basis of that property in the hands of the transferor, adjusted for gain or loss recognized by the transferor.22

The legislative history to the Act provides generally that in certain transactions involving transfers of built-in loss property, the basis of the property in the hands of the transferee should not be transferred basis but rather should be the fair market value (FMV) of the transferred property immediately after the transfer.23

The Act generally limits a corporation’s basis in property acquired in certain I.R.C. section 362 transfers at FMV. The limitation applies to importations of net built-in loss properties into the U.S. tax system subject to I.R.C. section 362 (i.e., I.R.C. section 351 exchanges). Property is imported into the U.S. tax system if gain or loss with respect to the property is not subject to U.S. income tax in the hands of the transferor immediately before the transfer, and gain or loss with respect to the property is subject to U.S. income tax in the hands of the transferee immediately after the transfer. If the transferee’s total basis in all such properties transferred otherwise exceeds the total FMV of the properties at the time of the transfer, the properties have a net built-in loss. Under the Act, all such properties have an FMV basis in the hands of the transferee immediately after the transfer. (There is no provision in the importation rules affecting the transferor’s basis in the stock of the transferee received in exchange for the properties.)

A transferee’s total basis in properties received from a transferor in an I.R.C. section 351 transaction that is not subject to the importation rule described above cannot exceed the total FMV of the properties immediately after the transfer. A special rule allocates the total reduction of basis among the properties received in proportion to their respective built-in loss immediately before the transaction. A transferor and transferee will be permitted to elect jointly to not have this amendment apply (thus permitting the transferee to receive a transferred basis in the properties) at a cost of having the transferor’s total basis in the transferee stock received capped at the FMV of the properties.24

The Treasury Department and IRS proposed regulations (REG-110405-05) that provide rules concerning the determination of the basis of assets and stock transferred in certain nonrecognition transactions. The proposed regulations generally apply to transfers of net built-in loss property within the U.S. tax system that otherwise would duplicate the net built-in loss in the stock of the transferee. Also included are proposals concerning the application of the limitation rules to transfers outside of the U.S. tax system and to reorganizations; the establishment of an exception for transactions in which net built-in loss is eliminated without recognition; the application of the limitation rules to transfers in exchange for securities; a clarification of the election to reduce stock basis; the effect of the limitation rules on partnerships and S corporations; and proposals concerning the application of section 336(d) to property previously transferred in a section 362(e)(2) transaction and to section 304 transactions.

Treasury and the IRS intend to issue additional guidance concerning the application of the limitation rules and the treatment of transactions that have the effect of importing losses into the U.S. tax system.

The regulations are proposed to apply to transactions occurring after the date when the rules are published as final regulations in the Federal Register.

With the issuance of the proposed regulations, Treasury issued Final Regulations section 1.1502-80(h), which provides that section 362(e) does not apply to intercompany transactions within consolidated groups on or after September 17, 2008. This exception is subject to an anti-abuse rule.

§ 7.4 LIQUIDATION

(a) Old I.R.C. Section 337

Prior to the Tax Reform Act of 1986 (TRA 1986), I.R.C. section 337 provided for no gain or loss on the sale or exchange of property pursuant to a 12-month plan of complete liquidation. Moreover, distributions of property to shareholders in complete liquidation were tax free at the corporate level.25 This escape from the corporate tax on sales and distribution was known as the General Utilities doctrine, based on the case of General Utilities and Operating Co. v. Helvering.26 Pursuant to a special exception, I.R.C. section 337 permitted an insolvent corporation to avoid recognition of gain on the sale of assets by adopting a plan of complete liquidation after a bankruptcy petition was filed and by transferring all of its assets to creditors or stockholders prior to the termination of the bankruptcy case. In a bankruptcy case, the 12-month requirement did not apply: The period began when the plan of liquidation was adopted and ended when the bankruptcy case terminated.

Effective January 1, 1987, the General Utilities doctrine and I.R.C. section 337 were repealed.27 Thus, gain (as well as some losses28) is recognized when a corporation sells or distributes its assets pursuant to a liquidation.29 In addition, gain (but not loss) is recognized when a corporation distributes appreciated property as a dividend or in a redemption.30 Distributions under I.R.C. section 35531 and complete liquidations of controlled subsidiaries (parent corporation owns 80 percent of the vote and 80 percent of the value32) generally continue to be tax free at both the shareholder and the corporate levels.

(b) Distribution to Certain Related Parties

To prevent shareholders from contributing property with a built-in loss to a corporation prior to liquidation (to offset such loss against the corporate-level gain), I.R.C. section 336(d)(1) precludes loss recognition if the distribution is to a more-than-50-percent shareholder as defined in I.R.C. section 267 and (a) the distribution is not pro rata, or (b) the property being distributed was transferred to the corporation during the previous five years (as a contribution to capital or pursuant to I.R.C. section 351). Note that for I.R.C. section 351 transactions after October 22, 2004, I.R.C. section 362(e) may apply to reduce that basis in loss property.33

(c) Examples

The following examples illustrate how loss recognition from selected transactions may be disallowed.

(d) Loss Reduction

Loss reduction rules (as opposed to total disallowance) are applied to both sales and distributions of property if the loss property is (a) acquired in a section 351 transaction or as a contribution to capital, and (b) acquired as part of a plan a principal purpose of which was to recognize loss by the liquidating corporation.34 Generally, any loss property acquired within the two years prior to the adoption of the plan of liquidation will be considered acquired as part of a plan for recognition of loss by the corporation. The Committee Reports to TRA 1986 indicate that, upon the issuance of regulations, the two-year presumption will be disregarded, “unless there is no clear and substantial relationship between the contributed property and the conduct of the corporation’s current or future business enterprises.”35 The loss reduction rules only apply if the FMV of the loss property is less than its adjusted basis at the time of its acquisition by the corporation.

The purpose of the loss reduction rule is to prevent “stuffing” a corporation with loss property prior to a complete liquidation, in order to offset other gains. Thus, this rule denies recognition of any losses accrued prior to the contribution of loss property but permits recognition of any loss accruing after the contribution. If both the loss reduction provisions and related party provisions apply, the related party provisions will prevail and will allow no recognition of loss. Note that for I.R.C. section 351 transactions after October 22, 2004, I.R.C. section 362(e) may apply to reduce the basis in the loss property.36

(e) I.R.C. Section 332

As described, in general, a liquidation is treated as a taxable distribution of assets by the liquidating corporation to its shareholders and a taxable receipt of those assets by the shareholders in exchange for their stock in the liquidating corporation. More favorable tax treatment is available for a liquidation of a subsidiary corporation into its parent corporation in conformance with the requirements of I.R.C. section 332. I.R.C. section 332 generally requires a liquidating distribution from a solvent corporation to an 80 percent owned distributee corporation within a prescribed time frame. The 80 percent ownership requirement is defined for this purpose in I.R.C. section 1504(a)(2) as ownership of 80 percent of the voting power and 80 percent of the value of all stock, excluding so-called vanilla preferred stock, defined in I.R.C. section 1504(a)(4). The solvency requirement may be more complicated. In fact, a corporation may need to be more than solvent to qualify for section 332 treatment. For example, assume that a solvent subsidiary corporation, which has assets with an FMV in excess of its indebtedness, has two classes of stock outstanding, nonvoting preferred stock and common stock. Parent owns 100 percent of both classes of stock. In liquidation, the parent of the subsidiary receives assets of the subsidiary with a value that is less than the liquidating preference of the preferred stock. As described in Commissioner v. Spaulding Bakeries, Inc.,37 because the subsidiary distributed all its assets with respect to its preferred stock and no assets with respect to its common stock, the liquidation will likely not qualify for section 332 treatment because there has not been a distribution with respect to all its stock.

Proposed regulations adopt Spaulding Bakeries.38 In order for a liquidation of a subsidiary to be tax-free under I.R.C. section 332, the proposed regulations clarify that the parent corporation must receive at least partial payment for each class of stock that it owns in the liquidating corporation. At the same time, the proposed regulations confirm that a transaction in which the parent corporation does not receive at least partial payment for each class of stock, but does receive at least partial payment for at least one class of stock, may qualify as an I.R.C. section 368 reorganization.

An insolvent subsidiary cannot be made solvent, prior to its liquidation, by having its parent cancel a debt due from the subsidiary. The liquidation of an insolvent subsidiary,39 however, entitles its parent to claim a bad debt deduction under I.R.C. section 166 and possibly a worthless stock deduction under I.R.C. section 165(g)(3).40

If a transaction satisfies the section 332 requirements, then under I.R.C. section 337(a), no gain or loss is recognized to a corporation that liquidates under I.R.C. section 332 to an 80 percent distributee. Although the liquidating corporation can recognize gain on a liquidating distribution to a minority shareholder, section 336(d) prevents the liquidating corporation from recognizing a loss on such a distribution. The Omnibus Budget Reconciliation Act of 1987 revised I.R.C. section 337(c) to require that, in determining whether there is a liquidation to an 80 percent distributee, the consolidation return regulations (and in particular the aggregate ownership rules of Treas. Reg. section 1.1502-34) cannot be used.

Thus, a liquidation of S into its 100 percent shareholder, P, results in no gain or loss to P or S. If, however, S is owned equally by P (parent of a consolidated group) and X (a wholly owned subsidiary of P and a member of the P consolidated group), the liquidation of S into P and X is tax free to P and X (Treas. Reg. section 1.152-34 continues to apply for purposes of I.R.C. section 332), but S will be taxed (I.R.C. section 337(a) is applied without regard to the aggregation rules of Treas. Reg. section 1.1502-34).41 The gain at the S level is an intercompany item subject to the recognition rules of Treas. Reg. section 1.1502-13.

If, in this example, P owned 80 percent of S and X owned 20 percent, I.R.C. section 337(a) would protect the portion of the liquidating distribution made to P, but a deferred gain would result to S on the portion of the distribution to X (triggered under the same circumstances as above).42

The deferred gain in a consolidated context and an immediate gain or loss in a nonconsolidated context can be avoided if, using the previous example, P and X jointly own all of the stock of S, P owns 100 percent of X, and X liquidates into P prior to S liquidating into P.

The I.R.C. section 332 changes were made to prevent the use of “mirror subsidiaries”43 to avoid the repeal of the General Utilities doctrine. The changes also affect an “old and cold” ownership of a subsidiary that liquidates into multiple members of a consolidated group. It appears that the intent is to grandfather all mirror structures established before December 15, 1987.

As described in connection with section 351, the American Jobs Creation Act of 2004 imposes a limitation on the transfer or importation of built-in loss property. Because this limitation applies to transactions in which basis is computed under section 362, it applies to section 332 transactions in addition to section 351 and section 368 transactions. Under old law, the basis of property received by a corporation—whether from domestic or foreign transferors—in a tax-free liquidation of a subsidiary corporation was the same as the adjusted basis of that property in the hands of the transferor, adjusted for gain or loss recognized by the transferor.44

The legislative history to the Act provides generally that in certain transactions involving transfers of built-in loss property, the basis of the property in the hands of the transferee should not be transferred basis but rather should be the FMV of the transferred property immediately after the transfer.45

The Act generally limits a corporation’s basis in property acquired in an I.R.C. section 362 transfer at FMV. The limitation applies to transfers of net built-in loss property into the U.S. tax system subject to I.R.C. section 334(b) (i.e., I.R.C. section 332 subsidiary liquidations). The changes to section I.R.C. 334(b)(1) refer to the amendments to I.R.C. section 362. The amendment applies if all properties imported into the U.S. tax system in a liquidation to a domestic corporate distributee have a total basis that otherwise exceeds their total FMV. If the change applies, I.R.C. section 334(b)(1) fixes the basis of all property received in the liquidation at FMV.46

(f) Proposed I.R.C. Section 336(e) Regulations

The Treasury Department and the IRS on August 22, 2008, released proposed regulations47 that would allow taxpayers in certain limited situations to elect to treat sales, exchanges, and distributions of a target corporation’s stock as taxable sales of the target’s assets, pursuant to I.R.C. section 336(e).

I.R.C. section 336(e) authorizes regulations under which a corporation (seller) (1) owns stock in another corporation (target) that meets the requirements of I.R.C. section 1504(a)(2), and (2) sells, exchanges, or distributes all of target’s stock to make an election to treat the sale, exchange, or distribution of the target stock as a sale of all of target’s underlying assets rather than as a sale, exchange, or distribution of such stock.

I.R.C. section 336(e) is part of the 1986 legislative changes that repealed the General Utilities rule. It is intended to provide taxpayers relief from potential multiple taxation at the corporate level of the same economic gain that can result when a transfer of appreciated corporate stock is taxed to a corporation without providing a corresponding step-up in the basis of the assets of the corporation.

Although the 1986 legislation authorized an I.R.C. section 336(e) election in a broad set of circumstances, the preamble to the proposed regulations states that their scope is limited “in order to provide guidance to a large number of taxpayers in the most efficient manner possible.” The proposed regulations include the requirements and mechanics for—and consequences of—treating a stock sale, exchange, or distribution that would not otherwise be eligible for an I.R.C. section 338 election as a deemed asset sale.

The preamble indicates that the proposed regulations do not authorize the making of I.R.C. section 336(e) elections under all the circumstances under the statutory grant of regulatory authority. For instance:

• The proposed regulations do not apply to transactions between related persons. (Persons are “related” if stock in a corporation owned by one of the persons would be attributed to the other person under I.R.C. section 318(a), other than I.R.C. section 318(a)(4).)
• The proposed regulations do not apply to transactions in which either the seller or the target is a foreign corporation.

The regulations are proposed to apply on the date after they are published in final form in the Federal Register.

Some high-level observations of the regulations are that they:

• Generally adopt the approach and consequences of an I.R.C. section 338(h)(10) election—that is, deemed sale and liquidation, allocation of basis, and so on
• Do not require that the seller dispose of all of its target stock, rather the seller is required to dispose of an amount of target stock meeting the requirement of I.R.C. section 1504(a)(2)
• Permit sales, exchanges, and distributions to be aggregated for purposes of satisfying the I.R.C. section 1504(a)(2) requirement
• Generally do not change the tax consequences with respect to the acquirer of target stock, other than any effect that may flow from the target-level gain; recognition (e.g., creating earnings and profits prior to a distribution, affecting the basis in the target assets, etc.)
• Provide that generally all members of a seller’s consolidated group are treated as a single seller
• Do not apply to a target that is an S corporation (note that the IRS permits an S corporation to be a target for an I.R.C. section 338(h)(10) election)
• Limit losses in the context of a distribution
• Allow, subject to special rules, an I.R.C. section 336(e) election in an otherwise tax-free spin-off if the distributing corporation would otherwise recognize the full amount of gain from a disposition described in I.R.C. section 355(d)(2) or (e)(2).

§ 7.5 I.R.C. SECTION 338

A common objective of corporate acquisitions is to obtain the assets of the acquired corporation (“target”) at a basis equal to their FMV. This objective is easily achieved by purchasing the target’s assets. Often, however, the shareholders of the target prefer to sell their stock rather than authorize the target to sell its assets. If stock of the target is purchased, I.R.C. section 338 provides an election mechanism to achieve a step-up in the basis of assets.

(a) Reasons for I.R.C. Section 338

The 1982 enactment of I.R.C. section 338 was rooted in certain inequities and complexities inherent in the application of its predecessor, I.R.C. section 334(b)(2). I.R.C. section 334(b)(2) required, as a prerequisite to basis step-up, that the target be completely liquidated. If the acquiring corporation found it desirable to operate the business of the target as a subsidiary, it would be frustrated by the requirement to liquidate the target. Any attempt to “drop down” the target assets after a complete liquidation ran the risk of being challenged under the concept of liquidation-reincorporation as less than a complete liquidation48 and thus of failing to qualify under I.R.C. section 334(b)(2) for the desired basis step-up. Although a complete liquidation of the target was required under I.R.C. section 334(b)(2), this liquidation could occur five years or more after the date the stock was purchased.49 The operations of the target during this interim period (the time between the purchase of stock and the liquidation) resulted in certain adjustments to the basis of the target stock in the hands of the purchasing corporation50 and hence to the basis of the assets received in the ensuing liquidation. These “interim adjustments” were among the most complex and misunderstood rules of corporate taxation and could, in fact, result in a higher basis than if the target’s assets had been purchased directly. Because of these complexities, and to provide a more flexible elective regime, Congress chose to repeal I.R.C. section 334(b)(2) and replace it with I.R.C. section 338. Unfortunately, I.R.C. section 338 falls short of its goal of simplicity.

(b) Applicability of I.R.C. Section 338

Because an I.R.C. section 338(g) election results in a deemed taxable sale of assets, as will be described in subsection (e) below , the repeal of the General Utilities doctrine under TRA 1986 substantially reduced the usefulness of I.R.C. section 338. Although the section remains intact, there will be few situations in which the corporate purchaser of a target corporation will choose to pay tax (on the appreciation in all target assets, not just recaptures) merely to receive a step-up in basis for certain depreciable assets. However, I.R.C. section 338 and the regulations promulgated thereunder have continued importance in three respects:

As will be described in greater detail, section 338 has been fertile ground for regulatory development, with the result that the applicable rules vary considerably depending on the tax years at issue. The discussion below will provide a broad overview of the section 338 rules and will then be followed by a discussion of significant regulatory developments.

(c) “Qualified Stock Purchase”

The threshold requirement for obtaining an FMV basis under section 338 is to make a “qualified stock purchase” (QSP).51 A QSP is an acquisition by purchase by one corporation (and other members of its affiliated group) of stock in another corporation possessing at least 80 percent of the voting power and at least 80 percent of the value of the total stock of the purchased corporation. This purchase must occur during a 12-month acquisition period.52

To acquire a target’s stock by purchase, the purchasing corporation must not acquire it (1) from a related party whose ownership of the target stock would be attributed to the purchasing corporation under I.R.C. section 318(a) (applied without certain of the section 318 attribution rules); (2) in an exchange described in I.R.C. sections 351, 354, 355, or 356; or (3) in a transaction in which the purchasing corporation’s basis is determined in whole or in part by the basis of the “seller” in the target stock.53 There are several exceptions to these general rules for stock acquired from a related corporation that was itself recently acquired in whole or in part in a taxable purchase.54

(d) 12-Month Acquisition Period

The 12-month acquisition period is the 12-month period beginning with the date of the first acquisition by purchase of stock included in a QSP.55 Suppose Corporation X makes the following cash purchases of Corporation Y’s stock from unrelated individuals: On January 10, 2000, Corporation X purchases 10 percent; on March 20, 2000, an additional 5 percent; on December 1, 2000, an additional 60 percent; on January 30, 2001, an additional 15 percent, and the remaining 10 percent on February 25, 2001. The 12-month acquisition period would begin on March 20, 2000, because between March 20, 2000, and March 20, 2001, Corporation X would have acquired by purchase 90 percent of Corporation Y’s stock (X did not acquire 80 percent of the Y stock during the 12-month period beginning January 10, 2000). The day within the 12-month acquisition period on which the purchasing corporation acquires the requisite percentage of the target’s stock to achieve a QSP is the acquisition date.56 In this example, January 30, 2001, would be the acquisition date.

(e) Impact of a Section 338(g) Election

The filing of a section 338(g) election has these results: The target is treated, for federal income tax purposes, as if it sold all its assets for FMV at the close of the acquisition date in a single taxable transaction, and the target is treated, as of the beginning of the day after the acquisition date, as a new corporation that purchased all those assets.57 The deemed sale by target of its assets will cause the target to recognize income based on the difference between the FMV of the assets in the target’s hands and the basis of those assets in the target’s hands. The deemed sale is a sale from target (Old T) to itself (New T). Old T is treated as having sold all of its assets for an amount designated as the aggregate deemed sales price (ADSP), and New T is treated as having purchased those assets for an amount designated as the adjusted grossed-up basis (AGUB).

In general, ADSP is the sum of (1) the amount realized on the sale of the target stock to the purchasing corporation and (2) the liabilities of Old T.58 In general, the liabilities of the Old T are the liabilities of target (and the liabilities to which the target assets are subject) as of the beginning of the day after the acquisition date. To be taken into account in ADSP, a liability must be one that would be taken into account as an amount realized under general principles of tax law had target sold its assets to an unrelated purchaser for consideration that included an assumption by the purchaser of the liabilities of the target (or a purchaser’s taking of assets subject to target liabilities). For example, ADSP includes the tax liability for the deemed sale gain, unless the tax liability is borne by some person other than the Target.

In general, the deemed purchase price (the AGUB) is equal to the purchasing corporation’s basis in the target stock, adjusted for liabilities of the target as of the beginning of the day after the acquisition date (including income tax liability resulting from the deemed sale of its assets under I.R.C. section 338(a)(1)).59 This purchase price is then allocated to the assets of the target using a residual approach. That approach, which was introduced into the law by TRA 1986, mandates the residual method for allocating goodwill (including the entire basis allocation regulations of I.R.C. section 338) for an asset acquisition of a business. Thus, to provide consistency, the section 338 basis rules are applicable when (1) 80 percent of the target’s stock is purchased and a section 338(g) election is made, (2) the purchasing corporation acquires all of the target’s assets, or (3) the purchasing corporation acquires one of the seller’s many businesses (whether or not the seller is a corporation). If the purchasing corporation has made a QSP (i.e., at least 80 percent of the required classes of stock) but has not purchased 100 percent of the target’s stock, an additional refinement reflecting a grossing up of the price of recently purchased target stock must be made to its basis in the target stock.60

Prior to 1982, this income could be offset by using losses of the purchasing corporation or other corporations included in a consolidated return with the purchasing corporation and target. However, pursuant to I.R.C. section 338, the target’s deemed sale of assets is not includable in the purchasing corporation’s consolidated return.61 The deemed sale is includable in the target’s final separate return where the target is not a member of a consolidated return group and is includable in the target’s final consolidated return where the target is the common parent of a consolidated return group. Finally, the deemed sale is not includable in a consolidated return where the target is not the common parent of the consolidated return group.62 Instead, the target is disaffiliated from its group immediately before the deemed sale and includes the deemed sale in a separate “deemed sale return.”63

(f) Consistency Rules

As originally enacted, I.R.C. section 338 was concerned with consistent treatment if a purchasing corporation acquired assets of the target (or an affiliate) at the same time that it made a QSP of the target stock, or if a purchasing corporation acquired the stock of two or more members of an affiliate group. These rules are less important than they were prior to the repeal of the General Utilities doctrine, but they survive in altered form. Proposed consistency regulations were finalized on December 22, 1993 (effective for targets with acquisition dates on or after January 20, 1994).64 The final regulations under I.R.C. section 338 restate, simplify, and substantially shorten the previous version of the regulations. Substantive changes were made in the stock and asset consistency rules under I.R.C. section 338(e) and (f), in an effort to simplify their application and narrow their scope. Gone from the lexicon are the concepts of protective carryover basis election, affirmative action carryover election, unincluded company asset acquisition, intercompany consolidated asset acquisition, and offset prohibition election. The discussion that follows focuses on the asset and stock consistency rules under current Treas. Reg. section 1.338-8.

With the repeal of the General Utilities doctrine, the old consistency rules no longer served their intended purpose of preventing cherry-picking of assets from target corporations without attendant tax costs. Because a basis step-up is accompanied by full gain recognition, the utility of the old consistency rules was greatly diminished. As a result, the final consistency rules address only limited circumstances where selectivity of asset or stock purchases may provide potential tax advantages to a purchaser.

Under the current rules, an acquisition by the buyer of (1) stock in a QSP and (2) an asset from the target, during the consistency period, will not deem or require a section 338 election to occur. Instead, the asset will have a cost basis unless the consistency rules require a carryover basis (this is known as the carryover basis rule). This is a simple general rule. However, in the few situations where a taxpayer seeks to circumvent the rules, a complex and convoluted set of “indirect acquisition” rules alters the carryover basis rule.

Generally, the consistency rules operate in the context of a consolidated return to prevent acquisitions from being structured to take advantage of the investment adjustment rules of Treas. Reg. section 1.1502-32. Under the carryover basis rule, an asset must take a carryover basis if:

• The asset is disposed of during the target consistency period;
• The basis of the target stock reflects gain from the disposition of the asset; and
• The asset is owned, immediately after its acquisition and on the target acquisition date, by a corporation that acquires stock of target in the QSP (or by an affiliate of an acquiring corporation).

The carryover basis rule generally applies to direct acquisitions of assets from T, a subsidiary in a consolidated group, by P, the purchaser (or an affiliate of P), during T’s consistency period. The rule also applies to assets acquired from lower-tier T affiliates or certain conduits if gain from the sale is reflected in the basis of the T stock under Treas. Reg. section 1.1502-32.

In Example 7.5, P may make a section 338 election or a section 338(h)(10) election to treat the purchase of the T stock as an asset acquisition and thus maintain a cost basis in the directly acquired asset.

The consistency rules also apply where a 100 percent dividends-received deduction (DRD) is used in conjunction with an asset disposition to achieve a result similar to that available under the investment adjustment rules. If the dividend paid during the consistency period that ends on the target acquisition date, and to which the 100 percent DRD is taken, exceeds the greater of $250,000 or 125 percent of the yearly average amount of dividends paid during the prior three years, the consistency rules apply.

(g) Elective Recognition of Gain or Loss by Target Corporation: I.R.C. Section 338(h)(10)

A section 338(g) election by a purchasing corporation has no effect on the seller of the target corporation, which treats the disposition of the target as a stock sale. I.R.C. section 338(h)(10) allows the purchasing corporation and specified sellers to make a joint election to permit the seller as well as the purchaser to treat the stock sale as an asset sale by the target corporation. The specified sellers are sellers that could have liquidated target and then sold its assets (or sold target and then liquidated) without incurring two levels of tax. Under former temporary regulations, the election was available only for a member of a consolidated group other than the common parent. Former final regulations, applicable to acquisition dates on or after January 20, 1994, or before January 6, 2000, added two previously excluded targets: S corporations and nonconsolidated affiliates. The new final regulations retain the same types of targets for which a section 338(h)(10) election can be made.65

As a result of a section 338(h)(10) election, the target is treated as selling all of its assets to an unrelated party in exchange for consideration that includes the assumption of or taking subject to liabilities in a single transaction at the close of the acquisition date, but while the target was a member of the selling consolidated group (or owned by the selling affiliate or owned by the S corporation shareholders).66 After the deemed asset sale and while target is a member of the consolidated group (or owned by the selling affiliate or owned by the S corporation shareholders), target is treated as if it transferred all of its assets to members of the selling consolidated group, the selling affiliate, or the S corporation shareholders and as if it ceased to exist.67 Note that target remains liable for the tax liabilities of “old target,” including the tax liability for the deemed sale gain.68

Generally, the section 338(h)(10) election is attractive to a selling corporation if its basis in target stock is less than, equal to, or not substantially greater than the target’s net basis in its assets (aggregate basis of assets less liabilities). Use of a section 338(h)(10) election will also be beneficial if the selling group (and in particular the target) has net operating losses, which can “shelter” the target’s gain on its hypothetical asset sale. Finally, the seller can distribute the proceeds of a section 338(h)(10) sale to its own shareholders in a transaction that may qualify as a partial liquidation. In addition, if target distributes assets to the seller prior to the sale of target stock for which a section 338(h)(10) election is made, the distribution may be treated as part of a deemed tax-free section 332 liquidation of target.69 Neither a straight section 338 election nor a mere sale of stock will so qualify.70

The current regulations provide that the deemed sale and liquidation will be characterized for federal income tax consequences as if the parties had actually engaged in the transactions that were deemed to occur.71 The regulations note that in most cases the transfer of assets in the deemed liquidation will be treated as a distribution in complete liquidation to which I.R.C. section 336 or section 337 applies.72

However, even if the target is a wholly owned subsidiary, tax-free I.R.C. section 332/337 treatment is not guaranteed. The target must satisfy the standards necessary for a tax-free liquidation, such as the solvency requirement.73 For example, in a chief counsel advice, the IRS held that a capital contribution of debt by the shareholder/parent to an insolvent target (prior to the actual sale of the target stock) prevented the deemed liquidation of the target from qualifying as a tax-free liquidation under I.R.C. section 332.74

(h) Regulatory Evolution

(i) Acquisition Dates after February 13, 1997, and before February 6, 2000

In 1993, Congress added I.R.C. section 197 (Amortization of Goodwill and Certain Other Intangibles) to the code. Prior to the enactment of I.R.C. section 197, amortization of the cost of an intangible asset was permitted only if the asset was distinct from goodwill or going concern value and the asset had a determinable useful life that could be estimated with reasonable accuracy. I.R.C. section 197 allows taxpayers to amortize certain acquired intangible assets over 15 years.

The report of the House Committee on Ways and Means accompanying the 1993 Act states that the drafters of I.R.C. section 197 anticipated that the residual method specified in the I.R.C. section 1060 and 338(b) regulations then in effect would be modified to treat all amortizable I.R.C. section 197 intangibles as Class IV assets and that this modification would apply to any acquisition of property to which I.R.C. section 197 applies.76 The regulations referred to in that legislative history generally provided for a residual method of allocation of purchase price, which placed an acquired asset into one of four asset classes. No asset in any class except for the last class could be allocated more than its FMV. The four classes specified by the regulations were:

On January 16, 1997, the IRS issued various amendments (the “allocation amendments”) to the final and temporary section 1060 and section 338(b) regulations providing for a change in the method of allocating the purchase price among the intangible assets of an acquired trade or business.77 With a minor modification, these amendments conformed the regulations to the 1993 Act legislative history. The amendments placed amortizable I.R.C. section 197 intangibles in Class IV, but they modified the treatment of goodwill and going concern value slightly. According to the allocation amendments, all I.R.C. section 197 intangibles except goodwill and going concern value (whether amortizable or not) were placed in Class IV, and goodwill and going concern value (whether amortizable or not) were placed in a new class, Class V.

The rationale for excluding goodwill and going concern value from Class IV was that, generally, when a buyer purchases assets subject to I.R.C. section 197, those assets can become amortizable I.R.C. section 197 intangibles even though they were not amortizable in the hands of the sellers. If the 1993 legislative history were applied literally, the seller would include the asset in Class III and the buyer would include the asset in Class IV. This rule would result in inconsistent reporting positions between the buyer and the seller. Citing strong policy concerns, including mandatory application of the rule of Commissioner v. Danielson,78 the IRS determined, and these amendments required, that all I.R.C. section 197 intangibles (other than goodwill and going concern value), whether amortizable or not, were to be placed in Class IV.

The rationale for placing goodwill and going concern value in a true residual class, Class V, is that the IRS was concerned that placing all I.R.C. section 197 intangibles (including goodwill and going concern value) in Class IV would require taxpayers to determine the FMV of goodwill and going concern for purposes of allocating purchase price to all the Class IV assets. The IRS was also concerned that if all I.R.C. section 197 intangibles were included in the most junior class, an allocation of purchase price could result in allocating more than FMV to each of the intangible assets in that class, possibly resulting in an unwarranted deferral of gain upon the sale of one of these assets.

With the enactment of I.R.C. section 197, many believed that the need to separately determine the FMVs of intangible assets had been eliminated. These allocation amendments reintroduced the requirement that separate values be determined, at least with respect to the intangibles that are severable from an ongoing business.

(ii) Acquisition Dates on or after January 6, 2000

In January 2000, the IRS and Treasury Department issued new temporary regulations under I.R.C. sections 338 and 1060, effective for transactions occurring on or after January 6, 2000.79 The new temporary regulations removed and replaced many of the former temporary and final regulations under I.R.C. sections 338 and 1060. The new temporary section 1060 regulations incorporated the new temporary section 338 regulations by cross-reference.

The new temporary regulations retained the residual method for purposes of allocating purchase price to target’s assets. The new temporary regulations, however, increased the number of asset classes from five to seven, adding new classes for receivables arising in the ordinary course of business and for inventory-type property. In particular, old Class III (the all-other-assets category) is subdivided into new Classes III, IV, and V.80 The new classes are:

The two new classes are intended to mitigate the phantom-income problem that existed under the former regulations. Under the former regulations, if the purchaser used contingent consideration, the former residual method sometimes caused certain assets to not have basis allocated in an amount equal to their FMV. If these assets were sold, the purchaser realized gain on the disposition, even if the asset values had not changed since the acquisition date of the target stock. In later years, if the purchaser paid additional amounts for the target stock, the purchaser could receive a deduction to offset the effect of the gain recognized. The “overrecognized” gain was commonly referred to as phantom income. The phantom-income problem was most acute for assets that turned over quickly.

The temporary regulations also altered the definitions of ADSP and AGUB, described earlier, and eliminated the concept of modified aggregate deemed sales price (MADSP), which was a modified version of ADSP previously applicable to I.R.C. section 338(h)(10) elections. And, as described, the temporary regulations removed a previous linkage between ADSP and AGUB that effectively afforded a target company so-called open transaction treatment, contrary to general tax principles.

(iii) Current Final Regulations

Effective March 16, 2001, Treasury Decision 894082 adopted with modifications the proposed regulations published on August 10, 1999, and the temporary regulations (T.D. 8858)83 published on January 7, 2000. Several of the changes included in the new final regulations are summarized next.

The proposed and temporary regulations included an anti-abuse rule to prevent taxpayers from changing the results of the residual method by engaging in asset-stuffing or asset-stripping transactions that have a transitory economic effect with respect to the ownership or use of assets. Although the anti-abuse rule is retained, several changes have been made to clarify its intended scope.84

The final regulations add a new rule clarifying that the “next day rule” of Treas. Reg. section 1.1502-76(b) applies in an I.R.C. section 338 context. The next day rule provides that if, on the day of a consolidated group member’s change in status as a member, a transaction occurs that is properly allocable to the portion of the member’s day after the event resulting in the change, the member and all related persons must treat the transaction as occurring at the beginning of the following day. Under the new rule, if an I.R.C. section 338 election is made for target and target engages in a transaction outside the ordinary course of business on the acquisition date, the transaction is treated as occurring at the beginning of the day following the transaction and after the deemed asset purchase by new target.85

The proposed regulations contained a definition of “purchase” requiring that more than a nominal amount be paid for the target stock to have a QSP. The temporary regulations reserved on the issue. The final regulations do not contain the more-than-nominal-amount requirement. Rather, target stock (or target affiliate stock) is considered purchased if, under general principles of tax law, the purchasing corporation is considered to own stock.86

The final regulations provide a new rule that the acquisition of target stock for consideration other than voting stock will not prevent the subsequent transfer of target assets to the purchasing corporation (or another member of the affiliated group) from qualifying as a C reorganization.87

The final regulations confirm the changes to ADSP and AGUB described earlier, clarifying in the preamble to the final regulations that a tax liability generally is treated like any other type of liability for purposes of computing ADSP and AGUB.88

The final regulations remove this language contained in the proposed and temporary regulations: “[in] certain cases, the IRS may make an independent showing of the value of goodwill and going concern value as a means of calling into question the validity of the taxpayer’s valuation of other assets.” Nevertheless, according to the preamble, the IRS retains the ability to challenge a taxpayer’s valuation of assets in Classes I through VI, but will do so on grounds consistent with the residual method of allocation.89

The final regulations continue to apply the “top-down” allocation system. Under this system, stock of a lower-tier subsidiary is allocated purchase price in the general asset category (Class V). The deemed purchase price of that lower-tier subsidiary’s assets is in turn computed from the amount allocated to its stock. The final regulations modify the scope of Class II assets (i.e., generally meaning actively traded personal property) providing that Class II assets do not include stock of target affiliates, other than actively traded stock described in I.R.C. section 1504(a)(4) (certain preferred stock).90

The final regulations expand the category of assets that are Class III assets. Under the proposed and temporary regulations, Class III assets generally consisted of accounts receivable, mortgages, and credit card receivables. Under the final regulations, Class III assets generally are assets that a taxpayer marks to market at least annually and certain debt instruments, excluding debt instruments issued by a related person and certain contingent payment and convertible debt instruments.91

The final regulations remove the rules providing special treatment for changes in ADSP and AGUB occurring before the close of new target’s first tax year. Rather, the general redetermination rules of Treas. Reg. section 1.338-7 apply to the allocation of all changes of AGUB and ADSP that occur after the acquisition date of target. Treas. Reg. section 1.338-7(a) provides that ADSP and AGUB are redetermined at such time and in such manner as an increase or decrease would be required under general principles of tax law for the elements of ADSP and AGUB.92

The final regulations also provide that the deemed sale and liquidation will be characterized for federal income tax consequences as if the parties had actually engaged in the transactions that were deemed to occur.93

The final regulations address several issues related to S corporation targets. For example, a payment of varying amounts to S corporation shareholders in a transaction for which a section 338(h)(10) election is made will not cause the S corporation to violate the single-class-of-stock requirement, provided that varying amounts are determined at arm’s-length negotiations with the purchaser.94

(iv) T.D. 9071

In July 2003, the IRS and Treasury released final and temporary regulations (T.D. 9071)95 that provide generally that if a section 338(h)(10) election is made as part of a multistep transaction, the purchasing corporation’s acquisition of target stock will be treated as a QSP for all federal income tax purposes, even if the overall transaction would otherwise be integrated and treated as a tax-free reorganization in the absence of an I.R.C. section 338(h)(10) election.

These regulations were forecast by Rev. Rul. 2001-46,96 in which the IRS applied the Step Transaction doctrine to treat a series of transactions occurring pursuant to a single plan—encompassing a first-step acquisition merger of a subsidiary of acquiring into target that would otherwise constitute a QSP, followed by a second-step upstream merger of target into acquiring—as a single statutory merger of target into acquiring.

In Situation 1 of Rev. Rul. 2001-46, Corporation X owned all of the stock of newly formed Y. Pursuant to an integrated plan, X acquired all of the stock of T (an unrelated corporation) in a statutory merger of Y into T (the Acquisition Merger) with T surviving. In the Acquisition Merger, the T shareholders exchanged T stock for consideration consisting of 70 percent X voting stock and 30 percent cash. After the Acquisition Merger, and as part of the plan, T merged into X in a statutory merger (the Upstream Merger).

The ruling provides that if viewed separately from the Upstream Merger, the Acquisition Merger would qualify as a QSP. However, in Rev. Rul. 2001-46, the IRS applied the step transaction doctrine to the Acquisition Merger and the Upstream Merger, treating the integrated transaction as an acquisition by X of all of T’s assets in a single statutory merger qualifying as a reorganization under I.R.C. section 368(a)(1)(A).

As contemplated by Rev. Rul. 2001-46, T.D. 9071 adopts new final and temporary regulations to give effect to I.R.C. section 338(h)(10) elections in multistep transactions in which the purchasing corporation’s acquisition of the target’s stock, viewed independently, constitutes a QSP.

The final and temporary regulations are applicable to acquisitions of stock occurring on or after July 9, 2003. The regulations provide taxpayers flexibility in structuring and planning the tax consequences of an acquisition and represent a novel approach by the Treasury in which tax-free reorganization treatment is, in certain circumstances, elective.

Rev. Rul. 2008-2597 is also of note. In form it involved an acquisition of stock of a target corporation in an I.R.C. section 368(a)(2)(E) reverse triangular merger, followed by a liquidation of the target (not accompanied by an upstream merger). If the reverse triangular merger and subsequent liquidation were stepped together, the integrated transaction would not qualify as a tax-free I.R.C. section 368 reorganization. The ruling disqualifies tax-free treatment with respect to the first step stock acquisition and treats the transaction as a QSP under I.R.C. section 338(d)(3), followed by a tax-free I.R.C. section 332 liquidation.

(i) Election Procedures

An election to be treated under I.R.C. section 338 must be filed by the purchasing corporation on Form 8023, Elections Under Section 338 for Corporations Making QSPs.98 The final regulations indicate that the IRS will recognize the validity of otherwise valid section 338(h)(10) elections made on the 1997 version of Form 8023 (Elections Under Section 338 for Corporations Making QSPs) not signed by nonselling S corporation shareholders, provided the S corporation target and all of its shareholders report the tax consequences consistent with the results of I.R.C. section 338(h)(10).99 Revised Form 8023 and Form 8883 reflect changes made by the final regulations. Revised Form 8023 also reflects the requirement that certain information now be reported on Form 8883, rather than on Form 8023. For example, the ADSP and the AGUB are now reported on Form 8883 rather than on Form 8023. The addition of Form 8883 also allows taxpayers to file a complete, timely I.R.C. section 338 election on Form 8023 even if all the information required to be supplied separately on Form 8883 is not available.

Form 8023 is filed with the IRS processing center in Ogden, Utah. Form 8023 is no longer required to be attached to either new target’s, old target’s, or the purchasing corporation’s income tax returns. Form 8883 is filed by old target and by new target. In general, Form 8883 is attached to the return on which the effects of the I.R.C. section 338 deemed sale and purchase of the target’s assets are required to be reported.

(j) Summary of I.R.C. Section 338

In summary, I.R.C. section 338 represents the only means of obtaining a step-up in basis in assets of a target following a purchase by an acquiring corporation of the target’s stock. The need for a liquidation, as under prior law, has been replaced with an election and deemed sale of assets. These results are achieved in a complex statutory scheme that includes broad delegation of power to the Treasury Department. In at least 16 instances, I.R.C. section 338 authorizes Treasury to write regulations to carry into effect the code provisions.100 Although the Tax Reform Act of 1986 substantially reduced the desirability of affirmatively making a section 338(g) election, knowledge of the I.R.C. section 338 rules is still important.

§ 7.6 LIMITED LIABILITY CORPORATION

In 2004, the Ninth Circuit Bankruptcy Appellate Panel (BAP) affirmed a bankruptcy court decision ordering the IRS and the California Franchise Tax Board to return to the bankruptcy estate of a limited liability corporation (LLC) payments it made to satisfy the estimated tax liabilities of its owners, because the funds were the separate property of the LLC’s bankruptcy estate. The Ninth Circuit BAP concluded that the LLC, unlike a sole proprietorship, is a separate legal entity with its own chapter 7 estate.101

The BAP also noted that a sole proprietorship is not a “person” for purposes of the Bankruptcy Code because it is not an individual, a partnership, or a “corporation.”102 Because it is not a “person,” a sole proprietorship is ineligible to be a debtor in bankruptcy.103 The BAP concluded that the taxpayer had made a reasonable attempt to comply with the code and found that he acted reasonably with respect to the underpayment and was not liable for accuracy-related penalties under I.R.C. section 6662(a).

§ 7.7 OTHER TAX CONSIDERATIONS

(a) I.R.C. Section 385

In 1969, Congress enacted I.R.C. section 385, which authorized the Secretary of the Treasury to prescribe regulations to determine whether an interest in a corporation is to be treated as stock or indebtedness or part stock and part indebtedness. I.R.C. section 385(b) lists five nonexclusive factors that are to be considered in determining whether an instrument is debt or equity. These factors are:

In 1980, the Treasury issued proposed and final regulations under I.R.C. section 385, but the regulations were withdrawn in November 1983. The withdrawn regulations set forth these six factors: (1) whether the repayment of the debt is contingent on some event; (2) the debt-to-equity ratio of the lender; (3) whether the interest rate is reasonable; (4) whether the debt holdings are proportionate to the borrower’s stock holdings of the lender; (5) whether the instrument is convertible into stock of the lender; and (6) whether interest and principal payments are made timely. Although these regulations were withdrawn, circuit courts have stated that these factors should be analyzed in determining whether a given relationship is a debtor-creditor relationship or a corporation-shareholder relationship.104

Courts have also set forth more detailed lists of factors to be examined in making the debt/equity determination. For example, the Eleventh Circuit listed the following factors:105

• The names given to the certificates evidencing the indebtedness
• The presence or absence of a fixed maturity date of the debt
• The source of payments on the debt
• The right to enforce payment of principal and interest
• Participation in management flowing as a result of the indebtedness
• The subordination of the debt
• The intent of the parties
• “Thin” or adequate capitalization of the corporation
• The identity of interest between creditor and stockholder
• The source of interest payments on the indebtedness
• The ability of the corporation to obtain loans from outside lending institutions
• The extent to which the advance was used to acquire capital assets
• The failure of the debtor to repay on the due date or to seek a postponement

The Third Circuit listed these factors:106

• The intent of the parties
• The identity between creditors and shareholders
• The extent of participation in management by the holder of the instrument
• The ability of the corporation to obtain funds from outside sources
• The “thinness” of the capital structure in relation to debt
• The risk involved
• The formal indicia of the arrangement
• The relative position of the obligees as to other creditors regarding the payment of interest and principal
• The voting power of the holder of the instrument
• The provision of a fixed rate of interest
• A contingency on the obligation to repay
• The source of the interest payments
• The presence or absence of a fixed maturity date
• A provision for redemption by the corporation
• A provision for redemption at the option of the holder
• The timing of the advance with reference to the organization of the corporation

Although different lists of factors have been developed in the various circuit courts, common themes exist.107

These factors are intended as a guide to the court in evaluating whether the parties created a fide debtor–creditor relationship in a manner comporting with economic reality in which the creditor has a reasonable expectation of repayment.108 Courts have also stated that the substance and not the form of a transaction controls and that the substance of the transaction will be closely scrutinized, especially if a debtor and creditor are jointly controlled.109

(b) Notice 94-47

In 1994, the IRS issued Notice 94-47,110 which outlined factors to be considered in determining whether an instrument should be treated as debt or equity for federal tax purposes. The notice states that “characterization of an instrument as debt or equity will depend on the terms of the instrument and all surrounding facts and circumstances,” but it also sets forth eight nonexclusive factors to assist the taxpayer in making this determination:

In the absence of regulations, debt/equity determinations remain a murky area of the tax law, and one that requires careful attention to the facts and circumstances of each case.

(c) Codification of Economic Substance Doctrine and Imposition of Penalties

In 2010, Congress codified the Economic Substance doctrine.111 For transactions entered into on or after March 31, 2010, I.R.C. section 7701(o) provides that, in the case of a transaction to which the Economic Substance doctrine is relevant, the transaction is treated as having economic substance only if: (i) the transaction changes in a meaningful way (apart from federal income tax effects) the taxpayer’s economic position; and (ii) the taxpayer has a substantial purpose (apart from federal income tax effects) for entering into the transaction.112 The IRS will continue to rely on relevant case law under the common law Economic Substance doctrine in applying the two-prong conjunctive test. Moreover, the determination of whether the Economic Substance doctrine is relevant to a transaction should be made in the same manner as if I.R.C. section 7701(o) had never been enacted. 113

Taxpayers will face a 40 percent penalty for tax understatements attributable to transactions lacking economic substance (a 20 percent penalty if the transaction is adequately disclosed) or failing to meet the requirements of any similar rule of law. These are strict liability penalties, with no reasonable cause or good faith exceptions to the penalty.114

The IRS also issued Notice 2010-40,115 which provides interim guidance regarding the codification of the Economic Substance doctrine under new I.R.C. section 7701(o) and the related amendments to the penalties under I.R.C. sections 6662, 6662A, 6664, and 6676 by section 1409 of the Health Care and Education Reconciliation Act of 2010.116

§ 7.8 ADMINISTRATIVE EXPENSES

(a) Introduction

As with other business transactions, the administrative and transactional expenses associated with various aspects of bankruptcy can be substantial. Thus, the deductibility or nondeductibility of these expenses is important. The discussion here considers various authorities that address the proper tax treatment of bankruptcy costs directly and considers broader authorities that address transactional expenses outside the bankruptcy context.

On December 31, 2003, the IRS and Treasury released final regulations addressing deduction and capitalization of certain expenditures. The discussion here first addresses the preregulatory authorities and then addresses the new regulations.

(b) Preregulatory Authorities

(i) Revenue Ruling 77-204

In Rev. Rul. 77-204,117 the IRS concluded that all costs associated with the institution and administration of a liquidation of a bankruptcy estate are deductible. Although this ruling deals with a straight liquidation under Chapter VII of the Bankruptcy Act and with a Chapter X reorganization, it should apply to liquidations under both Chapter VII and Chapter XI (where a plan of liquidation is approved) of the Bankruptcy Code.

In the ruling, the IRS looked at two situations—a Chapter X reorganization and a liquidation, both under the Bankruptcy Act—and concluded that administrative expenses incurred during the liquidation are deductible.

The IRS concluded that, in the case of a reorganization, the expenses are deductible to the extent that corporations in general are permitted to deduct expenses connected with a reorganization. For tax purposes, the filing of a bankruptcy petition by a corporation did not create a separate tax entity. Rev. Rul. 77-204 develops two categories of administrative expenses:

The costs associated with the institution and administration of a bankruptcy case are not deductible, because they are capital expenditures that will benefit the corporation in future years.

(ii) Placid Oil

One of the first major cases to deal with the deduction of administrative expenses in a bankruptcy context was In re Placid Oil Co.119 Placid Oil Co., which operated oil and gas interests, borrowed approximately $1 billion in 1983. When its lenders began foreclosure proceedings in 1986, Placid filed a chapter 11 bankruptcy petition. The company’s plan of reorganization was confirmed in 1988. On its tax return, the company deducted the fees it had paid to its lawyers and accountants, and the IRS disallowed the deductions.

Placid Oil argued that, once it had refuted the IRS’s proof of claim, the burden of proof was on the IRS to prove that the debtor was not entitled to the administrative expense deductions. The court agreed that in a bankruptcy court, which is different from a tax court, once the debtor provides sufficient evidence to rebut the proof of claim, the burden of proof is on the IRS to show why the administrative expense is not deductible. However, in this case, the court concluded that the debtor had not satisfied its burden regarding its objection to the IRS’s claim.

Placid Oil also argued that it did not have any nondeductible reorganization expenses for tax purposes. Placid Oil had not gone through a reorganization under I.R.C. section 368(a). The debtor had used chapter 11 to provide leverage in negotiating with its creditors. As a result, the expenses were ordinary and necessary business expenses.

The court determined that, under Placid Oil’s plan, a substantial percentage of its assets were sold, operations were downscaled, and its debts were reduced. Thus, although the bankruptcy court agreed that Placid Oil did not qualify for any of the reorganizations listed in I.R.C. section 368(a), it found no authority to conclude that the list in section 368(a) was an exhaustive list of all possible types of reorganizations for purposes of determining the deductibility of administrative expenses. The court stated: “Through the bankruptcy, Placid restructured its debt as to amount and terms of payment. Furthermore, Placid’s bankruptcy reorganization not only insured Placid’s survival but maintained the reorganization value of the corporation for the creditors and the owners.”120 The court denied the deduction of any of the administrative expenses.

On appeal, the Fifth Circuit reversed the bankruptcy court’s decision in Placid Oil.121 The Fifth Circuit held that a taxpayer in bankruptcy who challenges a federal tax claim arising from the disallowance of deductions does not have the burden of proof on its entitlement to the deductions. The court ordered the bankruptcy court to differentiate between the company’s capital expenses and its nondeductible fees and expenses.

The IRS has indicated that it will not follow the Fifth Circuit decision, on the grounds that it conflicts with the general rule that the taxpayer bears the ultimate burden of proof for deductions, and with the Fourth Circuit decision in IRS v. Levy (In re Landbank Equity Corp.).122

(iii) Private Letter Ruling 9204001

In Private Letter Ruling (P.L.R.) 9204001,123 a taxpayer asked the IRS to rule on the deductibility of all expenses associated with a bankruptcy involving substantial tort claims. The taxpayer argued that, because the dominant focus and work on the case related to defending those with business-related tort claims, all expenses associated with the bankruptcy should be deductible. The taxpayer invoked the “Origin of Claim” doctrine, which determines deductibility from the context in which the expenses were incurred. Because costs of defending against tort claims are generally deductible, all administrative costs associated with the chapter 11 case should be deductible.

The IRS ruled that the “dominant aspect” of the bankruptcy may not be used to determine the deductibility of all bankruptcy-related costs. The IRS stipulated that the “otherwise deductible” standard under Rev. Rul. 77-204 is applicable here rather than the Dominant Aspect doctrine.

(iv) Indopco and Related Authorities

In Indopco, Inc. v. Commissioner,124 the Supreme Court held that an expense will not be deductible if the taxpayer expects to realize a benefit from the expense in a year subsequent to the year in which the expense was incurred. This holding would support the doctrine adopted in Rev. Rul. 77-204, which would allow the deduction of an administrative expense if it would have been deductible except for the filing of the chapter 11 petition. The Supreme Court rejected the argument some commentators have advanced from Commissioner v. Lincoln Savings & Loan Association,125 that in order for an expense to be capitalized, the expense must be incurred either to create or enhance a separate or distinct asset.

In A.E. Staley Manufacturing Co. v. Commissioner,126 the Court of Appeals for the Seventh Circuit, reversing and remanding a decision of the Tax Court, held that a corporation was entitled to deduct costs relating to the defense of its business and its corporate policy against a hostile takeover.

In Staley, the corporation incurred investment bankers’ fees in defending against a takeover that the board viewed as hostile but ultimately approved due to a lack of alternative transactions. The Tax Court took the view that the transaction giving rise to the investment bankers’ fees was an acquisition and thus a change in corporate structure. The Tax Court relied on the Supreme Court’s decision in Indopco, which held that costs incurred to facilitate a friendly acquisition are capital expenditures and, therefore, not immediately deductible. Accordingly, the Tax Court held that expenses arising from the investment bankers’ fees were in connection with a change in ownership and must be capitalized.

The Seventh Circuit, however, focused its analysis on whether the investment bankers’ fees were more properly viewed as costs associated with defending a business or as costs associated with facilitating a capital transaction. The court reasoned that the bulk of the investment bankers’ time was spent attempting to frustrate the occurrence of a merger and to evaluate alternative transactions rather than facilitating the acquisition. The court noted that the Indopco decision merely reaffirmed a well-settled law that costs incurred to facilitate a capital transaction are capital costs. Indopco, the Court of Appeals pointed out, did not change the law with respect to costs incurred to defend a business. Such defense costs seek to preserve the status quo, not to produce future benefits.

Accordingly, Seventh Circuit held that costs incurred by the taxpayer to defend its business were deductible under I.R.C. section 162(a). Furthermore, costs incurred to evaluate alternative transactions, which were subsequently abandoned, were deductible under I.R.C. section 165 as abandonment expenses. The court did, however, state that the portion of investment banker fees incurred to facilitate the acquisition were to be capitalized (e.g., costs incurred to value the taxpayer’s stock).

Citing Staley, the United States Bankruptcy Court held in Hillsborough Holdings Corporation v. United States127 that the tax treatment of costs incurred by a taxpayer in bankruptcy proceedings for professional services depends on the nature of the services performed by professionals. To determine the nature of the services performed, all the facts of the case must be considered to determine the context of the expenditures and the types of services performed. In Hillsborough, the court reasoned that the restructuring of a corporation in bankruptcy was an extraordinary event outside of the corporation’s usual trade or business. In addition, the restructuring allows the corporation to continue to exist as a viable business. Thus, the court held that certain expenses incurred by the taxpayer were not properly deductible under section 162(a), including professional fees incurred for services rendered in connection with the administration of the taxpayer’s bankruptcy proceedings and for services rendered to various creditor committees. The court did, however, allow the taxpayer a deduction for certain expenses not directly related to the bankruptcy proceedings, including professional fees incurred for services rendered to the taxpayer in defending against asbestos-related personal injury claims and for services rendered in connection with the taxpayer’s failed attempt to obtain financing under a line of credit arrangement.

In Norwest Corp. v. Commissioner,128 the Tax Court held that officers’ salaries and legal fees incurred by a target company in a friendly acquisition had to be capitalized because the costs were sufficiently related to an event that produced a significant long-term benefit. In Norwest, the taxpayer was a target company in a friendly acquisition. A portion of the taxpayer’s officers’ salaries and certain legal fees were attributed to the acquisition. The taxpayer argued that (1) the officers’ salaries were ordinary and necessary business expenses and, therefore, not capitalizable as part of the acquisition because the officers’ work on the transaction was tangential to their ordinary duties, and (2) the legal fees were currently deductible because they were primarily for investigatory and due diligence services related to the expansion of its business. The taxpayer relied on the outcome in Briarcliff Candy Corp. v. Commissioner129 and NCNB Corp. v. United States,130 which allowed a deduction for investigation and due diligence costs incurred incident to the expansion of an existing business.

Relying on Indopco, the IRS argued, and the Tax Court agreed, that all of the costs at issue had to be capitalized because the transaction “involved a friendly acquisition from which the parties thereto anticipated significant long-term benefits for the acquired entity.” The Tax Court claimed that the decisions in Briarcliff and its progeny have been displaced by Indopco. On appeal, the Eighth Circuit allowed deductions for costs incurred before the taxpayers reached a final decision about the acquisition.131

In Dana Corp. v. United States,132 the Court of Appeals for the Federal Circuit held that a retainer fee paid to a law firm was nondeductible because the retainer fee was ultimately credited to the cost of legal services incurred in an acquisition. The taxpayer in Dana had a 16-year history of paying an annual retainer fee to a law firm with expertise in corporate takeovers. Dana paid the retainer fee to preclude the law firm from representing competitors of Dana in takeover situations and to guarantee the availability of the law firm’s services. The retainer fee was nonrefundable but could be used as a credit to offset any legal fees incurred during the corresponding year. During the year in question, the retainer fee was credited against legal fees associated with an acquisition of a target company.

In Rev. Rul. 99-23,133 the IRS outlined its position on the types of costs incurred by a taxpayer in an acquisition of a target’s assets that it considers to be amortizable start-up expenditures under I.R.C. section 195. The ruling outlines the IRS’s position in three independent fact patterns and in general concludes that: (1) expenditures incurred in the course of a general search for, or investigation of, an active trade or business to determine whether to enter a new business and which new business to enter are investigatory costs eligible for amortization under I.R.C. section 195, and (2) expenditures incurred in an attempt to acquire a specific business do not qualify as start-up expenditures because they are acquisition costs subject to the capitalization rules of I.R.C. section 263.

(v) Abandoned Plans

It might be argued under Indopco that costs associated with abandoned plans are deductible, because no benefit will be realized from abandoned plans. This argument was often made prior to Indopco. For example, in Rev. Rul. 73-580,134 the IRS ruled that amounts paid to employees with respect to plans for mergers or acquisitions are deductible as losses under I.R.C. section 165 in the year of abandonment. The purpose of the ruling was to clarify that costs of in-house employees are treated like any other expense when determining whether such expenses are deductible.

If administrative costs associated with abandoned plans are deductible, a critical question that must be addressed is what constitutes the abandonment of a plan as opposed to the modification of a plan. The Tax Court’s decision in Sibley, Lindsay, & Curr Co. v. Commissioner135 gives some insight. In that case, a corporate taxpayer retained the services of an investment banking firm to analyze the method available to change its capital structure. The investment bankers developed three restructuring plans, but only one was implemented. Sibley deducted the costs that it had allocated to the two plans that were not adopted and capitalized the costs related to the adopted plan. The court held that because the plans were not alternatives but were separate and distinct suggestions for revisions of the capital structure, the expenses allocated to the abandoned proposals were properly deductible in the year it was determined which of the proposals would be adopted. The court noted that new proposals were offered only as each previous proposal was rejected. This standard developed in Sibley was applied in Tobacco Products Export Corp. v. Commissioner,136 in which the court examined whether the plans were separate and distinct.

But if proposals are alternatives, only one of which can be completed, no abandonment loss will be allowed unless the entire transaction is abandoned.137

(c) Final Indopco Regulations

On December 31, 2003, the IRS and Treasury released final regulations (T.D. 9107) addressing deduction and capitalization of certain expenditures. These regulations address general deduction/capitalization issues as well as deduction/capitalization rules that arise in taxable and tax-free reorganizations.

In general, these regulations require capitalization of amounts that facilitate enumerated transactions (whether taxable or tax free), including:

• A taxpayer’s acquisition of assets that constitute a trade or business
• A taxpayer’s acquisition of an ownership interest that gives the acquirer a greater than 50 percent interest in a business entity
• An acquisition by another of an interest in a taxpayer (but not via redemption)
• A recapitalization, a reorganization, or a section 355 distribution
• An I.R.C. section 351 or section 721 transfer
• A formation of a corporation
• An acquisition of capital
• An issuance of stock
• A borrowing
• A writing of an option

Facilitate, for this purpose, means “paid in the process of investigating or otherwise pursuing” the transaction. The regulations indicate that this is a facts-and-circumstances inquiry, that the fact that an amount would/would not have been paid but for the transaction is not determinative, and that amounts paid to determine value are included.

The regulations also enumerate certain costs that do not facilitate. Thus, (1) amounts paid to facilitate a borrowing will not be treated as facilitating another transaction, and (2) amounts paid to facilitate a sale of assets will not be treated as facilitating another transaction (e.g., amounts paid to facilitate a divestiture prior to a merger are not costs that facilitate the merger). The regulations also treat the following as nonfacilitative: mandatory stock distributions, stock issuance costs of open-ended regulated investment companies, integration costs, routine stock registrar and transfer agent fees (although proxy statements requesting approval of a transaction enumerated by the regulation do facilitate), termination of earlier agreements, employee compensation (can elect to capitalize), and overhead and de minimis costs (not over $5,000) (can elect to capitalize).

With regard to costs associated with terminated/abandoned transactions, the regulations provide that, in general, amounts paid to facilitate a transaction are treated as facilitating a second transaction only if the transactions are mutually exclusive and the first transaction is abandoned to enable the taxpayer to engage in the second transaction. Also, amounts paid to terminate an earlier agreement will be treated as facilitating a later transaction only if the two transactions are mutually exclusive and the agreement is terminated to enable the taxpayer to engage in the second transaction.138

In general, the regulations treat most costs incurred to institute or administer a bankruptcy proceeding as costs that facilitate a bankruptcy reorganization. Thus, costs of the debtor to institute or administer a chapter 11 proceeding generally must be capitalized. However, costs to operate the debtor’s business during a chapter 11 proceeding (including the types of costs described in Rev. Rul. 77-204, discussed earlier), do not facilitate the bankruptcy and are treated in the same manner as such costs would have been treated had the bankruptcy proceeding not been instituted. The regulations also provide that capitalization is not required for (1) amounts paid by a taxpayer to defend against an involuntary bankruptcy proceeding and (2) amounts paid to formulate, analyze, contest, or obtain approval of the portion of a plan of reorganization under chapter 11 that resolves a taxpayer’s tort liability, provided the amount would have been treated in a nonbankruptcy context as an ordinary and necessary business expense under I.R.C. section 162.

Finally, the regulations set forth special rules for certain costs of covered transactions that are not inherently facilitative and that occur before a specified time. Subject to the exception for inherently facilitative amounts, amounts spent on covered transactions do not facilitate if they occur before earlier of (1) the issuance of a letter of intent and (2) the authorization or approval of material terms by the board of directors or appropriate governing officials (or if no one needs to authorize or approve, by the date of a binding written contract).

For this purpose, covered transactions include: (1) taxable acquisitions by a taxpayer of assets that are a trade or business, (2) taxable acquisitions of a greater-than-50-percent interest where the taxpayer is either the acquirer or the target, or (3) an A, B, C, or acquisitive D reorganization, where the taxpayer is either the acquirer or the target. Type G reorganizations are not referenced in this list.

The regulations provide that payments for inherently facilitative amounts with respect to a covered transaction will be treated as amounts that facilitate the transaction regardless of whether they are paid before the letter of intent/authorization date. Inherently facilitative amounts include amounts paid for:

• An appraisal or a fairness opinion
• Structuring or tax advice
• Preparing and reviewing documents
• Regulatory approval
• Shareholder approval
• Conveying property (transfer taxes, title registration)

Also, Rev. Proc. 2011-29 permits taxpayers to elect a safe harbor for fees incurred to investigate or otherwise pursue a covered transaction if the payment of the fees is contingent on the closing of the covered transaction. Specifically, if taxpayers make this election, they may treat 70 percent of such fees as an amount that does not facilitate the transaction and must capitalize the remaining 30 percent. This election is available for success-based fees paid or incurred in taxable years ending on or after April 8, 2011.

Once costs have been capitalized pursuant to the rules just set forth, the regulations address their subsequent treatment in limited cases but defer addressing that treatment in many others. For example, for costs incurred in taxable acquisitive transactions by an acquirer, the regulations require those costs to be added to the basis of the acquired assets or stock. For costs incurred in a borrowing, the regulations generally provide for amortization of the costs over the term of the debt. However, the regulations reserve on (among other things) the proper subsequent treatment of target’s costs in a taxable stock acquisition, stock issuance costs, and tax-free acquisitive transaction costs.

In general, the final regulations apply to amounts paid or incurred on or after January 5, 2004.139

§ 7.9 OTHER ADMINISTRATIVE ISSUES

(a) Responsibility for Filing Corporate Tax Returns

Filing a petition under title 11 does not generally affect the filing of a corporation’s income tax returns. That is, a separate taxable entity is not created as a result of the corporation’s commencement of title 11 proceedings.140 The return must be filed even though the corporate charter has been revoked.141 I.R.C. section 6012(b)(3) imposes a tax return filing obligation on trustees in bankruptcy who have possession of or hold title to “all or substantially all the property or business of a corporation, whether or not such property or business is being operated.” If the trustee possesses only a small part of the property of a corporation, then the trustee is not required to file an income tax return.142

Treas. Reg. section 1.6012-3(b)(4) requires a fiduciary that has possession of all or substantially all of a corporation’s assets to file corporate tax returns, regardless of whether the trust is an operating trust or a liquidating trust.143 Before the Supreme Court resolved the issue, some courts distinguished between an operating and a liquidating trustee.144 In Holywell Corp. v. Smith,145 the Supreme Court agreed with the IRS on the matter and required a liquidating trustee to file income tax returns and pay tax.

A trustee may be obligated to file tax returns and pay tax for prepetition periods. The IRS may impose late filing penalties and negligence penalties against the corporation or the trustee if the trustee files a late or inaccurate return.146 The In re Hudson Oil Co.147 court held that the trustee must file the corporate return for the year that ended just prior to the filing of the petition. The court disagreed with the trustee’s reliance on section 1106(a)(6) of the Bankruptcy Code. Section 1106(a)(6) provides that the trustee or debtor in possession must file a tax return, without personal liability, for any year in which the debtor has not filed a return. The return must include such information as may be required by the taxing authority in light of the condition of the debtor’s books and records and the availability of such information. The court held that section 1106(a)(6) did not excuse the trustee from filing a tax return.148

Rev. Rul. 84-123149 does, however, provide that a return need not be filed for a corporation with neither assets nor income. Even though a return is not filed, that period for which a return normally would be required will constitute a taxable year for the carryover of any net operating loss. Rev. Proc. 84-59150 states that, to obtain relief from filing, the trustee, receiver, or assignee should file a request with the proper district director, stating:

• Name, address, and employer identification number of the corporation
• Date notice of appointment as trustee, receiver, or assignee was filed with the IRS
• The reason why relief is needed.

The request should contain this sentence: “I hereby request relief from filing federal income tax returns for tax year(s) ending for the above named corporation and declare under penalties of perjury that to the best of my knowledge and belief the information contained herein is correct.”151

The district director will send notification within 90 days whether the request is granted or denied. See § 4.2(c) for a discussion of the responsibility for filing individual returns and § 3.2(c) for filing partnership returns.

In the case of a chapter 7 petition, section 704 of the Bankruptcy Code provides that the trustee must file tax returns where the trustee is authorized to operate the business. Sections 346, 728, 1146, and 1231 of the Bankruptcy Code deal with the responsibilities of the trustee or debtor in possession to file state and local tax returns. This responsibility is discussed in Chapter 10.

(b) Liquidating Trusts

Frequently a bankruptcy reorganization plan will require that assets be sold and the proceeds distributed to the unsecured creditors. Not surprisingly, in many such cases the assets may not be readily salable, except over an extended period of time. In such cases, the assets may be placed in a so-called liquidating trust to be sold over time. In general, the beneficiaries of a liquidating trust are the unsecured creditors. The failing company’s transfer of the assets to the trust discharges its liability to the creditors, and the company retains no interest in the assets. The trustee, which is usually a bank, has limited powers and is charged with selling the assets and distributing the proceeds to the creditors.

The primary tax issue raised by such an arrangement is whether the trust will be eligible for taxation as a liquidating trust (rather than as an association), with the incidence of taxation falling solely on the creditor-beneficiaries.

In general, a trust that qualifies as a liquidating trust is treated as a grantor trust under I.R.C. sections 671 to 677 (in general, a grantor trust is a trust whose grantors are the creditors/ beneficiaries of the trust). Treas. Reg. section 301.7701-4(d) defines a liquidating trust as follows:

Certain organizations which are commonly known as liquidating trusts are treated as trusts for purposes of the Internal Revenue Code. An organization will be considered a liquidating trust if it is organized for the primary purpose of liquidating and distributing the assets transferred to it, and if its activities are all reasonably necessary to, and consistent with, the accomplishment of that purpose. A liquidating trust is treated as a trust for purposes of the Internal Revenue Code because it is formed with the objective of liquidating particular assets and not as an organization having as its purpose the carrying on of a profit-making business which normally would be conducted through business organizations classified as corporations or partnerships. However, if the liquidation is unreasonably prolonged or if the liquidation purpose becomes so obscured by business activities that the declared purpose of liquidation can be said to be lost or abandoned, the status of the organization will no longer be that of a liquidating trust. Bondholders’ protective committees, voting trusts, and other agencies formed to protect the interests of security holders during insolvency, bankruptcy, or corporate reorganization proceedings are analogous to liquidating trusts but if subsequently utilized to further the control or profitable operation of a going business on a permanent continuing basis, they will lose their classification as trusts for purposes of the Internal Revenue Code.152

In Rev. Proc. 94-45,153 the IRS specified conditions under which it will consider issuing advance rulings classifying entities created under chapter 11 bankruptcy plans as liquidating trusts under Treas. Reg. section 301.7701-4(d). The revenue procedure also outlines income reporting requirements for liquidating trusts and provides a checklist that must accompany all ruling requests. The revenue procedure contains these requirements:

• The trust must be created pursuant to a confirmed plan under chapter 11 of the Bankruptcy Code for the primary purpose of liquidating the assets transferred to it, and with no objective to continue or engage in the conduct of a trade or business, except to the extent reasonably necessary to, and consistent with, the liquidating purpose of the trust.
• The plan and disclosure statement must explain how the bankruptcy estate will treat the transfer of its assets to the trust for federal income tax purposes. A transfer to a liquidating trust for the benefit of creditors must be treated for all purposes of the I.R.C. as a transfer of assets to the beneficiary creditors followed by a transfer by the beneficiary-creditors to the trust. The ruling request must explain whether the debtor or the bankruptcy estate will incur any tax liability from the transfer and, if so, how that liability will be paid.154
• The plan, disclosure statement, and any separate trust instrument must provide that the beneficiaries of the trust will be treated as the grantors and deemed owners of the trust. The trust instrument (which may be the plan if there is no separate trust instrument) must require that the trustee file returns for the trust as a grantor trust pursuant to Treas. Reg. section 1.671-4(a).
• The plan, disclosure statement, and any separate trust instrument must provide for consistent valuations of the transferred property by the trustee and the creditors (or equity interest holders), and those valuations must be used for all federal income tax purposes.
• Whether or not a reserve is established for disputed claims, all of the trust’s income must be treated as subject to tax on a current basis, and the ruling request must explain, in accordance with the plan, how the trust’s taxable income will be allocated and who will be responsible for payment of any tax due.155
• The trust instrument must contain a fixed or determinable termination date that is generally not more than five years from the date of creation of the trust and that is reasonable based on all the facts and circumstances. If warranted by the facts and circumstances, provided for in the plan and trust instrument, and subject to the approval of the bankruptcy court with jurisdiction over the case upon a finding that the extension is necessary to the liquidating purpose of the trust, the term of the trust may be extended for a finite term based on its particular facts and circumstances. The trust instrument must require that each extension be approved by the court within six months of the beginning of the extended term.
• If the trust is to hold any operating assets of a going business, a partnership interest in a partnership that holds operating assets, or 50 percent or more of the stock of a corporation with operating assets, the ruling request must explain why it is necessary to retain these assets.
• If the trust is to receive transfers of listed stocks or securities or other readily marketable assets, the ruling request must explain the necessity for doing so. The trust is not permitted to receive or retain cash or cash equivalents in excess of a reasonable amount to meet claims and contingent liabilities (including disputed claims) or to maintain the value of the assets during liquidation.
• The investment powers of the trustee, other than those reasonably necessary to maintain the value of the assets and to further the liquidating purpose of the trust, must be limited to powers to invest in demand and time deposits, such as short-term certificates of deposit, in banks or other savings institutions, or other temporary, liquid investments, such as Treasury bills.
• The trust must be required to distribute at least annually to the beneficiaries its net income plus all net proceeds from the sale of assets, except that the trust may retain an amount of net proceeds or net income reasonably necessary to maintain the value of its assets or to meet claims and contingent liabilities (including disputed claims).
• The ruling request must contain representations that the trustee will make continuing efforts to dispose of the trust assets, make timely distributions, and not unduly prolong the duration of the trust.

1 46 T.C. 65 (1966), rev’g, 383 F.2d 883 (8th Cir. 1967).

2 1975-2 C.B. 117.

3 See also Field Service Advice 1999-540, 1999 TNT 15-83 (Jan. 25, 1999). The IRS concluded that income from debt discharge increases earnings and profits to the extent it is not used to reduce the basis of assets under I.R.C. § 1017. The IRS also concluded that the increase in earnings and profits resulting from debt discharge creates current earnings and profits for purposes of determining whether a distribution during the year of the debt discharge is a dividend, and does not merely reduce a deficit in accumulated earnings and profits.

4 Eustice, Cancellation of Indebtedness Redux: The Bankruptcy Tax Act of 1980 Proposals—Corporate Aspects, 36 Tax L. Rev. 1, 42 (1980).

5 Id.

6 Watts, Corporate Acquisitions and Divisions Under the Bankruptcy Tax Act: The New “G” Type Reorganization, 59 Taxes 845, 854 (1981).

7 Id.

8 Id.

9 In the consolidated return context, see, e.g., Treas. Reg. § 1.1502-32 for basis consequences that might result from a debtor-member’s exclusion of discharge of indebtedness income.

10 Prior to 1989, I.R.C. § 351 could apply if a transferor received “stock or securities” in exchange for property. Removal of “securities” from this provision should not be confused with the later discussion under the heading I.R.C. Section 351(d), in which the securities under consideration are securities owned by a transferor that are being transferred (as property) in exchange for a transferee’s stock.

11 In Rev. Rul. 2007-8, 2007-1 C.B. 469, the IRS ruled that I.R.C. § 357(c)(1) no longer applies to acquisitive asset reorganizations (A, C, D, or G reorganizations) that also qualify as § 351 exchanges, in light of changes made under the American Jobs Creation Act of 2004. See § 5.4(a)(iv)(E). See also I.R.C. § 357(d), defining when a liability is “assumed.”

12 I.R.C. § 357(d) provides that, for purposes of I.R.C. § 357(a), a recourse liability (or portion thereof) shall be treated as assumed by a transferee corporation if the transferee corporation has agreed to, and is expected to

13satisfy, such liability (or portion), and a nonrecourse liability shall be treated as assumed by the transferee corporation acquiring assets subject to such nonrecourse liability (subject to certain exceptions).

Rev. Rul. 59-259, 1959-2 C.B. 115.

14 Duncan v. Commissioner, 9 T.C. 468 (1947), acq. 1948-2 C.B. 2; Rev. Rul. 77-81, 1977-1 C.B. 97.

15 See Commissioner v. Carman, 189 F.2d 363 (2d Cir. 1951), acq. 1954-2 C.B. 3.

16 Rev. Rul. 59-259, 1959-2 C.B. 115.

17 Eustice, supra note 4 at 40.

18 Note that the ability to recognize loss may also be limited by provisions such as I.R.C. § 267.

19 S. Rep. No. 1035, 96th Cong., 2d Sess. 34 (1980).

20 See § 5.2(g) for a more in-depth description of NQPS.

21 An example of a transaction in which a transferor receives solely NQPS in a transaction that in the aggregate qualifies under I.R.C. § 351 is as follows: Individuals A and B each own 50 percent of the stock of a corporation. Individual A transfers property to the corporation solely for NQPS and Individual B transfers property solely for common stock.

22 I.R.C. 362.

23See S. Rep. No. 192, 108th Cong., 1st Sess. 126 (2003); HR Conf. Rep. No. 755, 108th Cong., 2d Sess. 621 (2004).

24 Pub. L. No. 108-357, § 836 (2004).

25 I.R.C. §§ 337 and 336 provided for no gain or loss subject to statutory recaptures and tax benefit items.

26 296 U.S. 200 (1935).

27 Former I.R.C. § 337 has been revoked but new I.R.C. § 337 has been reconstituted to provide for the circumstances under which a liquidation of a controlled subsidiary to its parent corporations will be tax free to the subsidiary. See I.R.C. § 332.

28 See infra § 7.4(b).

29 A nonelective transitional rule applied to liquidating sales and distributions of long-term capital assets by certain closely held corporations occurring before January 1, 1989.

30 I.R.C. § 311(b).

31 I.R.C. § 355(c).

32 See note 27 supra.

33See supra § 7.3(e).

34 I.R.C. § 336(d)(2).

35 H.R. Rep. No. 841, 99th Cong., 2d Sess. II-201 (1986) (emphasis added).

36See supra § 7.3(e).

37 252 F.2d 693 (2d Cir. 1958); See also H.K. Porter Co. v. Commissioner, 87 T.C. 689 (1986).

38 70 Fed. Reg. 11903 (Mar. 10, 2005).

39 Rev. Rul. 68-602, 1968-2 C.B. 135. The IRS has applied this analysis to disqualify a deemed liquidation occurring pursuant to an I.R.C. § 338(h)(10) election from qualifying for treatment under I.R.C. § 332. See discussion in § 7. 5(g).

40 Rev. Rul. 2003-125, 2003-2 C.B. 1243. See also P.L.R. 9425024 (Mar. 25, 1994) (allowing deductions under I.R.C. §§ 165(g)(3) and 166). But see Chief Counsel Attorney Memorandum 2011-003, 2011 TNT 168-22 (Aug. 30, 2011) (denying bad debt deduction with respect to debts of an insolvent corporation that made a check-the-box election to be treated as a partnership). See also discussion at Chapter 6, note 10.

41 See I.R.C. § 337(c).

42 The Conference Report provides that, where an 80 percent corporate shareholder and a 20 percent corporate shareholder receive a liquidating distribution, the deferred gain of the 20 percent shareholder on the portion of the assets distributed to it would be triggered when the 80 percent shareholder leaves the group. H.R. Conf. Rep. No. 100-495, at 969 (1987).

43 See Bloom, Buying and Selling Corporations After Tax Reform, 14 J. Corp. Tax’n 167, 170 (1987).

44 I.R.C. 362; 334(b).

45See S. Rep. No. 192, 108th Cong., 1st Sess. 126 (2003); H.R. Conf. Rep. No. 755, 108th Cong., 2d Sess. 621 (2004).

46 Pub. L. No. 108-357, § 836 (2004).

47 REG-143544-04.

48 Rev. Rul. 76-429, 1976-2 C.B. 97.

49 Rev. Rul. 71-326, 1971-2 C.B. 177.

50 Treas. Reg. § 1.334-(c)(4), removed by T.D. 8474, 58 Fed. Reg. 25556 (Apr. 27, 1993).

51 I.R.C. § 338(a).

52 I.R.C. § 338(d)(3); I.R.C. § 1504(a)(2).

53 I.R.C. § 338(h)(3).

54See I.R.C. § 338(h)(3)(C) and Treas. Reg. § 1.338-3(b)(3) (testing relatedness for purposes of determining existence of a QSP after the last step in a series of related transactions). See also P.L.R. 201015028 (Jan. 4, 2010) (Newco’s acquisition of stock from a corporation that forms Newco qualifies as a “purchase” within the meaning of I.R.C. § 338(h)(3) where the corporation that formed Newco had a binding commitment to dispose of a portion of the Newco stock at the time of the receipt of the Newco stock). For application of Substance over Form/Step Transaction principles to determine if a stock purchase is qualified, see Rev. Rul. 2008-25, 2008-21 C.B. 986; Rev. Rul. 2001-46, 2001-2 C.B. 321; Rev. Rul. 90-95, 1990-2 C.B. 67; and discussion of some of these rulings in §§ 5.2(h) and 5.5(b)(iv).

55 I.R.C. § 338(h)(1).

56 I.R.C. § 338(h)(2).

57 I.R.C. §§ 338(a)(1) and (a)(2).

58 Treas. Reg. § 1.338-4(b). For acquisitions before January 6, 2000, see former Treas. Reg. 1.338-3, which, among other things, linked the determination of ADSP to the purchasing corporation’s basis in the target stock and included an adjustment for “other relevant items.” The former regulations did not always reflect the amount of gain and timing of gain under general tax principles. These issues were corrected in the Temporary Regulations; see § 7.5(h)(ii).

59 Treas. Reg. § 1.338(b)-5(b). For acquisitions before January 6, 2000, this amount was also adjusted for “other relevant items (items that might cause the deemed purchase price to improperly reflect the actual cost of the purchasing corporation’s interest in the target’s assets).” This language was rendered obsolete by temporary regulations. Former Treas. Reg. § 1.338-1(f) and (g). See § 7.5(h)(ii).

60 I.R.C. § 338(b)(1) and (4).

61 Treas. Reg. § 1.338-10(a)(5). The effect of excluding the target from any consolidated return, where it is not the common parent, is that in the year the target’s stock is sold it may be required to file three tax returns. One return would include the target in the affiliated group of the selling corporation; one return would include it in the affiliated group of the purchasing corporation; and a third return would be required for the date of the deemed asset sale (the acquisition date), to account for the income occasioned by the deemed sale.

62 Treas. Reg. § 1.338-10(a)(1).

63 Treas. Reg. § 1.338-10(a)(2).

64 T.D. 8515, 59 Fed. Reg. 2958 (Jan. 20, 1994). The final regulations also applied on an elective basis to targets with acquisition dates on or after January 14, 1992, and before January 20, 1994. See former Treas. Reg. § 1.338(i)-1 and former Temp. Reg. § 1.338(i)-1T. If such an election was made, a protective carryover basis election or an offset prohibition election made under the temporary regulations would have no effect. Later changes to these regulations are discussed later in this chapter.

65 Treas. Reg. § 1.338(h)(10)-1(c). For S corporations, a § 338(h)(10) election can be made if target is an S corporation immediately before the acquisition date. The deemed sale gain is reported on T’s final S corporation return and, therefore, affects a target shareholder’s basis in the target, including shareholders of the S corporation that do not sell their stock. See Treas. Reg. § 1.338(h)(10)-1(d)(5). Thus, all shareholders of the target S corporation must sign Form 8023, Elections Under § 338 for Corporations Making Qualified Stock Purchases. Temp. Treas. Reg. § 1.338(h)(10)-1T(c)(2).

66 Treas. Reg. § 1.338(h)(10)-1(d)(3).

67 Treas. Reg. § 1.338(h)(10)-1(d)(4).

68 Treas. Reg. § 1.338(h)(10)-1(d)(2).

69 P.L.R. 9007036 (Nov. 20, 1989); P.L.R. 9738031 (June 24, 1997).

70 See Rev. Rul. 75-223, 1975-1 C.B. 109.

71 Treas. Reg. § 1.338(h)(10)-1(c)(4).

72 One reason for the I.R.C. § 336 reference is to deal with I.R.C. § 338(h)(10) elections for S corporations.

73See generally § 7.4(e).

74 Chief Counsel Advice 200818005 (Jan. 18, 2008). See note 39, supra, and accompanying text.

75 Note the actual gain is based on a formula set forth in Treas. Reg. § 1.338(h)(10)-1(d).

76 H.R. Rep. No. 111, 103d Cong., 1st Sess. 760, 776 (1993).

77 T.D. 8711, 62 Fed. Reg. 2267 (Jan 16, 1997).

78 378 F.2d 771 (3d Cir. 1967).

79 T.D. 8858, 65 Fed. Reg. 1236 (Jan. 7, 2000).

80 Former Temp. Treas. Reg. § 1.338-6T(b).

81 See discussion in § 7.5(h)(iii) of modifications to several classes of assets in the final regulations.

82 T.D. 8940, 66 Fed. Reg. 9925 (Feb. 13, 2001).

83 T.D. 8858, 65 Fed. Reg. 1236 (Jan. 7, 2000).

84 See Treas. Reg. § 1.338-1(c).

85 See Treas. Reg. § 1.338-1(d).

86 See Treas. Reg. § 1.338-3(b)(2).

87 See Treas. Reg. § 1.338-3(d)(4). See also Chapter 5 note 43.

88 See Treas. Reg. §§ 1.338-4(d) and 1.338-5(e).

89 T.D. 8940, 66 Fed. Reg. 9925, 9926-27 (Feb. 13, 2001) (preamble). See Treas. Reg. § 1.338-6(a)(iii).

90 See Treas. Reg. § 1.338-6(b)(2)(ii).

91 See Treas. Reg. § 1.338-6(b)(2)(iii).

92 For an application of general principles of tax law concerning the tax treatment of contingent consideration, see Meredith Corp. v. Commissioner, 108 T.C. 89 (1997).

93 See § 7.5(g).

94 See amendment to Treas. Reg. § 1.1361-1(2)(v). T.D. 8940, 66 Fed. Reg. 9925 (Feb. 13, 2001). This amendment is consistent with the IRS’s informal ruling policy. See P.L.R.199918050 (Feb. 9, 1999).

95 T.D. 9071, 68 Fed. Reg. 40766 (July 9, 2003).

96 2001-2 C.B. 321.

97 2008-21 I.R.B. 986.

98 See Treas. Reg. § 1.338-2(d). An I.R.C. § 338 election, which is irrevocable, must be made not later than the 15th day of the ninth month beginning after the month in which the acquisition date occurs. See Rev. Proc. 2003-33, 2003-1 C.B. 803 (providing guidance to taxpayers in obtaining an automatic extension of time under Treas. Reg. § 301.9100-3 to file elections on Form 8023 under I.R.C. § 338. Cf. Chief Counsel Advice 201014059 (Mar. 4, 2010) (taxpayer is not granted an extension of time to file an election under I.R.C. § 338 where the taxpayer has not extended the statute of limitations, the parties have not amended their inconsistent returns, or both, and, thus, the requirements of Rev. Proc. 2003-33 have not been satisfied).

99 See Treas. Reg. § 1.338(i)-1(b).

100 I.R.C. §§ 338(b)(2), 338(b)(3), 338(b)(5), 338(e)(2)(D), 338(e)(3), 338(g)(1), 338(g)(2), 338(h)(3)(B), 338(h)(4)(B), 338(h)(6)(B), 338(h)(8), 338(h)(9), 338(h)(10)(A), 338(h)(11), 338(h)(15), and 338(i).

101 Gilliam v. Speier (In re KRSM Props.), 318 B.R. 712 (Bankr. 9th Cir. 2004).

102 11 U.S.C. § 101(41).

103 84.3 11 U.S.C. § 109(a)–(b).

104 See Sleiman v. Commissioner, 187 F.3d 1352, 1357 n.9 (11th Cir. 1999); Selfe v. United States, 778 F.2d 769, 773 n.9 (11th Cir. 1985).

105 See In re Lane, 742 F.2d 1311, 1314-15 (11th Cir. 1984), citing Mixon v. United States, 464 F.2d 394, 407 (5th Cir. 1972).

106 Fin Hay Realty Co. v. United States, 398 F.2d 694, 696 (3d Cir. 1968).

107 See, e.g., Hardman v. Commissioner, 827 F.2d 1409 (9th Cir. 1987); Roth Steel Tube Co. v. Commissioner, 800 F.2d 625 (6th Cir. 1986).

108 Litton Business Systems, Inc. v. Commissioner, 61 T.C. 367 (1973), acq., 1974-2 C.B. 3.

109 Laidlaw Transp., Inc. v. Commissioner, 75 T.C.M. (CCH) 2598 (1998), citing Road Materials, Inc. v. Commissioner, 407 F.2d 1121, 1124 (4th Cir. 1969).

110 1994-1 C.B. 357.

111 Pub. L. No. 111-152, 111th Cong., 2nd Sess., § 1409(a) (Mar. 30, 2010).

112 I.R.C. § 7701(o)(1).

113 I.R.C. § 7701(o)(5)(C).

114 2010-40 I.R.B. 411.

115 Id.

116 Health Care and Education Reconciliation Act of 2010, Pub. L. No. 111-152, H.R. 4872, § 1409, 111th Cong., 2nd Sess. (2010), modifying the revenue provisions of the Patient Protection and Affordable Care Act, Pub. L. No. 111-148 (2010).

117 1977-1 C.B. 40.

118 See Chicago, Milwaukee, St. Paul & Pacific R.R. Co. v. United States, 404 F.2d 960 (Ct. Cl. 1968); Denver & Rio Grande Western Railroad Co. v. Commissioner, 38 T.C. 557 (1962), acq. 1963-2 .B. 4; Bush Terminal Buildings Co. v. Commissioner, 7 T.C. 793 (1946), acq. 1947-2 C.B. 1.

119 In re Placid Oil Co., 140 B.R. 122 (Bankr. N.D. Tex. 1990), rev’d, 988 F.2d 554 (5th Cir. 1993).

120 140 B.R. at 128.

121 988 F.2d 554 (5th Cir. 1993).

122 973 F.2d 265 (4th Cir. 1992). See nonacquiescence in Placid Oil, 1995-2 C.B. 1.

123 May 13, 1991.

124 503 U.S. 79 (1992).

125 403 U.S. 345 (1971).

126 119 F.3d 482 (7th Cir. 1997), rev’g 105 T.C. 166 (1995).

127 1999 Bankr. LEXIS 445 (M.D. Fla. 1999).

128 112 T.C. 89 (1999), rev’d in part aff’d in part, Wells Fargo & Co. v. Commissioner, 224 F.3d 874 (8th Cir. 2000).

129 475 F.2d 775 (2d Cir. 1973), rev’g and remanding 31 T.C.M. (CCH) 171 (1972).

130 684 F.2d 285 (4th Cir. 1982).

131 Wells Fargo & Co. v. Commissioner, 224 F.3d 874, 889 (8th Cir. 2000).

132 174 F.3d 1344 (Fed. Cir. 1999).

133 1999-1 C.B. 998.

134 1973-2 C.B. 86.

135 15 T.C. 106 (1950), acq. 1951-1 C.B. 3.

136 18 T.C. 1100 (1952).

137 Larsen v. Commissioner, 66 T.C. 478, 483 (1976), acq. 1977-2 C.B. 1; P.L.R. 9402004 (Sept. 10, 1993) (“Taxpayer was not pursuing seven separate and distinct plans all of which could have been completed. Rather, finding seven potential buyers was part of the effort to accomplish a single transaction: the sale of Taxpayer. . . . Accordingly, Taxpayer is not entitled to claim a loss under section 165 of the Code.”). The final Indopco regulations, contain a similar rule. See Treas. Reg. § 1.263(a)-5(l) Ex. 13.

138 See Santa Fe Pacific Gold Company and Subsidiaries v. Commissioner, 132 T.C. 240 (2009) (taxpayer entitled to deduct termination fee paid to “white knight,” with which taxpayer had entered into a merger agreement in an unsuccessful attempt to prevent a hostile takeover; payment of termination fee did not lead to significant benefits for taxpayer extending past year at issue).

139 In P.L.R 200883009 (July 25, 2008), the IRS addressed the treatment of various transaction costs related to a merger.

140 I.R.C. § 1399.

141 See Rev. Rul. 84-170, 1984-2 C.B. 245.

142 Treas. Reg. § 1.6012-3(b)(4)-(5).

143 See also Rev. Rul. 84-170, 1984-2 C.B. 245 (“[I]t is clear that a receiver or trustee must make a return for a corporation in the process of liquidation even though business is no longer being conducted.”).

144 See, e.g., In re Holywell Corp., 911 F.2d 1539 (11th Cir. 1990).

145 503 U.S. 47 (1992).

146 Nicholas v. United States, 384 U.S. 678 (1966); In re Hudson Oil Co., 91 B.R. 932 (Bankr. D. Kan. 1988).

147 91 B.R. 932 (Bankr. D. Kan. 1988).

148 But see P.L.R. 850938 (Nov. 30 1984) (ruling trustee is not obligated to file returns for that were due prior to the trustee’s appointment).

149 1984-2 C.B. 244.

150 1984-2 C.B. 504.

151 Id.

152 See also Rev. Proc. 82-58, 1982-2 C.B. 847, amplified by Rev. Proc. 91-15, 1991-1 C.B. 484 (addressing advance rulings on status of liquidating trusts), and modified by Rev. Proc. 94-45, 1994-2 C.B. 685.

153 1994-2 C.B. 684.

154 This requirement should obviate any possible problems that might otherwise arise under the 1992 Supreme Court case of Holywell Corp. v. Smith, discussed supra at § 7.8(a).

155 See supra § 7.8(a).