APPENDIX E

Selected Provisions from the General Explanation of the Tax Reform Act of 1986

(H.R. 3838, 99th Congress; Public Law 99-514)

Discharge of Indebtedness Income for Certain Farmers 1

Special Limitations on Net Operating Loss and Other Carryforwards 3

Recognition of Gain or Loss on Liquidating Sales and Distributions of Property 41

Cancellation of Indebtedness for Solvent Taxpayers 67

DISCHARGE OF INDEBTEDNESS INCOME FOR CERTAIN FARMERS (SEC. 405 OF THE ACT AND SECS. 108 AND 1017 OF THE CODE)1

Prior Law

Under prior and present law, gross income is defined to include income from discharge of indebtedness (sec. 61). If a solvent taxpayer received income from discharge of trade or business indebtedness, prior law provided the taxpayer an election to exclude that income if the taxpayer’s basis in depreciable property was reduced (secs. 108 and 1017). If the amount of the discharge of indebtedness income exceeded a solvent taxpayer’s available basis, the taxpayer recognized income in an amount of the excess.

Under prior (and present) law, if an insolvent taxpayer receives income from discharge of indebtedness, the income is excluded (to the extent it does not exceed the amount of the taxpayer’s insolvency).2 The taxpayer’s tax attributes must be reduced by the amount of the excluded income. Reduction is required in the following attributes (in the following order): net operating losses and carryovers, general business credit carryovers, capital loss carryovers, basis of property,3 and foreign tax credit carryovers. An insolvent taxpayer may elect to reduce basis in depreciable property before reducing net operating losses or other attributes.

If the amount of the insolvent taxpayer’s discharge of indebtedness income (not in excess of the amount of its insolvency) exceeds its available tax attributes, the excess is disregarded, i.e., is not includible in income.

Reasons for Change

Congress was aware of enacted and pending legislation intended to alleviate the credit crisis in the farming sector, and of potential tax problems that might undermine the effectiveness of this legislation. For example, programs providing Federal guarantees on limited amounts of farm indebtedness in exchange for a lender’s agreement to reduce the total amount of a farmer’s indebtedness when that farmer had a high debt-to-equity ratio (but was not insolvent) were under consideration. Congress was concerned that such farmers would recognize large amounts of discharge of indebtedness income as a result of these loan write-downs—forcing them to forfeit their farmland rather than participate in programs designed to enable them to continue in farming.

Explanation of Provision

Under the Act, certain solvent taxpayers realizing income from the discharge of certain farming-related indebtedness may reduce tax attributes, including basis in property, under rules similar to those applicable to insolvent taxpayers. The discharged indebtedness must have been incurred directly in connection with the operation of a farming business by a taxpayer who satisfies a gross receipts test.4 The gross receipts test is satisfied if the taxpayer’s aggregate gross receipts from farming for the three years preceding the year of the discharge are 50 percent or more of his aggregate gross receipts from all sources for the same period.5

If a taxpayer elects to exclude income under this provision, the excluded amount must be applied to reduce tax attributes of the taxpayer in the following order: (1) net operating losses, (2) general business credits, (3) capital loss carryovers, (4) foreign tax credit carryovers, (5) basis in property other than land used or held for use in the trade or business of farming, and (6) basis in land used or held for use in the trade or business of farming.

The amount of the exclusion under this provision may not exceed the aggregate amount of the tax attributes of the taxpayer specified above. Accordingly, income must be recognized to the extent the amount of the discharged indebtedness exceeds his available attributes.6

Effective Date

The provision applies to discharge of indebtedness income realized after the April 9, 1986, in taxable years ending after that date.

Revenue Effect

This provision is estimated to decrease fiscal year budget receipts by $9 million in 1987, $10 million in 1988, $8 million in 1989, $7 million in 1990, and $5 million in 1991.

SPECIAL LIMITATIONS ON NET OPERATING LOSS AND OTHER CARRYFORWARDS (SEC. 621 OF THE ACT AND SECS. 382 AND 383 OF THE CODE)7

Prior Law

Overview

In general, a corporate taxpayer is allowed to carry a net operating loss (“NOL(s)”) forward for deduction in a future taxable year, as long as the corporation’s legal identity is maintained. After certain nontaxable asset acquisitions in which the acquired corporation goes out of existence, the acquired corporation’s NOL carryforwards are inherited by the acquiring corporation. Similar rules apply to tax attributes other than NOLs, such as net capital losses and unused tax credits. Historically, the use of NOL and other carryforwards has been subject to special limitations after specified transactions involving the corporation in which the carryforwards arose (referred to as the “loss corporation”). Prior law also provided other rules that were intended to limit tax-motivated acquisitions of loss corporations.

The operation of the special limitations on the use of carryforwards turned on whether the transaction that caused the limitations to apply took the form of a taxable sale or exchange of stock in the loss corporation or one of certain specified tax-free reorganizations in which the loss corporation’s tax attributes carried over to a corporate successor. After a purchase (or other taxable acquisition) of a controlling stock interest in a loss corporation, NOL and other carryforwards were disallowed unless the loss corporation continued to conduct its historical trade or business. In the case of a tax-free reorganization, NOL and other carryforwards were generally allowed in full if the loss corporation’s shareholders received stock representing at least 20 percent of the value of the acquiring corporation.

NOL and Other Carryforwards

Although the Federal income tax system generally requires an annual accounting, a corporate taxpayer was allowed to carry NOLs back to the three taxable years preceding the loss and then forward to each of the 15 taxable years following the loss year (sec. 172). The rationale for allowing the deduction of NOL carryforwards (and carrybacks) was that a taxpayer should be able to average income and losses over a period of years to reduce the disparity between the taxation of businesses that have stable income and businesses that experience fluctuations in income.8

In addition to NOLs, other tax attributes eligible to be carried back or forward include unused investment tax credits (secs. 30 and 39), excess foreign tax credits (sec. 904(c)), and net capital losses (sec. 1212). Like NOLs, unused investment tax credits were allowed a three-year carryback and a 15-year carryforward. Subject to an overall limitation based on a taxpayer’s U.S. tax attributable to foreign-source income, excess foreign tax credits were allowed a two-year carryback and a five-year carryforward. For net capital losses, generally, corporations had a three-year carryback (but only to the extent the carrybacks did not increase or create a NOL) and a five-year carryforward.

NOL and other carryforwards that were not used before the end of a carryforward period expired.

Carryovers to Corporate Successors

In general, a corporation’s tax history (e.g., carryforwards and asset basis) was preserved as long as the corporation’s legal identity was continued. Thus, under the general rules of prior law, changes in the stock ownership of a corporation did not affect the corporation’s tax attributes. Following are examples of transactions that effected ownership changes without altering the legal identity of a corporation:

Statutory rules also provided for the carryover of tax attributes (including NOL and other carryforwards) from one corporation to another in certain tax-free acquisitions in which the acquired corporation went out of existence (sec. 381). These rules applied if a corporation’s assets were acquired by another corporation in one of the following transactions:

In general, to qualify an acquisitive transaction (including a B reorganization) as a tax-free reorganization, the shareholders of the acquired corporation had to retain “continuity of interest.” Thus, a principal part of the consideration used by the acquiring corporation had to consist of stock, and the holdings of all shareholders had to be traced. Further, a tax-free reorganization was required to satisfy a “continuity of business enterprise” test. Generally, continuity of business enterprise requires that a significant portion of an acquired corporation’s assets be used in a business activity (see Treas. reg. sec. 1.368-1(d)).

Acquisitions to Evade or Avoid Income Tax

The Secretary of the Treasury was authorized to disallow deductions, credits, or other allowances following an acquisition of control of a corporation or a tax-free acquisition of a corporation’s assets if the principal purpose of the acquisition was tax avoidance (sec. 269). This provision applied in the following cases:

Treasury regulations under section 269 provided that the acquisition of assets with an aggregate basis that is materially greater than their value (i.e., assets with built-in losses), coupled with the utilization of the basis to create tax-reducing losses, is indicative of a tax-avoidance motive (Treas. reg. sec. 1.269-3(c)(1)).

Consolidated Return Regulations

To the extent that NOL carryforwards were not limited by the application of section 382 or section 269, after an acquisition, the use of such losses might be limited under the consolidated return regulations. In general, if an acquired corporation joined the acquiring corporation in the filing of a consolidated tax return by an affiliated group of corporations, the use of the acquired corporation’s preacquisition NOL carryforwards against income generated by other members of the group was limited by the “separate return limitation year” (“SRLY”) rules (Treas. reg. sec. 1.1502-21(c)). An acquired corporation was permitted to use pre-acquisition NOLs only up to the amount of its own contribution to the consolidated group’s taxable income. Section 269 was available to prevent taxpayers from avoiding the SRLY rules by diverting income-producing activities (or contributing income-producing assets) from elsewhere in the group to a newly acquired corporation (see Treas. reg. sec. 1.269-3(c)(2), to the effect that the transfer of income-producing assets by a parent corporation to a loss subsidiary filing a separate return may be deemed to have tax avoidance as a principal purpose).

Applicable Treasury regulations provided rules to prevent taxpayers from circumventing the SRLY rules by structuring a transaction as a “reverse acquisition” (defined in regulations as an acquisition where the “acquired” corporation’s shareholders end up owning more than 50 percent of the value of the “acquiring” corporation) (Treas. reg. sec. 1.1502-75(d)(3)). Similarly, under the “consolidated return change of ownership” (“CRCO”) rules, if more than 50 percent of the value of stock in the common parent of an affiliated group changed hands, tax attributes (such as NOL carryforwards) of the group were limited to use against post-acquisition income of the members of the group (Treas. reg. sec. 1.1502-21(d)).

Treasury regulations also prohibited the use of an acquired corporation’s built-in losses to reduce the taxable income of other members of an affiliated group (Treas. reg. sec. 1.1502-15). Under the regulations, built-in losses were subject to the SRLY rules. In general, built-in losses were defined as deductions or losses that economically accrued prior to the acquisition but were recognized for tax purposes after the acquisition, including depreciation deductions attributable to a built-in loss (Treas. reg. sec. 1.1502-15(a)(2)). The built-in loss limitations did not apply unless, among other things, the aggregate basis of the acquired corporation’s assets (other than cash, marketable securities, and goodwill) exceeded the value of those assets by more than 15 percent.

Allocation of Income and Deductions Among Related Taxpayers

The Secretary of the Treasury was authorized to apportion or allocate gross income, deductions, credits, or allowances, between or among related taxpayers (including corporations), if such action was necessary to prevent evasion of tax or to clearly reflect the income of a taxpayer (sec. 482). Section 482 could apply to prevent the diversion of income to a loss corporation in order to absorb NOL carryforwards.

Libson Shops Doctrine

In Libson Shops v. Koehler, 353 U.S. 382 (1957) (decided under the 1939 Code), the U.S. Supreme Court adopted a test of business continuity for use in determining the availability of NOL carryovers. The court denied NOL carryovers following the merger of 16 identically owned corporations (engaged in the same business at different locations) into one corporation, on the ground that the business generating post-merger income was not substantially the same business that incurred the loss (three corporations that generated the NOL carryovers continued to produce losses after the merger).

There was uncertainty whether the Libson Shops doctrine had continuing application as a separate nonstatutory test under the 1954 Code. Compare Maxwell Hardware Co. v. Commissioner, 343 F.2d 713 (9th Cir. 1965) (holding that Libson Shops is inapplicable to years governed by the 1954 Code) with Rev. Rul. 63-40, 1963-1 C.B.46, as modified by T.I.R. 773 (October 13, 1965) (indicating that Libson Shops may have continuing vitality where, inter alia, there is a shift in the “benefits” of an NOL carryover).9

1954 Code Special Limitations

The application of the special limitations on NOL carryforwards was triggered under the 1954 Code by specified changes in stock ownership of the loss corporation (sec. 382). In measuring changes in stock ownership, section 382(c) specifically excluded “nonvoting stock which is limited and preferred as to dividends.” Different rules were provided for the application of special limitations on the use of carryovers after a purchase and after a tax-free reorganization. Section 382 did not address the treatment of built-in losses.

If the principal purpose of the acquisition of a loss corporation was tax avoidance, section 269 would apply to disallow NOL carryforwards even if section 382 was inapplicable. Similarly, the SRLY rules could apply even if section 382 did not apply.

Taxable purchases

If the special limitations applied after a purchase, NOL carryforwards were disallowed entirely under the 1954 Code. The rule for purchases applied if (1) one or more of the loss corporation’s ten largest shareholders increased their common stock ownership within a two-year period by at least 50 percentage points, (2) the change in stock ownership resulted from a purchase or a decrease in the amount of outstanding stock, and (3) the loss corporation failed to continue the conduct of a trade or business substantially the same as that conducted before the proscribed change in ownership (sec. 382(a)). An exception to the purchase rule was provided for acquisitions from related persons.

Tax-free reorganizations

After a tax-free reorganization to which section 382(b) applied, NOL carryovers were allowed in full under the 1954 Code so long as the loss corporation’s shareholders received stock representing 20 percent or more of the value of the successor corporation (and section 269 did not apply). For each percentage point less than 20 percent received by the loss corporation’s shareholders, the NOL carryover was reduced by five percent (e.g., if the loss corporation’s shareholders received 15 percent of the acquiring corporation’s stock, 25 percent of the NOL carryover was disallowed). The reorganizations described in section 382(b) were those referred to in section 381(a)(2), in which the loss corporation goes out of existence and NOL carryforwards carry over to a corporate successor. Where an acquiring corporation used stock of a parent corporation as consideration (in a triangular reorganization), the 20-percent test was applied by treating the loss corporation’s shareholders as if they received stock of the acquiring corporation with an equivalent value, rather than stock of the parent corporation. An exception to the reorganization rule was provided for mergers of corporations that are owned substantially by the same persons in the same proportion (thus, the result in the Libson Shops case was reversed).

Bankruptcy proceedings and stock-for-debt exchanges

In the case of a G reorganization, a creditor who received stock in the reorganization was treated as a shareholder immediately before the reorganization. Thus, NOL carryforwards were generally available without limitation following changes in stock ownership resulting from a G reorganization.

If security holders exchanged securities for stock in a loss corporation, the transaction could qualify as an E reorganization or a section 351 exchange. If unsecured creditors (e.g., trade creditors) exchanged their debt claims for stock in a loss corporation, such creditors recognized gain or loss: (1) indebtedness of the transferee corporation not evidenced by a security was not considered as issued for property for purposes of section 351, and (2) the definition of an E reorganization required an exchange involving stock or securities. Thus, a stock-for-debt exchange by unsecured creditors was treated as a taxable purchase that triggered the special limitation.

Transactions involving “thrifts”

The general rules applied to taxable purchases of stock in a savings and loan association or savings bank (referred to as a “thrift”). Thus, after an ownership change resulting from a taxable purchase, a thrift’s NOL carryforwards were unaffected if the thrift continued its business. Moreover, section 382 did not apply to a section 351 transfer to a thrift.

Where the acquisition of a thrift resulted from a reorganization described in section 368(a)(3)(D)(ii),10 depositors were treated as stockholders and their deposits were treated as stock for purposes of the special limitations applicable to reorganizations (prior law sec. 382(b)(7)). Thus, a thrift’s NOL carryforwards were unaffected if the depositors’ interests (including the face amount of their deposits) represented at least 20 percent of the acquiring corporation’s value after the merger.

Special Limitations on Other Tax Attributes

Section 383 incorporated by reference the same limitations contained in section 382 for carryforwards of investment credits, foreign tax credits, and capital losses.

1976 Act Amendments

The Tax Reform Act of 1976 extensively revised section 382 to provide more nearly parallel rules for taxable purchases and tax-free reorganizations and to address technical problems arising under the 1954 Code. The 1976 Act amendments were to be effective in 1978; however, the effective date was delayed several times. The 1976 Act amendments to the rule for purchases technically became effective for taxable years beginning after December 31, 1985. The amended reorganization rules technically became effective for reorganizations pursuant to plans adopted on or after January 1, 1986.

Reasons for Change

The Act draws heavily on the recommendations regarding limitations on NOL carryforwards that were made by the Finance Committee Staff as part of its comprehensive final report regarding reform of subchapter C of the Internal Revenue Code. (See S. Prt. 99-47, 99th Cong., 1st Sess. (1985), “The Subchapter C Revision Act of 1985, A Final Report Prepared by the Staff”.)

Preservation of the Averaging Function of Carryovers

The primary purpose of the special limitations is the preservation of the integrity of the carryover provisions. The carryover provisions perform a needed averaging function by reducing the distortions caused by the annual accounting system. If, on the other hand, carryovers can be transferred in a way that permits a loss to offset unrelated income, no legitimate averaging function is performed. With completely free transferability of tax losses, the carryover provisions become a mechanism for partial recoupment of losses through the tax system. Under such a system, the Federal Government would effectively be required to reimburse a portion of all corporate tax losses. Regardless of the merits of such a reimbursement program, the carryover rules appear to be an inappropriate and inefficient mechanism for delivery of the reimbursement.

Appropriate Matching of Loss to Income

The 1976 Act amendments reflect the view that the relationship of one year’s loss to another year’s income should be largely a function of whether and how much the stock ownership changed in the interim, while the Libson Shops business continuation rule measures the relationship according to whether the loss and the income were generated by the same business. The Act acknowledges the merit in both approaches, while seeking to avoid the economic distortions and administrative problems that a strict application of either approach would entail.

A limitation based strictly on ownership would create a tax bias against sales of corporate businesses, and could prevent sales that would increase economic efficiency. For example, if a prospective buyer could increase the income from a corporate business to a moderate extent, but not enough to overcome the loss of all carryovers, no sale would take place because the business would be worth more to the less-efficient current owner than the prospective buyer would reasonably pay. A strict ownership limitation also would distort the measurement of taxable income generated by capital assets purchased before the corporation was acquired, if the tax deductions for capital costs economically allocable to post-acquisition years were accelerated into preacquisition years, creating carryovers that would be lost as a result of the acquisition.

Strict application of a business continuation rule would also be undesirable, because it would discourage efforts to rehabilitate troubled businesses. Such a rule would create an incentive to maintain obsolete and inefficient business practices if the needed changes would create the risk of discontinuing the old business for tax purposes, thus losing the benefit of the carryovers.

Permitting the carryover of all losses following an acquisition, as is permitted under the 1954 Code if the loss business is continued following a purchase, provides an improper matching of income and loss. Income generated under different corporate owners, from capital over and above the capital used in the loss business, is related to a pre-acquisition loss only in the formal sense that it is housed in the same corporate entity. Furthermore, the ability to use acquired losses against such unrelated income creates a tax bias in favor of acquisitions. For example, a prospective buyer of a loss corporation might be a less efficient operator of the business than the current owner, but the ability to use acquired losses could make the loss corporation more valuable to the less efficient user and thereby encourage a sale.

Reflecting the policies described above, the Act addresses three general concerns: (1) the approach of prior law (viz., the disallowance or reduction of NOL and other carryforwards), which is criticized as being too harsh where there are continuing loss-corporation shareholders, and ineffective to the extent that NOL carryforwards may be available for use without limitation after substantial ownership changes, (2) the discontinuities in the prior law treatment of taxable purchases and tax-free reorganizations, and (3) defects in the prior law rules that presented opportunities for tax avoidance.

General Approach

After reviewing various options for identifying events that present the opportunity for a tax benefit transfer (e.g., changes in a loss corporation’s business), it was concluded that changes in a loss corporation’s stock ownership continue to be the best indicator of a potentially abusive transaction. Under the Act, the special limitations generally apply when shareholders who bore the economic burden of a corporation’s NOLs no longer hold a controlling interest in the corporation. In such a case, the possibility arises that new shareholders will contribute income-producing assets (or divert income opportunities) to the loss corporation, and the corporation will obtain greater utilization of carryforwards than it could have had there been no change in ownership.

To address the concerns described above, the Act adopts the following approach: After a substantial ownership change, rather than reducing the NOL carryforward itself, the earnings against which an NOL carryforward can be deducted are limited. This general approach has received wide acceptance among tax scholars and practitioners. This “limitation on earnings” approach is intended to permit the survival of NOL carryforwards after an acquisition, while limiting the ability to utilize the carryforwards against unrelated income.

The limitation on earnings approach is intended to approximate the results that would occur if a loss corporation’s assets were combined with those of a profitable corporation in a partnership. This treatment can be justified on the ground that the option of contributing assets to a partnership is available to a loss corporation. In such a case, only the loss corporation’s share of the partnership’s income could be offset by the corporation’s NOL carryforward. Presumably, except in the case of tax-motivated partnership agreements, the loss corporation’s share of the partnership’s income would be limited to earnings generated by the assets contributed by the loss corporation.

For purposes of determining the income attributable to a loss corporation’s assets, the Act prescribes an objective rate of return on the value of the corporation’s equity. Consideration was given to the arguments made in favor of computing the prescribed rate of return by reference to the gross value of a loss corporation’s assets, without regard to outstanding debt. It was concluded that it would be inappropriate to permit the use of NOL carryforwards to shelter earnings that are used (or would be used in the absence of an acquisition) to service a loss corporation’s debt. The effect of taking a loss corporation’s gross value into account would be to accelerate the rate at which NOL carryforwards would be used had there been no change in ownership, because interest paid on indebtedness is deductible in its own right (thereby deferring the use of a corresponding amount of NOLs). There is a fundamental difference between debt capitalization and equity capitalization: true debt represents a claim against a loss corporation’s assets.

Annual limitation

The annual limitation on the use of pre-acquisition NOL carryforwards is the product of the prescribed rate and the value of the loss corporation’s equity immediately before a proscribed ownership change. The average yield for long-term marketable obligations of the U.S. government was selected as the measure of a loss corporation’s expected return on its assets.

The rate prescribed by the Act is higher than the average rate at which loss corporations actually absorb NOL carryforwards. Indeed, many loss corporations continue to experience NOLs, thereby increasing-rather than absorbing—NOL carryforwards. On the other hand, the adoption of the average absorption rate may be too restrictive for loss corporations that out-perform the average. Therefore, it would be inappropriate to set a rate at the lowest rate that is theoretically justified. The use of the long-term rate for Federal obligations was justified as a reasonable risk-free rate of return a loss corporation could obtain in the absence of a change in ownership.

Anti-abuse rules

The mechanical rules described above could present unintended tax-planning opportunities and might foster certain transactions that many would perceive to be violative of the legislative intent. Therefore, the Act includes several rules that are designed to prevent taxpayers from circumventing the special limitations or otherwise appearing to traffic in loss corporations by (1) reducing a loss corporation’s assets to cash or other passive assets and then selling off a corporate shell consisting primarily of NOLs and cash or other passive assets, or (2) making pre-acquisition infusions of assets to inflate artificially a loss corporation’s value (and thereby accelerate the use of NOL carryforwards). In addition, the Act retains the prior law principles that are intended to limit tax-motivated acquisitions of loss corporations (e.g., section 269, relating to acquisitions to evade or avoid taxes, and the regulatory SRLY and CRCO rules).

Consideration also was given to transactions in which taxpayers effectively attempt to purchase the NOLs of a loss corporation by the use of a partnership in which the loss corporation, as a partner, is allocated a large percentage of taxable income for a limited time period. During this time, the NOL partner’s losses are expected to shelter the partnership’s income while the cash flow from the partnership’s assets is used for other purposes. Later the NOL partner’s share of income is reduced. When all the facts and circumstances are considered, including the arrangements and actual transactions with respect to capital accounts, it often appears to be questionable whether the economic benefit that corresponds to the initial special allocation to the NOL partner is fully received by such partner. Nevertheless, some taxpayers take the position that such allocations have substantial economic effect under section 704(b). The Act contemplates that the Treasury Department will review this situation under section 704(b).

The Act provides that the Treasury Department shall prescribe such regulations as may be necessary or appropriate to prevent the avoidance of section 382 through the use of related parties, pass-through entities, or other intermediaries. For example, regardless of whether a special allocation has substantial economic effect under section 704(b), special allocations of income to a loss partner, or other arrangements shifting taxable income, will not be permitted to result in a greater use of losses than would occur if the principles of section 382 were applied to the arrangement.

Technical Problems

The Act addresses the technical problems of prior law by (1) coordinating the rules for taxable purchases with the rules for tax-free transactions, (2) expanding the scope of the rules to cover economically similar transactions that effect ownership changes (such as capital contributions, section 351 exchanges, and B reorganizations), (3) refining the definition of the term “stock,” and (4) applying the special limitations to built-in losses and taking into account built-in gains.

Discontinuities

Because the 1954 Code threshold for purchases was 50 percent, but the threshold for reorganizations was 20 percent, those rules presented the possibility that economically similar transactions would receive disparate tax treatment. Further, the special limitations applied after a purchase only if a pre-acquisition trade or business was discontinued, while the reorganization rule looked solely to changes in ownership. Finally, if the purchase rule applied, all NOL carryforwards were disallowed. In contrast, the rule for reorganizations merely reduced NOL carryforwards in proportion to the ownership change. The Act eliminates such discontinuities.

Continuity-of-business enterprise

The requirement under the 1954 Code rules that a loss corporation continue substantially the same business after a purchase presented potentially difficult definitional issues. Specifically, taxpayers and the courts were required to determine at what point a change in merchandise, location, size, or the use of assets should be treated as a change in the loss corporation’s business. It was also difficult to identify a particular business where assets and activities were constantly combined, separated, or rearranged. Further, there was a concern that the prior law requirement induced taxpayers to continue uneconomic businesses.

The Act eliminates the business-continuation rule. The continuity-of-business-enterprise rule generally applicable to tax-free reorganizations also applies to taxable transactions.

Participating stock

The Act addresses the treatment of transactions in which the beneficial ownership of an NOL carryforward does not follow stock ownership. This problem is illustrated by the case of Maxwell Hardware Co., in which a loss corporation’s old shareholders retained common stock representing more than 50 percent of the corporation’s value, but new shareholders received specially tailored preferred stock that carried with it a 90-percent participation in the corporation’s earnings attributable to income-producing assets contributed by the new shareholders.11

Built-in gains and losses

Built-in losses should be subject to special limitations because they are economically equivalent to pre-acquisition NOL carryforwards. If built-in losses were not subject to limitations, taxpayers could reduce or eliminate the impact of the general rules by causing a loss corporation (following an ownership change) to recognize its built-in losses free of the special limitations (and then invest the proceeds in assets similar to the assets sold).

The Act also provides relief for loss corporations with built-in gain assets. Built-in gains are often the product of special tax provisions that accelerate deductions or defer income (e.g., accelerated depreciation or installment sales reporting). Absent a special rule, the use of NOL carryforwards to offset built-in gains recognized after an acquisition would be limited, even though the carryforwards would have been fully available to offset such gains had the gains been recognized before the change in ownership occurred. (Similarly, a partnership is required to allocate built-in gain or loss to the contributing partner.)

Although the special treatment of built-in gains and losses may require valuations of a loss corporation’s assets, the Act limits the circumstances in which valuations will be required by providing a generous de minimis rule.

Other technical gaps

The Act also corrects the following defects in the 1954 Code rules: (1) only NOL deductions from prior taxable years were limited; thus, NOLs incurred in the year of a substantial ownership change were unaffected, (2) the rule for purchases was inapplicable to ownership changes resulting from section 351 exchanges, capital contributions, the liquidation of a partner’s interest in a partnership that owns stock in a loss corporation, and nontaxable acquisitions of interests in a partnership (e.g., by contribution) that owns stock in a loss corporation, (3) the reorganization rule was inapplicable to B reorganizations, (4) the measurement of the continuing interest of a loss corporation’s shareholders after a triangular reorganization enabled taxpayers to circumvent the 20-percent-continuity-of-interest rule, and (5) taxpayers took the position that the reorganization rule did not apply to reverse mergers (where an acquiring corporation’s subsidiary merged into a loss corporation and the loss corporation’s shareholders received stock of the acquiring corporation in the exchange).

Insolvent corporations

Under the general rule of the Act, no carryforwards would be usable after the acquisition of an insolvent corporation because the corporation’s value immediately before the acquisition would be zero. In such a case, however, the loss corporation’s creditors are the true owners of the corporation, although it may be impossible to identify the point in time when ownership shifted from the corporation’s shareholders.12 Relief from a strict application of the general rule is provided, as the creditors of an insolvent corporation frequently have borne the losses reflected in an NOL carryforward. There was a concern, however, about the potential for abusive transactions if an exception were generally available. For example, if there were a general stock-for-debt exception, an acquiring corporation could purchase a loss corporation’s debt immediately before or during a bankruptcy proceeding, exchange the debt for stock without triggering the special limitations, and then use the loss corporation’s NOL carryforwards immediately and without limitation. Alternatively, an acquiring corporation could purchase stock from the creditors after the bankruptcy proceeding, and after the loss corporation’s value has been increased by capital contributions.

For these reasons, the Act provides an exception for ownership changes that occur as part of a G reorganization or a stock-for-debt exchange in a Title 11 or similar proceeding, but includes appropriate safeguards intended to tax-motivated acquisitions of debt issued by loss corporations.

Explanation of Provisions

Overview

The Act alters the character of the special limitations on the use of NOL carryforwards. After an ownership change, as described below, the taxable income of a loss corporation available for offset by pre-acquisition NOL carryforwards is limited annually to a prescribed rate times the value of the loss corporation’s stock immediately before the ownership change. In addition, NOL carryforwards are disallowed entirely unless the loss corporation satisfies continuity-of-business enterprise requirements for the two-year period following any ownership change. The Act also expands the scope of the special limitations to include built-in losses and allows loss corporations to take into account built-in gains. The Act includes numerous technical changes and several anti-avoidance rules. Finally, the Act applies similar rules to carryforwards other than NOLs, such as net capital losses and excess foreign tax credits.

Ownership Change

The special limitations apply after any ownership change. An ownership change occurs, in general, if the percentage of stock of the new loss corporation owned by any one or more 5-percent shareholders (described below) has increased by more than 50 percentage points relative to the lowest percentage of stock of the old loss corporation owned by those 5-percent shareholders at any time during the testing period (generally a three-year period) (new sec. 382(g)(1)).13 The determination of whether an ownership change has occurred is made by aggregating the increases in percentage ownership for each 5-percent shareholder whose percentage ownership has increased during the testing period. For this purpose, all stock owned by persons who own less than five percent of a corporation’s stock generally is treated as stock owned by a single 5-percent shareholder (new sec. 382(g)(4)(A)). The determination of whether an ownership change has occurred is made after any owner shift involving a 5-percent shareholder or any equity structure shift.

Determinations of the percentage of stock in a loss corporation owned by any person are made on the basis of value. Except as provided in regulations to be prescribed by the Secretary, changes in proportionate ownership attributable solely to fluctuations in the relative fair market values of different classes of stock are not taken into account (new sec. 382(1)(3)(D)).

In determining whether an ownership change has occurred, changes in the holdings of certain preferred stock are disregarded. Except as provided in regulations, all “stock” (not including stock described in section 1504(a)(4)) is taken into account (new sec. 382(k)(6)(A)). Under this standard, the term stock does not include stock that (1) is not entitled to vote, (2) is limited and preferred as to dividends and does not participate in corporate growth to any significant extent, (3) has redemption and liquidation rights that do not exceed the stock’s issue price upon issuance (except for a reasonable redemption premium), and (4) is not convertible to any other class of stock. If preferred stock carries a dividend rate materially in excess of a market rate, this may indicate that it would not be disregarded.

Under grants of regulatory authority, the Treasury Department is expected to publish regulations disregarding, in appropriate cases, certain stock that would otherwise be counted in determining whether an ownership change has occurred, when necessary to prevent avoidance of the special limitations (new sec. 382(k)(6)(B)). For example, it may be appropriate to disregard preferred stock (even though voting) or common stock where the likely percentage participation of such stock in future corporate growth is disproportionately small compared to the percentage value of the stock as a proportion of total stock value, at the time of the issuance or transfer. Similarly, there is a concern that the inclusion of voting preferred stock (which is not described in section 1504(a)(4) solely because it carries the right to vote) in the definition of stock presents the potential for avoidance of section 382. As another example, stock such as that issued to the old loss company shareholders and retained by them in the case of Maxwell Hardware Company v. Commissioner, 343 F.2d 716 (9th Cir. 1969), is not intended to be counted in determining whether an ownership change has occurred.

In addition, the Treasury Department will promulgate regulations regarding the extent to which stock that is not described in section 1504(a)(4) should nevertheless not be considered stock. For example, the Treasury Department may issue regulations providing that preferred stock otherwise described in section 1504(a)(4) will not be considered stock simply because the dividends are in arrears and the preferred shareholders thus become entitled to vote.

Owner Shift Involving a 5-Percent Shareholder

An owner shift involving a 5-percent shareholder is defined as any change in the respective ownership of stock of a corporation that affects the percentage of stock held by any person who holds five percent or more of the stock of the corporation (a “5-percent shareholder”) before or after the change (new sec. 382(g)(2)). For purposes of this rule, all less-than-5-percent shareholders are aggregated and treated as one 5-percent shareholder. Thus, an owner shift involving a 5-percent shareholder includes (but is not limited to) the following transactions:

Example 1. The stock of L corporation is publicly traded; no shareholder holds five percent or more of L stock. During the three-year period between January 1, 1987 and January 1, 1990, there are numerous trades involving L stock. No ownership change will occur as a result of such purchases, provided that no person (or persons) becomes a 5-percent shareholder, either directly or indirectly, and increases his (or their) ownership of L stock by more than 50 percentage points.

Example 2. On January 1, 1987, the stock of L corporation is publicly traded; no shareholder holds five percent or more of L stock. On September 1, 1987, individuals A, B, and C, who were not previously L shareholders and are unrelated to each other or any L shareholders each acquire one-third of L stock. A, B, and C each have become 5-percent shareholders of L and, in the aggregate, hold 100 percent of the L stock. Accordingly, an ownership change has occurred, because the percentage of L stock owned by the three 5-percent shareholders after the owner shift (100 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by A, B, and C at any time during the testing period (0 percent prior to September 1, 1987).

Example 3. On January 1, 1987, individual I owns all 1,000 shares of corporation L. On June 15, 1987, I sells 300 of his L shares to unrelated individual A. On June 15, 1988, L issues 100 shares to each of B, C, and D. After these owner shifts involving I, A, B, C, and D, each of whom is a 5-percent shareholder, there is no ownership change, because the percentage of stock owned by A, B, C, and D after the owner shifts (approximately 46 percent-A 23 percent; B, C, and D 7.7 percent each) has not increased by more than 50 percentage points over the lowest percentage of stock owned by those shareholders during the testing period (0 percent prior to June 15, 1987). On December 15, 1988, L redeems 200 of the shares owned by I. Following this owner shift affecting I, a 5-percent shareholder, there is an ownership change, because the percentage of L stock owned by A, B, C, and D (approxi mately 55 percent-A-27.3 percent; B, C, and D-9.1 percent each) has increased by more than 50 per centage points over the lowest percentage owned by those shareholders during the testing period (0 percent prior to June 15, 1987).

Example 4. L corporation is closely held by four unrelated individuals, A, B, C, and D. On January 1, 1987, there is a public offering of L stock. No person who acquires stock in a public offering acquires five percent or more, and neither A, B, C, nor D acquires any additional stock. As a result of the offering, less-than-5-percent shareholders own stock representing 80 percent of the outstanding L stock. The stock ownership of the less-than-5-percent shareholders are aggregated and treated as owned by a single 5-percent shareholder for purposes of determining whether an ownership change has occurred. The percentage of stock owned by the less-than-5-percent shareholders after the owner shift (80 percent) has increased by more than 50 percentage points over the lowest percentage of stock owned by those shareholders at any time during the testing period (0 percent prior to January 1, 1987). Thus, an ownership change has occurred.

Example 5. On January 1, 1987, L corporation is wholly owned by individual X. On January 1, 1988, X sells 50 percent of his stock to 1,000 shareholders, all of whom are unrelated to him. On January 1, 1989, X sells his remaining 50-percent interest to an additional 1,000 shareholders, all of whom also are unrelated to him. Based on these facts, there is not an ownership change immediately following the initial sales by X, because the percentage of L stock owned by the group of less-than-5-percent shareholders (who are treated as a single 5-percent shareholder) after the owner shift (50 percent) has not increased by more than 50 percentage points over the lowest percentage of stock owned by this group at any time during the testing period (0 percent prior to January 1, 1988). On January 1, 1989, however, there is an ownership change, because the percentage of L stock owned by the group of less-than-5-percent shareholders after the owner shift (100 percent) has increased by more than 50 percentage points over their lowest percentage ownership at any time during the testing period (0 percent prior to January 1, 1988).

Example 6. The stock of L corporation is publicly traded; no shareholder owns five percent or more. On January 1, 1987, there is a stock offering as a result of which stock representing 60 percent of L’s value is acquired by an investor group consisting of 12 unrelated individuals, each of whom acquires five percent of L stock. Based on these facts, there has been an ownership change, because the percentage of L stock owned after the owner shift by the 12 5-percent shareholders in the investor group (60 percent) has increased by more than 50 percentage points over the lowest percentage of stock owned by those shareholders at any time during the testing period (0 percent prior to January 1, 1987).

Example 7. On January 1, 1987, L corporation is owned by two unrelated shareholders, A (60 percent) and C (40 percent). LS corporation is a wholly owned subsidiary of L corporation and is therefore deemed to be owned by A and C in the same proportions as their ownership of L (after application of the attribution rules, as discussed below). On January 1, 1988, L distributes all the stock of LS to A in exchange for all of A’s L stock in a section 355 transaction. There has been an ownership change of L, because the percentage of L stock owned by C (100 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by C at any time during the testing period (40 percent prior to the distribution of LS stock). There has not been an ownership change of LS, because the percentage of stock owned by A (100 percent) has not increased by more than 50 percentage points over the lowest percentage of stock owned by A at any time during the testing period (60 percent, after application of the attribution rules, as discussed below), prior to January 1, 1988.

An equity structure shift is defined as any tax-free reorganization within the meaning of section 368, other than a divisive “D” or “G” reorganization or an “F” reorganization (new sec. 382(g)(3)(A)). In addition, to the extent provided in regulations, the term equity structure shift may include other transactions, such as public offerings not involving a 5-percent shareholder or taxable reorganization-type transactions (e.g., mergers or other reorganization-type transactions that do not qualify for tax-free treatment due to the nature of the consideration or the failure to satisfy any of the other requirements for a tax-free transaction) (new secs. 382(g)(3)(B), (g)(4), and (m)(5)).14 A purpose of the provision that considers only owner shifts involving a 5-percent shareholder is to relieve widely held companies from the burden of keeping track of trades among less-than-5-percent shareholders. For example, a publicly traded company that is 60 percent owned by less-than-5-percent shareholders would not experience an ownership change merely because, within a three-year period, every one of such shareholders sold his stock to a person who was not a 5-percent shareholder. There are situations involving transfers of stock involving less-than-5-percent shareholders, other than tax-free reorganizations (for example, public offerings), in which it will be feasible to identify changes in ownership involving such shareholders, because, unlike public trading, the changes occur as part of a single, integrated transaction. Where identification is reasonably feasible or a reasonable presumption can be applied, the Treasury Department is expected to treat such transactions under the rules applicable to equity structure shifts.

For purposes of determining whether an ownership change has occurred following an equity structure shift, the less-than-5-percent shareholders of each corporation that was a party to the reorganization will be segregated and treated as a single, separate 5-percent shareholder (new sec. 382(g)(4)(B)(i)). The Act contemplates that this segregation rule will similarly apply to acquisitions by groups of less-than-5-percent shareholders through corporations as well as other entities (e.g., partnerships) and in transactions that do not constitute equity structure shifts (new sec. 382(g)(4)(C)). Moreover, the Act provides regulatory authority to apply similar segregation rules to segregate groups of less-than-5-percent shareholders in cases that involve only a single corporation (for example, a public offering or a recapitalization). (New sec. 382(m)(5)).

Example 8. On January 1, 1988, L corporation (a loss corporation) is merged (in a transaction described in section 368(a)(1)(A)) into P corporation (not a loss corporation), with P surviving. Both L and P are publicly traded corporations with no shareholder owning five percent or more of either corporation or the surviving corporation. In the merger, L shareholders receive 30 percent of the stock of P. There has been an ownership change of L, because the percentage of P stock owned by the former P shareholders (all of whom are less-than-5-percent shareholders who are treated as a separate, single 5-percent shareholder) after the equity structure shift (70 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by such shareholders at any time during the testing period (0 percent prior to the merger). If, however, the former shareholders of L had received at least 50 percent of the stock of P in the merger, there would not have been an ownership change of L.

An ownership change would similarly occur after a taxable merger in which L acquires P (in which L’s losses are not affected other than by the special limitations), if L’s former shareholders receive only 30 percent of the combined company, pursuant to new section 382(g)(4)(C). The Congress expected that section 382(g)(4)(C) would by its terms generally cause the segregation of the less-than-5-percent shareholders of separate entities where an entity other than a single corporation is involved in a transaction. Section 382(g)(3)(B) and section 382(m)(5) provide additional authority for the Treasury to segregate groups of less-than-5-percent shareholders where there is only one corporation involved.

Example 9. January 1, 1987, L corporation is owned by two unrelated shareholders, A (60 percent) and C (40 percent). On January 1, 1988, L redeems all of A’s L stock in exchange for non-voting preferred stock described in section 1504(a)(4). Following this recapitalization (which is both an equity structure shift and an owner shift involving a 5-percent shareholder), there has been an ownership change of L, because the percentage of L stock (which does not include preferred stock within the meaning of section 1504(a)(4)) owned by C following the equity structure shift (100 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by C at any time during the testing period (40 percent prior to the recapitalization).

Assume, alternatively, that on January 1, 1987, the stock of L corporation was widely held, with no shareholder owning as much as five percent, and that 60 percent of the stock was redeemed in exchange for non-voting preferred stock in a transaction that is otherwise identical to the transaction described above (which would be an equity structure shift, but not an owner shift involving a 5-percent shareholder because of the existence of only a single 5-percent shareholder, the aggregated less-than-5-percent shareholders, who owns 100 percent of L both before and after the exchange). In such a case, the Secretary will prescribe regulations segregating the less-than-5-percent shareholders of the single corporation, so that the group of shareholders who retain common stock in the recapitalization will be treated as a separate, single 5-percent shareholder. Accordingly, such a transaction would constitute an ownership change, because the percentage of L stock owned by the continuing common shareholders (100 percent) has increased by more than 50 percentage points over the lowest percent of stock owned by such shareholders at any time during the testing period (40 percent prior to the recapitalization).

Example 10. L corporation stock is widely held; no shareholder owns as much as five percent of L stock. On January 1, 1988, L corporation, which has a value of $1 million, directly issues stock with a value of $2 million to the public; no one person acquired as much as five percent in the public offering. No ownership change has occurred, because a public offering in which no person acquires as much as five percent of the corporation’s stock, however large, by a corporation that has no five-percent shareholder before the offering would not affect the percentage of stock owned by a 5-percent shareholder.15 In other words, the percentage of stock owned by less-than-5-percent shareholders of L immediately after the public offering (100 percent) has not increased by more than 50 percentage points over the lowest percentage of stock owned by the less-than-5-percent shareholders of L at any time during the testing period (100 percent).

To the extent provided in regulations that will apply prospectively from the date the regulations are issued, a public offering can be treated, in effect, as an equity structure shift with the result that the offering is a measuring event, even if there is otherwise no change in ownership of a person who owns 5-percent of the stock before or after the transaction. Rules also would be provided to segregate the group of less-than-5-percent shareholders prior to the offering and the new group of less-than-5-percent shareholders that acquire stock pursuant to the offering. Under such regulations, therefore, the less-than-5-percent shareholders who receive stock in the public offering could be segregated and treated as a separate 5-percent shareholder. Thus, an ownership change may result from the public offering described above, because the percentage of stock owned by the group of less-than-5-percent shareholders who acquire stock in the public offering, who are treated as a separate 5-percent shareholder (66.67 percent), has increased by more than 50 percentage points over the lowest percentage of L stock owned by such shareholders at any time during the testing period (0 percent prior to the public offering). The Act contemplates that the regulations may provide rules to allow the corporation to establish the extent, if any, to which existing shareholders acquire stock in the public offering.

Multiple Transactions

As described above, the determination of whether an ownership change has occurred is made by comparing the relevant shareholders’ stock ownership immediately after either an owner shift involving a 5-percent shareholder or an equity structure shift with the lowest percentage of such shareholders’ ownership at any time during the testing period. Thus, changes in ownership that occur by reason of a series of transactions including both owner shifts involving a 5-percent shareholder and equity structure shifts may constitute an ownership change. Where the segregation rule applies, for purposes of determining whether an ownership change has occurred as a result of any transaction, the acquisition of stock shall be treated as being made proportionately from all the shareholders immediately before the acquisition, unless a different proportion is established (new section 382(g)(4)(B)(ii) and (C)).

Example 11. On January 1, 1988, I (an individual) purchased 40 percent of the stock of L. The remaining stock of L is owned by 25 shareholders, none of whom own as much as five percent. On July 1, 1988, L is merged into P—which is wholly owned by I—in a tax-free reorganization. In exchange for their stock in L, the L shareholders (immediately before the merger) receive stock with a value representing 60 percent of the P stock that is outstanding immediately after the merger (24 percent to I; 36 percent to the less-than-5-percent shareholders of L). No other transactions occurred with respect to L stock during the testing period preceding the merger. There is an ownership change with respect to L immediately following the merger, because the percentage of stock owned by I in the combined entity (64 percent-40 percent by virtue of I’s ownership of P prior to the merger plus 24 percent received in the merger) has increased by more than 50 percentage points over the lowest percentage of stock in L owned by I during the testing period (0 percent prior to January 1, 1988).

Example 12. On July 12, 1989, L corporation is owned 45 percent by P, a publicly traded corporation (with no 5-percent shareholders), 40 percent by individual A, and 15 percent by individual B. All of the L shareholders have owned their stock since L’s organization in 1984. Neither A nor B owns any P stock. On July 30, 1989, B sells his entire 15-percent interest to C for cash. On August 13, 1989, P acquires A’s entire 40-percent interest in exchange for P stock representing an insignificant percentage of the outstanding P voting stock in a “B” reorganization.

There is an ownership change immediately following the B reorganization, because the percentage of L stock held (through attribution, as described below) by P shareholders (all of whom are less-than-5-percent shareholders who are treated as one 5-percent shareholder) and C (100 percent—P shareholders-85 percent; C-15 percent) has increased by more than 50 percentage points over the lowest percentage of stock owned by P shareholders and C at any time during the testing period (45 percent held constructively by P shareholders prior to August 13, 1989).

Example 13. The stock of L corporation is widely held by the public; no single shareholder owns five percent or more of L stock. G corporation also is widely held with no shareholder owning five percent or more. On January 1, 1988, L corporation and G corporation merge (in a tax-free transaction), with L surviving, and G shareholders receive 49 percent of L stock. On July 1, 1988, B, an individual who has never owned stock in L or G, purchases five percent of L stock in a transaction on a public stock exchange.

The merger of L and G is not an ownership change of L, because the percentage of stock owned by the less-than-5-percent shareholders of G (who are aggregated and treated as a single 5-percent shareholder) (49 percent) has not increased by more than 50 percentage points over the lowest percentage of L stock owned by such shareholders during the testing period (0 percent prior to the merger). The purchase of L stock by B is an owner shift involving a five-percent shareholder, which is presumed (unless otherwise established) to have been made proportionately from the groups of former G and L shareholders (49 percent from the G shareholders and 51 percent from the L shareholders). There is an ownership change of L because, immediately after the owner shift involving B, the percentage of stock owned by the G shareholders (presumed to be 46.55 percent—49 percent actually acquired in the mergerless 2.45 percent presumed sold to B) and B (5 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by those shareholders at any time during the testing period (0 percent prior to the merger).

Example 14. The stock of L corporation and G corporation is widely held by the public; neither corporation has any shareholder owning as much as five percent of its stock. On January 1, 1988, B purchases 10 percent of L stock. On July 1, 1988, L and G merge (in a tax-free transaction), with L surviving, and G shareholders receiving 49 percent of L stock.

The merger of L and G is an ownership change because, immediately after the merger, the percentage of stock owned by G shareholders (49 percent) and B (5.1 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by such shareholders at any time during the testing period (0 percent prior to the stock purchase by B).

Attribution and Aggregation of Stock Ownership

Attribution from entities. In determining whether an ownership change has occurred, the constructive ownership rules of section 318, with several modifications, are applied (new sec. 382(1)(3)). Except to the extent provided in regulations, the rules for attributing ownership of stock (within the meaning of new section 382(k)(6)) from corporations to their shareholders are applied without regard to the extent of the shareholders’ ownership in the corporation.16 Thus, any stock owned by a corporation is treated as being owned proportionately by its shareholders. Moreover, except as provided in regulations, any stock attributed to a corporation’s shareholders is not treated as being held by such corporation. Stock attributed from a partnership, estate, or trust similarly shall not be treated as being held by such entity. The effect of the attribution rules is to prevent application of the special limitations after an acquisition that does not result in a more than 50 percent change in the ultimate beneficial ownership of a loss corporation.17 Conversely, the attribution rules result in an ownership change where more than 50 percent of a loss corporation’s stock is acquired indirectly through an acquisition of stock in the corporation’s parent corporation.

Example 15. L corporation is publicly traded; no shareholder owns as much as five percent. P corporation is publicly traded; no shareholder owns as much as five percent. On January 1, 1988, P corporation purchases 100 percent of L corporation stock on the open market. The L stock owned by P is attributed to the shareholders of P, all of whom are less-than-5-percent shareholders who are treated as a single, separate 5-percent shareholder under section 382(g)(4)(C). Accordingly, there has been an ownership change of L, because the percentage of stock owned by the P shareholders after the purchase (100 percent) has increased by more than 50 percentage points over the lowest percentage of L stock owned by that group at any time during the testing period (0 percent prior to January 1, 1988).

Aggregation rules. Special aggregation rules are applied for all stock ownership, actual or deemed, by shareholders of a corporation who are less-than-5-percent shareholders. Except as provided in regulations, stock owned by such persons is treated as being held by a single, separate 5-percent shareholder. For purposes of determining whether transactions following an equity structure shift or owner shift involving a 5-percent shareholder constitute an ownership change, the aggregation rules trace any subsequent change in ownership by a group of less-than-5-percent shareholders. In analyzing subsequent shifts in ownership, unless a different proportion is established otherwise, acquisitions of stock shall be treated as being made proportionately from all shareholders immediately before such acquisition.

Example 16. Corporation A is widely held by a group of less-than-5-percent shareholders (“Shareholder Group A”). Corporation A owns 80 percent of both corporation B and corporation C, which respectively own 100 percent of corporation L and corporation P. Individual X owns the remaining stock in B (20 percent) and individual Y owns the remaining stock in C (20 percent). On January 1, 1988, L and P are, respectively, the only assets of B and C; and B and C are of equal value. On January 1, 1988, B merges into C with C surviving. After the merger, X owns 10 percent of C stock, Y owns 10 percent of C stock, and A owns 80 percent of C stock. The attribution rules (see sec. 382(1)(3)) and special aggregation rules (see sec. 382(g)(4)) apply to treat Shareholder Group A as a single, separate 5-percent shareholder owning 80 percent of the stock of L prior to the merger. Following the merger, Shareholder Group A still owns 80 percent of the stock of L, X owns 10 percent of the stock of L, and Y owns 10 percent of the stock of L. No ownership change occurs as a result of the merger, because the stock of L owned by Shareholder Group A is the same before and after the merger (80 percent), the stock of L owned by X has not increased but has decreased, and the stock of L owned by Y (0 percent before the merger and 10 percent after the merger) has not increased by more than 50 percentage points.

Example 17. L corporation is publicly traded; no shareholder owns more than five percent. LS is a wholly owned subsidiary of L corporation. On January 1, 1988, L distributes all the stock of LS pro rata to the L shareholders. There has not been any change in the respective ownership of the stock of LS, because the less-than-5-percent shareholders of L, who are aggregated and treated as a single, separate 5-percent shareholder, are treated as owning 100 percent of LS (by attribution) before the distribution and directly own 100 percent of LS after the distribution. Thus, no owner shift involving a 5-percent shareholder has occurred; accordingly, there has not been an ownership change.

Example 18. L Corporation is valued at $600. Individual A owns 30 percent of L stock, with its remaining ownership widely held by less-than-5-percent shareholders (“Shareholder Group L”). P corporation is widely held by less-than-5-percent shareholders (“Shareholder Group P”), and is valued at $400. On January 1, 1988, L and P consolidate in a tax-free reorganization into L/P Corporation, with 60 percent of the value of such stock being distributed to former L corporation shareholders. On June 15, 1988, 17 percent of L/P corporation stock is acquired in a series of open market transactions by individual B. At all times between January 1, 1988 and June 15, 1988, A’s ownership interest in L/P Corporation remained unchanged.

The consolidation by L and P on January 1, 1988 is an equity structure shift, but not an ownership change with respect to L. Under the attribution and aggregation rules, the ownership interest in new loss corporation, L/P Corporation, is as follows: A owns 18 percent (60 percent of 30 percent), Shareholder Group L owns 42 percent (60 percent of 70 percent) and Shareholder Group P owns 40 percent. The only 5-percent shareholder whose stock interest in new loss corporation increased relative to the lowest percentage of stock ownership in old loss corporation during the testing period, Shareholder Group P, did not increase by more than 50 percentage points.

The Act provides that, unless a different proportion is established by the taxpayer or the Internal Revenue Service, acquisitions of stock following the consolidation are treated as being made proportionately from all shareholders immediately before such transaction. Thus, under the general rule, B’s open market purchase on June 15, 1988 of L/P Corporation stock would be treated as being made proportionately from A, Shareholder Group L, and Shareholder Group P. As a result, the application of this convention without modification would result in an ownership change, because the interests of B (17 percent) and Shareholder Group P (40 percent less the 6.8 percent deemed acquired by B) in new loss corporation would have increased by more than 50 percentage points during the testing period (50.2 percent). A’s ownership interest in L/P corporation, however, has in fact remained unchanged. Because L/P Corporation could thus establish that the acquisition by B was not proportionate from all existing shareholders, however, it would be permitted to establish a different proportion for the deemed shareholder composition following B’s purchase as follows: (1) A actually owns 18 percent, (2) B actually owns 17 percent, (3) Shareholder Group L is deemed to own 33.3 percent (42 percent less (17 percent × 42/82)), and (4) Shareholder Group P is deemed to own 31.7 percent (40 percent less (17 percent × 40/82)). If L/P Corporation properly establishes these facts, no ownership change has occurred, because B and Shareholder Group P have a stock interest in L/P Corporation (48.7 percent) that has not increased by more than 50 percentage points over the lowest percentage of stock owned by such shareholders in L/P Corporation, or L Corporation at any time during the testing period (0 percent).

If B purchased eleven percent from A, there would be an ownership change. The presumption does not apply in the case of subsequent purchases from persons who are 5-percent shareholders without regard to the aggregation rules.

Other attribution rules. The family attribution rules of sections 318(a)(1) and 318(a)(5)(B) do not apply, but an individual, his spouse, his parents, his children, and his grandparents are treated as a single shareholder. “Back” attribution to partnerships, trusts, estates, and corporations from partners, beneficiaries, and shareholders will not apply except as provided in regulations.

The Act does not provide rules for attributing stock that is owned by a government. For example, stock that is owned by a foreign government is not treated as owned by any other person. Thus, if a government of a country owned 100% of the stock of a corporation and, within the testing period, sold all of such stock to members of the public who were citizens of the country, an ownership change would result. Governmental units, agencies, and instrumentalities that derive their powers, rights, and duties from the same sovereign authority will be treated as a single shareholder.

Finally, except as provided in regulations, the holder of an option is treated as owning the underlying stock if such a presumption would result in an ownership change.18 This rule is intended to apply to options relating to stock in a loss corporation as well as any other instrument relating to the direct or indirect ownership in a loss corporation. The subsequent exercise of an option is disregarded if the holder of the option has been treated as owning the underlying stock. On the other hand, if the holder of the option was not treated as owning the underlying stock, the subsequent exercise will be taken into account in determining whether there is an owner shift at time of exercise. This rule is to be applied on an option-by-option basis so that, in appropriate cases, certain options will be deemed exercised while others may not. Similarly, a person will be treated as owning stock that may be acquired pursuant to any contingency, warrant, right to acquire stock, conversion feature, put, or similar interest, if such a presumption results in an ownership change.19 If the option or other contingency expires without a transfer of stock ownership, but the existence of the option or other contingency resulted in an ownership change under this rule, the loss corporation will be able to file amended tax returns (subject to any applicable statute of limitations) for prior years as if the corporation had not been subject to the special limitations.

Example 19. L corporation has 1,000 shares of stock outstanding, which are owned by 25 unrelated shareholders, none of whom own five percent or more. P corporation is wholly owned by individual A. On January 1, 1987, L corporation acquires 100 percent of P stock from A. In exchange, A receives 750 shares of L stock and a contingent right to receive up to an additional 500 shares of L stock, depending on the earnings of P corporation over the next five years.

Except as provided in regulations, A would be treated as owning all the L stock that he might receive on occurrence of the contingency (and such stock is thus treated as additional outstanding stock). Accordingly, an ownership change of L would occur, because the percentage of stock owned (and treated as owned) by A (1.250 shares-55.5 percent (33.3 percent (750 of 2,250 shares) directly and 22.2 percent (500 of 2,250 shares) by attribution)) increased by more than 50 percentage points over the lowest percentage of stock owned by A at any time during the testing period (0 percent prior to January 1, 1987).

Example 20. L corporation and P corporation are publicly traded; no shareholder owns five percent or more of either corporation. On January 1, 1989, P corporation purchases 40 percent of the stock in L corporation and an option to acquire the remaining 60 percent of L corporation stock. The option is exercisable three years after the date on which the option is issued.

Under the Act, if P is treated as owning the L corporation stock obtainable on exercise of the option, then P corporation would be treated as owning 100 percent of L corporation. Thus, the presumption provided by section 382(1)(3)(A) would apply, and an ownership change would result. The same result would apply even if the option were exercisable only in the event of a contingency such as the attaining of a specified earnings level by the end of a specified period.

Stock acquired by reason of death, gift, divorce or separation. If (i) the basis of any stock in the hands of any person is determined under section 1014 (relating to property acquired from a decedent), section 1015 (relating to property acquired by a gift or transfer in trust), or section 1041(b) (relating to transfers of property between spouses or incident to divorce), (ii) stock is received by any person in satisfaction of a right to receive a pecuniary bequest, or (iii) stock is acquired by a person pursuant to any divorce or separation instrument (within the meaning of section 71(b)(2)), then such persons shall be treated as owning such stock during the period such stock was owned by the person from whom it was acquired (new sec. 382(1)(3)(B)). Such transfers, therefore, would not constitute owner shifts.

Special rule for employee stock ownership plans. If certain ownership and allocation requirements are satisfied, the acquisition of employer securities (within the meaning of section 409(1)) by either a tax credit employee stock ownership plan or an employee stock ownership plan (within the meaning of section 4975(e)(7)) shall not be taken into account in determining whether an ownership change has occurred (new sec. 382(1)(3)(C)). The acquisition of employer securities from any such plan by a participant of any such plan pursuant to the requirements of section 409(h) also will not be taken into account in determining whether an ownership change has occurred.

Utilization of holding company structures. The mere formation of a holding company unaccompanied by a change in the beneficial ownership of the loss corporation will not result in an ownership change. The attribution rules of section 318, as modified for purposes of applying these special limitations, achieve this result by generally disregarding any corporate owner of stock as the owner of any loss corporation stock (new sec. 382(1)(3)(A)(ii)(II)). Instead, the attribution rules are designed to provide a mechanism for tracking the changes in ownership by the ultimate beneficial owners of the loss corporation. The creation of a holding company structure is significant to the determination of whether an ownership change has occurred only if it is accompanied by a change in the ultimate beneficial ownership of the loss corporation.

Example 21. The stock of L corporation is owned equally by unrelated individuals, A, B, C, and D. On January 1, 1988, A, B, C, and D contribute their L corporation stock to a newly formed holding company (“HC”) in exchange for equal interests in stock and securities of HC in a transaction that qualifies under section 351.

The formation of HC does not result in an ownership change with respect to L. Under the attribution rules, A, B, C, and D following the incorporation of L corporation are considered to own 25 percent of the stock of L corporation and, unless provided otherwise in regulations, HC is treated as not holding any stock in L corporation. Accordingly, the respective holdings in L corporation were not altered to any extent and there is thus no owner shift involving a 5-percent shareholder. The result would be the same if L corporation were owned by less-than-5-percent shareholders prior to the formation of the holding company.

Example 22. The stock of L corporation is widely held by the public (“Public/L”) and is valued at $600. P is also widely held by the public (“Public/P”) and is valued at $400. On January 1, 1988, P forms Newco with a contribution of P stock. Immediately thereafter, Newco acquires all of the properties of L corporation in exchange for its P stock in a forward triangular merger qualifying under section 368(a)(2)(D). Following the transaction, Public/L and Public/P respectively are deemed to own 60 percent and 40 percent of P stock.

Inserting P between Public/L and L corporation (which becomes Newco in the merger) does not result in an ownership change with respect to Newco, the new loss corporation. Under new section 382(g)(4)(B)(i), Public/L and Public/P are each treated as a separate 5-percent shareholder of Newco, the new loss corporation.20 Unless regulations provide otherwise, P’s direct ownership interest in L corporation is disregarded. Because the percentage of Newco stock owned by Public/P shareholders after the equity structure shift (40 percent) has not increased by more than 50 percentage points over the lowest percentage of stock of L (the old loss corporation) owned by such shareholders at any time during the testing period (0 percent prior to January 1, 1988), the transaction does not constitute an ownership change with respect to Newco.

3-Year Testing Period

In general, the relevant testing period for determining whether an ownership change has occurred is the three-year period preceding any owner shift involving a 5-percent shareholder or any equity structure shift (new sec. 382(i)(1)). Thus, a series of unrelated transactions occurring during a three-year period may constitute an ownership change. A shorter period, however, may be applicable following any ownership change. In such a case, the testing period for determining whether a second ownership change has occurred does not begin before the day following the first ownership change (new sec. 382(i)(2)).

In addition, the testing period does not begin before the first day of the first taxable year from which there is a loss carryforward (including a current NOL that is defined as a pre-change loss) or excess credit (new sec. 382(i)(3)). Thus, transactions that occur prior to the creation of any attribute subject to limitation under section 382 or section 383 are disregarded. Except as provided in regulations, the special rule described above does not apply to any corporation with a net unrealized built-in loss. The Act contemplates, however, that the regulations will permit such corporations to disregard transactions that occur before the year for which such a corporation establishes that a net unrealized built-in loss first arose.

Effect of Ownership Change

Section 382 limitation

For any taxable year ending after the change date (i.e., the date on which an owner shift resulting in an ownership change occurs or the date of the reorganization in the case of an equity structure shift resulting in an ownership change), the amount of a loss corporation’s (or a successor corporation’s) taxable income that can be offset by a pre-change loss (described below) cannot exceed the section 382 limitation for such year (new sec. 382(a)). The section 382 limitation for any taxable year is generally the amount equal to the value of the loss corporation immediately before the ownership change multiplied by the long-term tax-exempt rate (described below) (new sec. 382(b)(1)).

The Treasury Department is required to prescribe regulations regarding the application of the section 382 limitation in the case of a short taxable year. These regulations will generally provide that the section 382 limitation applicable in a short taxable year will be determined by multiplying the full section 382 limitation by the ratio of the number of days in the year to 365. Thus, taxable income realized by a new loss corporation during a short taxable year may be offset by pre-change losses not exceeding a ratable portion of the full section 382 limitation.

If there is a net unrealized built-in gain, the section 382 limitation for any taxable year is increased by the amount of any recognized built-in gains (determined under rules described below). Also, the section 382 limitation is increased by built-in gain recognized by virtue of a section 338 election (to the extent such gain is not otherwise taken into account as a built-in gain). Finally, if the section 382 limitation for a taxable year exceeds the taxable income for the year, the section 382 limitation for the next taxable year is increased by such excess.

If two or more loss corporations are merged or otherwise reorganized into a single entity, separate section 382 limitations are determined and applied to each loss corporation that experiences an ownership change.

Example 23. X corporation is wholly owned by individual A and its stock has a value of $3,000; X has NOL carryforwards of $10,000. Y corporation is wholly owned by individual B and its stock has a value of $9,000; Y has NOL carryforwards of $100. Z corporation is owned by individual C and its stock has a value of $18,000; Z has no NOL carryforwards. On July 22, 1988, X, Y, and Z consolidate into W corporation in a transaction that qualifies as a tax-free reorganization under section 368(a)(1)(A). The applicable long-term tax-exempt rate on such date is 10 percent. As a result of the consolidation, A receives 10 percent of W stock, B receives 30 percent, and C receives 60 percent.

The consolidation of X, Y, and Z results in an ownership change for old loss corporations X and Y. The Act applies a separate section 382 limitation to the utilization of the NOL carryforwards of each loss corporation that experiences an ownership change. Therefore, the annual limitation on X’s NOL carryforwards is $300 and the annual limitation on Y’s NOL carryforwards is $900.

For W’s taxable year ending on December 31, 1989, W’s taxable income before any reduction for its NOLs is $1,400. The amount of taxable income of W that may be offset by X and Y’s pre-change losses (without regard to any unused section 382 limitation) is $400 (the $300 section 382 limitation for X’s NOL carryforwards and all $100 of Y’s NOL carryforwards because that amount is less than Y’s $900 section 382 limitation). The unused portion of Y’s section 382 limitation may not be used to augment X’s section 382 limitation for 1989 or in any subsequent year.

Special rule for post-change year that includes the change date. In general, the section 382 limitation with respect to an ownership change that occurs during a taxable year does not apply to the utilization of losses against the portion of the loss corporation’s taxable income, if any, allocable to the period before the change. For this purpose, except as provided in regulations, taxable income (not including built-in gains or losses, if there is a net unrealized built-in gain or loss) realized during the change year is allocated ratably to each day in the year. The regulations may provide that income realized before the change date from discrete sales of assets would be excluded from the ratable allocation and could be offset without limit by pre-change losses. Moreover, these regulations may provide a loss corporation with an option to determine the taxable income allocable to the period before the change by closing its books on the change date and thus forgoing the ratable allocation.

Value of loss corporation

The value of a loss corporation is generally the fair market value of the corporation’s stock (including preferred stock described in section 1504(a)(4)) immediately before the ownership change (new sec. 382(e)(1)). If a redemption occurs in connection with an ownership change—either before or after the change—the value of the loss corporation is determined after taking the redemption into account (new sec. 382(e)(2)).21 The Treasury Department is given regulatory authority to treat other corporate contractions in the same manner as redemptions for purposes of determining the loss corporation’s value. The Treasury Department also is required to prescribe such regulations as are necessary to treat warrants, options, contracts to acquire stock, convertible debt, and similar interests as stock for purposes of determining the value of the loss corporation (new sec. 382(k)(6)(B)(i)).

In determining value, the price at which loss corporation stock changes hands in an arms-length transaction would be evidence, but not conclusive evidence, of the value of the stock. Assume, for example, that an acquiring corporation purchased 40 percent of loss corporation stock over a 12-month period. Six months following this 40 percent acquisition, the acquiring corporation purchased an additional 20 percent of loss corporation stock at a price that reflected a premium over the stock’s proportionate amount of the value of all the loss corporation stock; the premium is paid because the 20-percent block carries with it effective control of the loss corporation. Based on these facts, it would be inappropriate to simply gross-up the amount paid for the 20-percent interest to determine the value of the corporation’s stock. Under regulations, it is anticipated that the Treasury Department will permit the loss corporation to be valued based upon a formula that grosses up the purchase price of all of the acquired loss corporation stock if a control block of such stock is acquired within a 12-month period.

Example 24. All of the outstanding stock of L corporation is owned by individual A and has a value of $1,000. On June 15, 1988, A sells 51 percent of his stock in L to unrelated individual B. On January 1, 1989, L and A enter into a 15-year management contract and L redeems A’s remaining stock interest in such corporation. The latter transactions were contemplated in connection with B’s earlier acquisition of stock in 1988.

The acquisition of 51 percent of the stock of L on June 15, 1988, constituted an ownership change. The value of L for purposes of computing the section 382 limitation is the value of the stock of such corporation immediately before the ownership change. Although the value of such stock was $1,000 at that time, the value must be reduced by the value of A’s stock that was subsequently redeemed in connection with the ownership change.

Long-term tax-exempt rate

The long-term tax-exempt rate is defined as the highest of the Federal long-term rates determined under section 1274(d), as adjusted to reflect differences between rates on long-term taxable and tax-exempt obligations, in effect for the month in which the change date occurs or the two prior months (new sec. 382(f)). The Treasury Department will publish the long-term tax-exempt rate by revenue ruling within 30 days after the date of enactment and monthly thereafter. The long-term tax-exempt rate will be computed as the yield on a diversified pool of prime, general obligation tax-exempt bonds with remaining periods to maturity of more than nine years.

The use of a rate lower than the long-term Federal rate is necessary to ensure that the value of NOL carryforwards to the buying corporation is not more than their value to the loss corporation. Otherwise there would be a tax incentive to acquire loss corporations. If the loss corporation were to sell its assets and invest in long-term Treasury obligations, it could absorb its NOL carryforwards at a rate equal to the yield on long-term government obligations. Since the price paid by the buyer is larger than the value of the loss company’s assets (because the value of NOL carryforwards are taken into account), applying the long-term Treasury rate to the purchase price would result in faster utilization of NOL carryforwards by the buying corporation. The long-term tax-exempt rate normally will fall between 66 (1 minus the maximum corporate tax rate of 34 percent) and 100 percent of the long-term Federal rate.

Example 25. Corporation L has $1 million of net operating loss carryforwards. L’s taxable year is the calendar year, and on July 1, 1987, all of the stock of L is sold in a transaction constituting an ownership change of L. (Assume the transaction does not terminate L’s taxable year.) On that date, the value of L’s stock was $500,000 and the long-term tax-exempt rate was 10 percent. Finally, L incurred net operating loss during 1987 of $100,000, and L had no built-in gains or losses.

On these facts, the taxable income of L after July 1, 1987, that could be offset by L’s losses incurred prior to July 1, 1987, would generally be limited. In particular, for all taxable years after 1987, the pre-change losses of L generally could be used to offset no more than $50,000 of L’s taxable income each year. (For L’s 1987 taxable year, the limit would be $25,000 (1/2 × the $50,000 section 382 limitation).) The pre-change losses of L would constitute the $1 million of NOL carryforwards plus one-half of the 1987 net operating loss, or a total of $1,050,000. If, in taxable year 1988, L had $30,000 of taxable income to be offset by L’s losses, it could be fully offset by L’s pre-change NOLs and the amount of L’s 1989 taxable income that could be offset by pre-change losses would be limited to $95,000 ($50,000 annual limit plus $45,000 carryover).

If L had income of $100,000 in 1987, instead of a net operating loss, L’s 1987 taxable income that could be offset by pre-change losses would generally be limited to $75,000 (1/2 × the $50,000 section 382 limitation plus 1/2 × $100,000 1987 income). (In appropriate circumstances, the Secretary could, by regulations, require allocation of income using a method other than daily proration. Such circumstances might include, for example, an instance in which substantial income-producing assets are contributed to capital after the change date.)

Continuity of business enterprise requirements

Following an ownership change, a loss corporation’s NOL carryforwards (including any recognized built-in losses, described below) are subject to complete disallowance (except to the extent of any recognized built-in gains or section 338 gain, described below), unless the loss corporation’s business enterprise is continued at all times during the two-year period following the ownership change. If a loss corporation fails to satisfy the continuity of business enterprise requirements, no NOL carryforwards would be allowed to the new loss corporation for any post-change year. This continuity of business enterprise requirement is the same requirement that must be satisfied to qualify a transaction as a tax-free reorganization under section 368. (See Treasury regulation section 1.368-1(d).) Under these continuity of business enterprise requirements, a loss corporation (or a successor corporation) must either continue the old loss corporation’s historic business or use a significant portion of the old loss corporation’s assets in a business. Thus, the requirements may be satisfied even though the old loss corporation discontinues more than a minor portion of its historic business. Changes in the location of a loss corporation’s business or the loss corporation’s key employees, in contrast to the results under the business-continuation rule in the 1954 Code version of section 382(a), will not constitute a failure to satisfy the continuity of business enterprise requirements under the conference agreement.

Reduction in loss corporation’s value for certain capital contributions

Any capital contribution (including a section 351 transfer) that is made to a loss corporation as part of a plan a principal purpose of which is to avoid any of the special limitations under section 382 shall not be taken into account for any purpose under section 382. For purposes of this rule, except as provided in regulations, a capital contribution made during the two-year period ending on the change date is irrebuttably presumed to be part of a plan to avoid the limitations. The application of this rule will result in a reduction of a loss corporation’s value for purposes of determining the section 382 limitation. The term “capital contribution” is to be interpreted broadly to encompass any direct or indirect infusion of capital into a loss corporation (e.g., the merger of one corporation into a commonly owned loss corporation). Regulations generally will except (i) capital contributions received on the formation of a loss corporation (not accompanied by the incorporation of assets with a net unrealized built-in loss) where an ownership change occurs within two years of incorporation, (ii) capital contributions received before the first year from which there is an NOL or excess credit carryforward (or in which a net unrealized built-in loss arose), and (iii) capital contributions made to continue basic operations of the corporation’s business (e.g., to meet the monthly payroll or fund other operating expenses of the loss corporation). The regulations also may take into account, under appropriate circumstances, the existence of substantial nonbusiness assets on the change date (as described below) and distributions made to shareholders subsequent to capital contributions, as offsets to such contributions.

Reduction in value for corporations having substantial nonbusiness assets

If at least one-third of the fair market value of a corporation’s assets consists of nonbusiness assets, the value of the loss corporation, for purposes of determining the section 382 limitation, is reduced by the excess of the value of the nonbusiness assets over the portion of the corporation’s indebtedness attributable to such assets. The term nonbusiness assets includes any asset held for investment, including cash and marketable stock or securities. Assets held as an integral part of the conduct of a trade or business (e.g., assets funding reserves of an insurance company or similar assets of a bank) would not be considered nonbusiness assets. In addition, stock or securities in a corporation that is at least 50 percent owned (voting power and value) by a loss corporation are not treated as nonbusiness assets. Instead, the parent loss corporation is deemed to own its ratable share of the subsidiary’s assets. The portion of a corporation’s indebtedness attributable to nonbusiness assets is determined on the basis of the ratio of the value of nonbusiness assets to the value of all the loss corporation’s assets.

Regulated investment companies, real estate investment trusts, and real estate mortgage investment conduits are not treated as having substantial nonbusiness assets.

Losses subject to limitation

The term “pre-change loss” includes (i) for the taxable year in which an ownership change occurs, the portion of the loss corporation’s NOL that is allocable (determined on a daily pro rata basis, without regard to recognized built-in gains or losses, as described below) to the period in such year before the change date, (ii) NOL carryforwards that arose in a taxable year preceding the taxable year of the ownership change and (iii) certain recognized built-in losses and deductions (described below).

For any taxable year in which a corporation has income that, under section 172, may be offset by both a pre-change loss (i.e., an NOL subject to limitation) and an NOL that is not subject to limitation, taxable income is treated as having been first offset by the pre-change loss (new sec. 382(1)(2)(B)). This rule minimizes the NOLs that are subject to the special limitations. For purposes of determining the amount of a prechange loss that may be carried to a taxable year (under section 172(b)), taxable income for a taxable year is treated as not greater than the section 382 limitation for such year reduced by the unused pre-change losses for prior taxable years. (New sec. 382(1)(2)(A)).

Built-in losses

If a loss corporation has a net unrealized built-in loss, the recognized built-in loss for any taxable year ending within the five-year period ending at the close of the fifth post-change year (the “recognition period”) is treated as a pre-change loss (new sec. 382(h)(1)(B)).

Net unrealized built-in losses. The term “net unrealized built-in loss” is defined as the amount by which the fair market value of the loss corporation’s assets immediately before the ownership change is less than the aggregate adjusted bases of a corporation’s assets at that time. Under a de minimis exception, the special rule for built-in losses is not applied if the amount of a net unrealized built-in loss does not exceed 25 percent of the value of the corporation’s assets immediately before the ownership change. For purposes of the de minimis exception, the value of a corporation’s assets is determined by excluding any (1) cash, (2) cash items (as determined for purposes of section 368(a)(2)(F)(iv)), or (3) marketable securities that have a value that does not substantially differ from adjusted basis.

Example 26. L corporation owns two assets: asset X, with a basis of $150 and a value of $50 (a built-in loss asset), and asset Y, with a basis of zero and a value of $50 (a built-in gain asset, described below). L has a net unrealized built-in loss of $50 (the excess of the aggregate bases of $150 over the aggregate value of $100).

Recognized built-in losses. The term “recognized built-in loss” is defined as any loss that is recognized on the disposition of an asset during the recognition period, except to the extent that the new loss corporation establishes that (1) the asset was not held by the loss corporation immediately before the change date, or (2) the loss (or a portion of such loss) is greater than the excess of the adjusted basis of the asset on the change date over the asset’s fair market value on that date. The recognized built-in loss for a taxable year cannot exceed the net unrealized built-in loss reduced by recognized built-in losses for prior taxable years ending in the recognition period.

The amount of any recognized built-in loss that exceeds the section 382 limitation for any post-change year must be carried forward (not carried back) under rules similar to the rules applicable to net operating loss carryforwards and will be subject to the special limitations in the same manner as a pre-change loss.

Accrued deductions. The Treasury Department is authorized to issue regulations under which amounts that accrue before the change date, but are allowable as a deduction on or after such date (e.g., deductions deferred by section 267 or section 465), will be treated as built-in losses. Depreciation deductions cannot be treated as accrued deductions or built-in losses;22 however, the Secretary of the Treasury is required to conduct a study of whether built-in depreciation deductions should be subject to section 382, and report to the tax-writing committees of the Congress before January 1, 1989.

Built-in gains

If a loss corporation has a net unrealized built-in gain, the section 382 limitation for any taxable year ending within the five-year recognition period is increased by the recognized built-in gain for the taxable year (new sec. 382(h)(1)(A)).

Net unrealized built-in gains. The term “net unrealized built-in gain” is defined as the amount by which the value of a corporation’s assets exceeds the aggregate bases of such assets immediately before the ownership change. Under the de minimis exception described above, the special rule for built-in gains is not applied if the amount of a net unrealized built-in gain does not exceed 25 percent of the value of a loss corporation’s assets.

Recognized built-in gains. The term “recognized built-in gain” is defined as any gain recognized on the disposition of an asset during the recognition period, if the taxpayer establishes that the asset was held by the loss corporation immediately before the change date, to the extent the gain does not exceed the excess of the fair market value of such asset on the change date over the adjusted basis of the asset on that date. The recognized built-in gain for a taxable year cannot exceed the net unrealized built-in gain reduced by the recognized built-in gains for prior years in the recognition period.

Bankruptcy proceedings

The special limitations do not apply after any ownership change of a loss corporation if (1) such corporation was under the jurisdiction of a bankruptcy court in a Title 11 or similar case immediately before the ownership change, and (2) the corporation’s historic shareholders and creditors (determined immediately before the ownership change) own 50 percent of the value and voting power of the loss corporation’s stock immediately after the ownership change (new sec. 382(1)(5)). The 50-percent test is satisfied if the corporation’s shareholders and creditors own stock of a controlling corporation that is also in bankruptcy (new sec. 382(1)(5)(A)(ii)).

This special rule applies only if the stock-for-debt exchange, reorganization, or other transaction is ordered by the court or is pursuant to a plan approved by the court. For purposes of the 50-percent test, stock of a creditor that was converted from indebtedness is taken into account only if such indebtedness was held by the creditor for at least 18 months before the date the bankruptcy case was filed or arose in the ordinary course of the loss corporation’s trade or business and is held by the person who has at all times held the beneficial interest in the claim. Indebtedness will be considered as having arisen in the ordinary course of the loss corporation’s business only if the indebtedness was incurred by the loss corporation in connection with the normal, usual, or customary conduct of its business. It is not relevant for this purpose whether the debt was related to ordinary or capital expenditures of the loss corporation. In addition, stock of a shareholder is taken into account only to the extent such stock was received in exchange for stock that was held immediately before the ownership change.

If the exception for bankruptcy proceedings applies, several special rules are applicable. First, the pre-change losses and excess credits that may be carried to a post-change year are reduced by one-half of the amount of any cancellation of indebtedness income that would have been included in the loss corporation’s income as a result of any stock-for-debt exchanges that occur as part of the Title 11 or similar proceeding under the principles of section 108(e)(10) (without applying section 108(e)(10)(B)). Thus, the NOL carryforwards would be reduced by 50 percent of the excess of the amount of the indebtedness canceled over the fair market value of the stock exchanged. Second, the loss corporation’s pre-change NOL carryforwards are reduced by the interest on the indebtedness that was converted to stock in the bankruptcy proceeding and paid or accrued during the period beginning on the first day of the third taxable year preceding the taxable year in which the ownership change occurs and ending on the change date. Finally, after an ownership change that qualifies for the bankruptcy exception, a second ownership change during the following two-year period will result in the elimination of NOL carryforwards that arose before the first ownership change. The special bankruptcy provisions do not apply to stock-for-debt exchanges in informal workouts, but the Secretary of the Treasury is required to study informal bankruptcy workouts under sections 108 and 382, and report to the tax-writing committees of the Congress before January 1, 1988.

The Act provides an election, subject to such terms and conditions as the Secretary may prescribe, to forgo the exception for Title 11 or similar cases (new sec. 382(1)(5)(H)). If this election is made, the general rules described above will apply except that the value of the loss corporation will reflect any increase in value resulting from any surrender or cancellation of creditors’ claims in the transaction (for purposes of applying new section 382(e)).

Thrift institutions

A modified version of the bankruptcy exception (described above) applies to certain ownership changes of a thrift institution involved in a G reorganization by virtue of section 368(a)(3)(D)(ii). This rule also applies to ownership changes resulting from an issuance of stock or equity structure shift that is an integral part of a transaction involving such a reorganization, provided that the transaction would not have resulted in limitations under prior law.23 The bankruptcy exception is applied to qualified thrift reorganizations by requiring shareholders and creditors (including depositors) to retain a 20-percent (rather than 50-percent) interest. For this purpose, the fair market value of the outstanding stock of the new loss corporation includes the amount of deposits in such corporation immediately after the change, as under prior law.24 The general bankruptcy rules that eliminate from the NOL carryforwards both interest deductions on debt that was converted and income that would be recognized under the principles of section 108(e)(10) are not applicable to thrifts.

Transactions involving solvent thrifts, including a purchase of the stock of a thrift, or merger of a thrift into another corporation, will be subject to the general rules relating to ownership changes. The conversion of a solvent mutual savings and loan association into a stock savings and loan (or other transactions involving a savings and loan not entitled to special treatment), although not within the special rules applicable to troubled thrifts, will not necessarily constitute an ownership change. In such a conversion, the mutual thrift converts to stock form as a preliminary step to the issuance of stock to investors for purposes of raising capital. Under prior law IRS rulings, the entire transaction may qualify as a tax-free reorganization if certain conditions are met. For purposes of determining whether there has been an ownership change causing a limitation on the use of losses, the issuance of stock generally will be treated under the rules applicable to owner shifts. For example, the depositors holding liquidation accounts would generally be considered a group of less-than-5-percent shareholders, and if the stock were issued entirely to less-than-5-percent shareholders, or 5-percent shareholders acquired less than 50 percent, no ownership change would occur. Treasury regulations may be issued, on a prospective basis, that would treat public offerings generally in the same manner as equity structure shifts and treat the old shareholders and the persons acquiring stock in the offering as separate 5-percent shareholder groups. If such regulations are issued and apply this same approach to the conversion of a solvent mutual savings and loan association to stock form and the issuance of new stock, an ownership change could result, however, if the value of the stock issued in the public offering exceeds the equity of the depositors in the mutual represented by liquidation accounts. The application of any such regulations to thrift institutions (whether solvent or insolvent) would not be effective before January 1, 1989.

Carryforwards other than NOLs

The Act also amends section 383, relating to special limitations on unused business credits and research credits, excess foreign tax credits, and capital loss carryforwards. Under regulations to be prescribed by the Secretary, capital loss carryforwards will be limited to an amount determined on the basis of the tax liability that is attributable to so much of the taxable income as does not exceed the section 382 limitation for the taxable year, with the same ordering rules that apply under present law. Thus, any capital loss carryforward used in a post-change year will reduce the section 382 limitation that is applied to pre-change losses. In addition, the amount of any excess credit that may be used following an ownership change will be limited, under regulations, on the basis of the tax liability attributable to an amount of taxable income that does not exceed the applicable section 382 limitation, after any NOL carryforwards, capital loss carryforwards, or foreign tax credits are taken into account. The Act also expands the scope of section 383 to include passive activity losses and credits and minimum tax credits.

Anti-abuse rules

The Act does not alter the continuing application of section 269, relating to acquisitions made to evade or avoid taxes, as under prior law. Similarly, the SRLY and CRCO principles under the regulations governing the filing of consolidated returns will continue to apply. The Libson Shops doctrine will have no application to transactions subject to the provisions of the Act.

The Act provides that the Treasury Department shall prescribe regulations preventing the avoidance of the purposes of section 382 through the use of, among other thing, pass-through entities. For example, a special allocation of income to a loss partner should not be permitted to result in a greater utilization of losses than would occur if the principles of section 382 were applicable.

In the case of partnerships, for example, the regulations are expected to limit the tax benefits that may be derived from transactions in which allocations of partnership income are made to a loss partner or to a corporation that is a member of a consolidated group with NOL carryovers (a “loss corporation partner”) under an arrangement that contemplates the diversion of any more than an insignificant portion of the economic benefit corresponding to such allocation (or any portion of the economic benefit of the loss corporation partner’s NOL) to a higher tax bracket partner.

This grant of authority contemplates any rules that the Treasury Department considers appropriate to achieve this objective. For example, regulations may provide, as a general rule, that the limitations of section 382 (and section 383) should be made applicable to restrict a loss corporation partner’s use of losses against its distributive share of each item of partnership income and that any portion of the distributive share of partnership income so allocated which may not be offset by the loss corporation’s NOLs should be taxed at the highest marginal tax rate. Such regulations could also provide that the allocation of income to the loss corporation may, in the discretion of the Secretary, be reallocated to the extent that other partners in the partnership have not been reasonably compensated for their services to the partnership. If the Treasury Department uses such a format to restrict the utilization of NOLs, it may be appropriate to exempt from these rules any partnership with respect to which, throughout the term of the partnership, (i) every allocation to every partner would be a qualified allocation as described in section 168(j)(9)(B) if it were made to a tax-exempt entity, with appropriate exceptions (e.g., section 704(c) allocations) and (ii) distributions are made to one partner only if there is a simultaneous pro rata distribution to all partners at the same time. Special rules would, of course, have to be provided to apply section 382 (and section 383) in this context.

No inference was intended regarding whether allocations made to loss corporations by partnerships that involve transfers of the economic benefit of a loss partner’s loss to another partner have substantial economic effect. As described in the report of the Committee on Finance, there are circumstances in which it appears to be questionable whether the economic benefit that corresponds to a special allocation to the NOL partner is fully received by such partner; however, some taxpayers nevertheless take the position that such allocations have substantial economic effect under section 704(b). The Treasury Department is expected to review this situation.

The regulations issued under this grant of authority with respect to partnerships should be effective for transactions after the date of enactment. Any regulations addressing other situations, under the Treasury Department’s general authority to limit the ability of other parties to obtain any portion of the benefit of a loss corporation’s losses, may be prospective within the general discretion of the Secretary.

1976 Act Amendments

The Act generally repeals the amendments to section 382 and 383 made by the Tax Reform Act of 1976, effective retroactively as of January 1, 1986. Thus, the law that was in effect as of December 31, 1985, applies to transactions that are not subject to the new provisions because of the effective dates of the conference agreement. The Act, by repealing the 1976 Act amendments, also retroactively repeals section 108(e)(10)(C), as included by the Tax Reform Act of 1984.

Effective Dates

The provisions of the Act generally apply to ownership changes that occur on or after January 1, 1987. In the case of equity structure shifts (notwithstanding the fact that the transaction falls within the definition of an owner shift), the new rules apply to reorganizations pursuant to plans adopted on or after January 1, 1987. In the case of an ownership change occurring immediately after an owner shift (other than an equity structure shift) completed on or after January 1, 1987, new section 382 shall apply. In the case of an equity structure shift (including equity structure shifts that are also owner shifts), Congress intended that new section 382 shall apply to any post-1986 ownership change occurring immediately after the completion of any reorganization pursuant to a plan adopted on or after January 1, 1987. Congress also intended that new section 382 shall apply to any post-1986 ownership change occurring immediately after the completion of a reorganization pursuant to a plan adopted before January 1, 1987, unless the shift in ownership caused by such reorganization, when considered together only with any other shifts in ownership that may have occurred on or after May 6, 1986, and before December 31, 1986, would have caused an ownership change.25

For purposes of the effective date rules, if there is an ownership change with respect to a subsidiary corporation as the result of the acquisition of the parent corporation, the subsidiary’s treatment is governed by the nature of the parent-level transaction. For example, if all the stock of a parent corporation is acquired in a tax-free reorganization pursuant to a plan adopted before January 1, 1987, then the resulting indirect ownership change with respect to a subsidiary loss corporation will be treated as having occurred by reason of a reorganization pursuant to a plan adopted before January 1, 1987.

A reorganization plan will be considered adopted on the date that the boards of directors of all parties to the reorganization adopt the plans or recommend adoption to the shareholders, or on the date the shareholders approve, whichever is earlier. The parties’ boards of directors may approve a plan of reorganization based on principles, and negotiations to date, and delegate to corporate officials the power to refine and execute a binding reorganization agreement, including a binding agreement subject to regulatory approval. Any subsequent board approval or ratification taken at the time of consummating the transaction as a formality (i.e., that is not required, because the reorganization agreement is already legally binding under prior board approval) may occur without affecting the application of the effective date rule for reorganizations. In the case of a reorganization described in section 368(a)(1)(G) or an exchange of debt for stock in a Title 11 or similar case, the amendments do not apply to any ownership change resulting from such a reorganization or proceeding if a petition in such case was filed with the court before August 14, 1986.

The earliest testing period under the Act begins on May 6, 1986 (the date of Senate Finance Committee action).26 If an ownership change occurs after May 5, 1986, but before January 1, 1987, and section 382 and 383 (as amended by the Act) do not apply, then the earliest testing date will not begin before the first day following the date of such ownership change. For example, assume 60 percent of a loss corporation’s stock (wholly owned by X) is purchased by B on May 29, 1986, and section 382 under the 1954 Code does not apply (because, for example, the loss corporation’s business is continued and section 269 is not implicated). Assume further that X’s remaining 40 percent stock interest is acquired by B on February 1, 1987. Under the Act, no ownership change occurs after the second purchase because the testing period begins on May 30, 1986, the day immediately after the ownership change; thus, an ownership change would not result from the second purchase. Conversely, if 40 percent of a loss corporation’s stock (wholly owned by X) is purchased by D on July 1, 1986, and an additional 15 percent is purchased by P on January 15, 1987, then an ownership change would result from the second purchase, and the amendments would apply to limit the use of the loss corporation’s NOL carryforwards.

Moreover, if an ownership change that occurs after December 31, 1986 is not affected by the amendments to section 382 (because, for example, in the foregoing example the initial 40 percent stock purchase occurred on May 5, 1986, prior to the commencement of the testing period), the 1954 Code version of section 382 will remain applicable to the transaction. The 1954 Code version of section 382 is generally intended to have continuing application to any increase in percentage points to which the amendments made by the Act do not apply by application of any transitional rule, including the rules prescribing measurement of the testing period by reference only to transactions after May 5, 1986, and the rules grandfathering or disregarding ownership changes following or resulting from certain transactions.27

For purposes of determining whether shifts in ownership have occurred on or after May 6, 1986 and before December 31, 1986, the rule of section 382(1)(3)(A)(iv) in the case of options, and the similar rule in the case of any contingent purchase, warrant, convertible debt, stock subject to a risk of forfeiture, contract to acquire stock, or similar interests, shall apply. For example, in the case of such interests issued on or after May 6, 1986,28 the underlying stock could generally be treated as acquired at the time the interest was issued. However, for this transition period, it is expected that the Treasury Department may provide for a different treatment in the case of an acquisition of an option or other interest that is not in fact exercised, as appropriate where the effect of treating the underlying stock as if it were acquired would be to cause an ownership change that would be grandfathered under the transition rules and start a new testing period.

Contingent interests arising prior to January 1, 1987, for example, contingent options created in business transactions occurring prior to that date, are not treated as ownership changes merely by operation of the January 1, 1987, effective date. No inference is intended regarding the treatment of such contingent interests under the Act, other than to clarify that they are not treated as ownership changes merely by operation of the January 1, 1987 effective date.29

Special transitional rules are provided under which prior law continues to apply to certain ownership changes after January 1, 1987.

Revenue Effect

These provisions are estimated to increase fiscal year budget receipts by $9 million in 1987, $29 million in 1988, $39 million in 1989, $38 million in 1990, and $29 million in 1991.

RECOGNITION OF GAIN OR LOSS ON LIQUIDATING SALES AND DISTRIBUTIONS OF PROPERTY (GENERAL UTILITIES) (SECS. 631, 632, AND 633 OF THE ACT AND SECS. 336, 337, AND 1374 OF THE CODE)330

Prior Law

Overview

As a general rule, under prior law (as under present law) corporate earnings from sales of appreciated property were taxed twice, first to the corporation when the sale occurred, and again to the shareholders when the net proceeds were distributed as dividends. At the corporate level, the income was taxed at ordinary rates if it resulted from the sale of inventory or other ordinary income assets, or at capital gains rates if it resulted from the sale of a capital asset held for more than six months. With certain exceptions, shareholders were taxed at ordinary income rates to the extent of their pro rata share of the distributing corporation’s current and accumulated earnings and profits.

An important exception to this two-level taxation of corporate earnings was the so-called General Utilities rule.31 The General Utilities rule permitted nonrecognition of gain by corporations on certain distributions of appreciated property32 to their shareholders and on certain liquidating sales of property. Thus, its effect was to allow appreciation in property accruing during the period it was held by a corporation to escape tax at the corporate level. At the same time, the transferee (the shareholder or third-party purchaser) obtained a stepped-up, fair market value basis under other provisions of the Code, with associated additional depreciation, depletion, or amortization deductions. Accordingly, the “price” of a step up in the basis of property subject to the General Utilities rule was typically a single capital gains tax paid by the shareholder on receipt of a liquidating distribution from the corporation.

Although the General Utilities case involved a dividend distribution of appreciated property by an ongoing business, the term “General Utilities rule” was often used in a broader sense to refer to the nonrecognition treatment accorded in certain situations to liquidating as well as nonliquidating distributions to shareholders and to liquidating sales. The rule was reflected in Code sections 311, 336, and 337 of prior law.33 Section 311 governed the treatment of nonliquidating distributions of property (dividends and redemptions), while section 336 governed the treatment of liquidating distributions in kind. Section 337 provided nonrecognition treatment for certain sales of property pursuant to a plan of complete liquidation.

Numerous limitations on the General Utilities rule, both statutory and judicial, developed over the years following its codification. Some directly limited the statutory provisions embodying the rule, while others, including the collapsible corporation provisions, the recapture provisions, and the tax benefit doctrine, did so indirectly.

Case Law and Statutory Background

Genesis of the General Utilities rule

The precise meaning of General Utilities was a matter of considerable debate in the years following the 1935 decision. The essential facts were as follows. General Utilities had purchased 50 percent of the stock of Islands Edison Co. in 1927 for $2,000. In 1928, a prospective buyer offered to buy all of General Utilities’ shares in Islands Edison, which apparently had a fair market value at that time of more than $1 million. Seeking to avoid the large corporate-level tax that would be imposed if it sold the stock itself, General Utilities offered to distribute the Islands Edison stock to its shareholders with the understanding that they would then sell the stock to the buyer. The company’s officers and the buyer negotiated the terms of the sale but did not sign a contract. The shareholders of General Utilities had no binding commitment upon receipt of the Islands Edison shares to sell them to the buyer on these terms.

General Utilities declared a dividend in an amount equal to the value of the Islands Edison stock, payable in shares of that stock. The corporation distributed the Islands Edison shares and, four days later, the shareholders sold the shares to the buyer on the terms previously negotiated by the company’s officers.

The Internal Revenue Service took the position that the distribution of the Islands Edison shares was a taxable transaction to General Utilities. Before the Supreme Court, the Commissioner argued that the company had created an indebtedness to its shareholders in declaring a dividend, and that the discharge of this indebtedness using appreciated property produced taxable income to the company under the holding in Kirby Lumber Co. v. United States.34 Alternatively, he argued, the sale of the Islands Edison stock was in reality made by General Utilities rather than by its shareholders following distribution of the stock. Finally, the Commissioner contended that a distribution of appreciated property by a corporation in and of itself constitutes a realization event. All dividends are distributed in satisfaction of the corporation’s general obligation to pay out earnings to shareholders, he argued, and the satisfaction of that obligation with appreciated property causes a realization of the gain.

The Supreme Court held that the distribution did not give rise to taxable income under a discharge of indebtedness rationale. The Court did not directly address the Commissioner’s third argument, that the company realized income simply by distributing appreciated property as a dividend. There is disagreement over whether the Court rejected this argument on substantive grounds or merely on the ground it was not timely made. Despite the ambiguity of the Supreme Court’s decision, however, subsequent cases interpreted the decision as rejecting the Commissioner’s third argument and as holding that no gain is realized on corporate distributions of appreciated property to its shareholders.

Five years after the decision in General Utilities, in a case in which the corporation played a substantial role in the sale of distributed property by its shareholders, the Commissioner successfully advanced the imputed sale argument the Court had rejected earlier on procedural grounds. In Commissioner v. Court Holding Co.,35 the Court upheld the Commissioner’s determination that, in substance, the corporation rather than the shareholders had executed the sale and, accordingly, was required to recognize gain.

In United States v. Cumberland Public Service Co.,36 the Supreme Court reached a contrary result where the facts showed the shareholders had in fact negotiated a sale on their own behalf. The Court stated that Congress had imposed no tax on liquidating distributions in kind or on dissolution, and that a corporation could liquidate without subjecting itself to corporate gains tax notwithstanding the primary motive is to avoid the corporate tax.37

In its 1954 revision of the Internal Revenue Code, Congress reviewed General Utilities and its progeny and decided to address the corporate-level consequences of distributions statutorily. It essentially codified the result in General Utilities by enacting section 311(a) of prior law, which provided that a corporation recognized no gain or loss on a nonliquidating distribution of property with respect to its stock. Congress also enacted section 336, which in its original form provided for non-recognition of gain or loss to a corporation on distributions of property in partial or complete liquidation. Although distributions in partial liquidations were eventually removed from the jurisdiction of section 336, in certain limited circumstances a distribution in partial liquidation could, prior to the Act, still qualify for nonrecognition at the corporate level.”38

Finally, Congress in the 1954 Act provided that a corporation did not recognize gain or loss on a sale of property if it adopted a plan of complete liquidation and distributed all of its assets to its shareholders within twelve months of the date of adoption of the plan (sec. 337). Thus, the distinction drawn in Court Holding Co. and Cumberland Public Service Co., between a sale of assets followed by liquidating distribution of the proceeds and a liquidating distribution in kind followed by a shareholder sale, was in large part eliminated. Regulations subsequently issued under section 311 acknowledged that a distribution in redemption of stock constituted a “distribution with respect to . . . stock” within the meaning of the statute.39 The 1954 Code in its original form, therefore, generally exempted all forms of nonliquidating as well as liquidating distributions to shareholders from the corporate-level tax.

Nonliquidating distributions: section 311

Congress subsequently enacted a number of statutory exceptions to the General Utilities rule. Under prior law (as under present law), the presumption under General Utilities was reversed for nonliquidating distributions: the general rule was that a corporation recognized gain (but not loss) on a distribution of property as a dividend or in redemption of stock.40 The distributing corporation is treated as if it sold the property for its fair market value on the date of the distribution. A number of exceptions to the general rule were provided. First, no gain was generally recognized to the distributing corporation with respect to distributions in partial liquidation made with respect to “qualified stock.” Qualified stock was defined as stock held by noncorporate shareholders who at all times during the five-year period prior to the distribution (or the period the corporation had been in existence, if shorter) owned 10 percent or more in value of the distributing corporation’s outstanding stock.41

Second, an exception from the general gain recognition rule was provided for a distribution with respect to qualified stock that constituted a “qualified dividend.” A “qualified dividend” for this purpose was a dividend of property (other than inventory or receivables) used in the active conduct of certain “qualified businesses.”42 A “qualified business” was any trade or business that had been actively conducted for the five-year period ending on the date of the distribution and was not acquired in a transaction in which gain or loss was recognized in whole or in part during such period.43 Thus, nonrecognition under this exception did not apply to distributions from holding companies or consisting of ordinary income property, and was limited to distributions to certain long-term, 10-percent shareholders other than corporations.

Third, an exception was provided for distributions with respect to qualified stock of stock or obligations in a subsidiary if substantially all of the assets of the subsidiary consisted of the assets of one or more qualified businesses, no substantial part of the subsidiary’s nonbusiness assets were acquired in a section 351 transaction or as a capital contribution from the distributing corporation within the five-year period ending on the date of the distribution, and more than 50 percent in value of the stock of the subsidiary was distributed with respect to qualified stock.44 Finally, exceptions were provided for redemptions to pay death taxes, certain distributions to private foundations, and distributions by certain regulated investment companies in redemption of stock upon the demand of a shareholder.45

Section 311 also provided under separate rules that a corporation recognized gain on the distribution of encumbered property to the extent the liabilities assumed or to which the property was subject exceeded the distributing corporation’s adjusted basis;46 on the distribution of LIFO inventory, to the extent the basis of the inventory determined under a FIFO method exceeded its LIFO value;47 and on the distribution of an installment obligation, to the extent of the excess of the face value of the obligation over the distributing corporation’s adjusted basis in the obligation.48

Liquidating distributions and sales: sections 336 and 337

The rules regarding nonrecognition of gain on distributions in liquidation of a corporation were less restrictive than those applicable to nonliquidating distributions under prior law. Section 336 of prior law generally provided for nonrecognition of gain or loss by a corporation on the distribution of property in complete liquidation of the corporation. Gain was recognized, however, on a distribution of an installment obligation, unless the obligation was acquired in a liquidating sale that would have been tax-free under section 337, or the distribution was by a controlled subsidiary in a section 332 liquidation where the parent took a carryover basis under section 334(b)(1).49 Section 336 also required recognition of the LIFO recapture amount in liquidating distributions.

Section 337 of prior law provided that if a corporation adopted a plan of complete liquidation and within twelve months distributed all of its assets in complete liquidation, gain or loss on any sales by the corporation during that period generally was not recognized. Section 337 did not apply, and recognition was required, on sales of inventory (other than inventory sold in bulk), stock in trade, and property held primarily for sale to customers in the ordinary course of business. If the corporation accounted for inventory on a LIFO basis, section 337 required that the LIFO recapture amount be included in income.

Distributions by S corporations

Under both prior and present law, a closely-held business operating in corporate form may elect to have business gains and losses taxed directly to or deducted directly by its individual shareholders. This election is available under subchapter S of the Code (secs. 1361–1379). The principal advantage of a subchapter S election to the owners of a business is the ability to retain the advantages of operating in corporate form while avoiding taxation of corporate earnings at both the corporate and shareholder levels.

Prior to 1983, shareholders of corporations making a subchapter S election were taxed on actual cash dividend distributions of current earnings and profits of the corporation, and on undistributed taxable income as a deemed dividend. Accordingly, all of the taxable income of a corporation taxable under subchapter S passed through to its shareholders as dividends. A shareholder increased his basis in his stock by the amount of his pro rata share of undistributed taxable income.

The Subchapter S Revision Act of 1982 substantially modified these rules. The dividends-earnings and profits system was abandoned in favor of a pass-through approach based more closely on the system under which partnership income is taxed. Under these new rules, gain must be recognized by an S corporation (which gain is passed through to its shareholders) on a nonliquidating distribution of appreciated property as if it had sold the property for its fair market value (sec. 1363(d)). The purpose of this rule is to assure that the appreciation does not escape tax entirely. A shareholder in an S corporation generally does not recognize gain on receipt of property from the corporation, but simply reduces his basis in his stock by the fair market value of the property, taking a basis in the property equal to that value. The shareholder can then sell the property without recognizing any gain. Thus, unless the distribution triggered gain at the corporate level, no current tax would be paid on the appreciation in the distributed property.

Under prior law, liquidating distributions by an S corporation were taxed in the same manner as liquidating distributions of C corporations. Thus, no gain was recognized by the corporation (secs. 1363(e) and 336). Although the General Utilities rule in this context was not responsible for the imposition of only a single, shareholder level tax on appreciation in corporate property,50 it could allow a portion of the gain that would otherwise be ordinary to receive capital gains treatment under prior law.

Statutory Law and Judicial Doctrines Affecting Application of General Utilities Rule

Recapture rules

The nonrecognition provisions of sections 311, 336, and 337 were subject to several additional limitations beyond those expressly set forth in those sections. These limitations included the statutory “recapture” rules for depreciation deductions, investment tax credits, and certain other items that might have produced a tax benefit for the transferor-taxpayer in prior years.51

The depreciation recapture rules (sec. 1245) required inclusion, as ordinary income, of any gain attributable to depreciation deductions previously claimed by the taxpayer with respect to “section 1245 property”—essentially, depreciable personal property—disposed of during the year, to the extent the depreciation claimed exceeded the property’s actual decline in value.52

A more limited depreciation recapture rule applied to real estate. Under section 1250, gain on disposition of residential real property held for more than one year was recaptured as ordinary income to the extent prior depreciation deductions exceeded depreciation computed on the straight-line method. Gain on disposition of nonresidential real property held for more than one year, however, was generally subject to recapture of all depreciation unless a straight-line method had been elected, in which case there was no recapture.53

A number of other statutory recapture provisions could apply to a liquidating or nonliquidating distribution of property, including section 617(d) (providing for recapture of post-1965 mining exploration expenditures), section 1252 (soil and water conservation and land-clearing expenditures), and section 1254 (post-1975 intangible drilling and development costs).

Collapsible corporation rules

Under prior law (as under present law), section 341 modified the tax treatment of transactions involving stock in or property held by “collapsible” corporations. In general, a collapsible corporation was one the purpose of which was to convert ordinary income into capital gain through the sale of stock by its shareholders, or through liquidation of the corporation, before substantial income had been realized.

Under section 341, if a shareholder disposed of stock in a collapsible corporation in a transaction that would ordinarily produce long-term capital gain, the gain was treated as ordinary income. Likewise, any gain realized by a shareholder on a liquidating distribution of property from a collapsible corporation was ordinary income. Finally, prior law section 337 was inapplicable in the case of a collapsible corporation. Thus, liquidating sales of appreciated inventory or other property held by the corporation for sale to customers generated ordinary income that was fully recognized at the corporate level.54

Certain stock purchases treated as asset purchases

Under both prior and present law, section 338 permits a corporation that purchases a controlling stock interest in another corporation (the “target” corporation) within a twelve-month period to elect to treat the transaction as a purchase of the assets of that corporation for tax purposes. If the election is made, the target is treated as if it had sold all of its assets pursuant to a plan of complete liquidation on the date the purchaser obtained a controlling interest in the target (the “acquisition date”), for an amount essentially equal to the purchase price of the stock plus its liabilities. Under prior law, this deemed sale was regarded as occurring under 337. Accordingly, no gain was recognized on the deemed sale other than gain attributable to section 1245 or other provisions that overrode section 337. The target was then treated as a newly organized corporation which purchased all of the “old” target’s assets for a price essentially equal to the purchase price of the stock plus the old target’s liabilities on the beginning of the day after the qualified stock purchase. Thus, the new target corporation was able to obtain a stepped-up basis in its assets equal to their fair market value.

Prior to the enactment of section 338, similar results could be achieved under section 332 and former section 334(b)(2) by liquidating the acquired corporation into its parent within a specified period of time. One abuse Congress sought to prevent in enacting section 338 was selective tax treatment of corporate acquisitions. Taxpayers were able to take a stepped-up basis in some assets held by a target corporation or its affiliates while avoiding recapture tax and other unfavorable tax consequences with respect to other assets.55 Section 338 contains elaborate “consistency” rules designed to prevent selectivity with respect to acquisitions of stock and assets of a target corporation (and its affiliates) by an acquiring corporation (and its affiliates). All such purchases by the acquiring group must be treated consistently as either asset purchases or stock purchases if they occur within the period beginning one year before and ending one year after the twelve-month acquisition period.56

Section 338 of prior (and present) law contained an alternative election under which, in certain circumstances, a corporate purchaser and a seller of an 80-percent-controlled subsidiary could elect to treat the sale of the subsidiary stock as if it had been a sale of the underlying assets. Among the requirements for the filing of an election under section 338(h)(10) were that the selling corporation and its target subsidiary must be members of an affiliated group filing a consolidated return for the taxable year that included the acquisition date. If an election was made, the underlying assets of the corporation that was sold received a stepped-up, fair market value basis; the selling consolidated group recognized the gain or loss attributable to the assets; and there was no separate tax on the seller’s gain attributable to the stock. This provision offered taxpayers relief from a potential multiple taxation at the corporate level of the same economic gain, which could result when a transfer of appreciated corporate stock was taxed without providing a corresponding step-up in basis of the assets of the corporation.

Judicially created doctrines

Under prior law, the courts applied nonstatutory doctrines from other areas of the tax law to inkind distributions to shareholders. These doctrines also apply under present law. For example, it was held that, where the cost of property distributed in a liquidation or sold pursuant to a section 337 plan of liquidation had previously been deducted by the corporation, the tax benefit doctrine overrode the statutory rules to cause recognition of income.57 The application of the tax benefit doctrine turns on whether there is a “fundamental inconsistency” between the prior deduction and some subsequent event.58

The courts also applied the assignment of income doctrine to require a corporation to recognize income on liquidating and nonliquidating distributions of its property.59

Reasons for Change

In General

Congress believed that the General Utilities rule, even in its more limited form, produced many incongruities and inequities in the tax system. First, the rule could create significant distortions in business behavior. Economically, a liquidating distribution is indistinguishable from a nonliquidating distribution; yet the Code provided a substantial preference for the former. A corporation acquiring the assets of a liquidating corporation was able to obtain a basis in assets equal to their fair market value, although the transferor recognized no gain (other than possibly recapture amounts) on the sale. The tax benefits made the assets potentially more valuable in the hands of a transferee than in the hands of the current owner. This might induce corporations with substantial appreciated assets to liquidate and transfer their assets to other corporations for tax reasons, when economic considerations might indicate a different course of action. Accordingly, Congress reasoned, the General Utilities rule could be at least partly responsible for the dramatic increase in corporate mergers and acquisitions in recent years. Congress believed that the Code should not artificially encourage corporate liquidations and acquisitions, and that repeal of the General Utilities rule was a major step towards that goal.

Second, the General Utilities rule tended to undermine the corporate income tax. Under normally applicable tax principles, nonrecognition of gain is available only if the transferee takes a carryover basis in the transferred property, thus assuring that a tax will eventually be collected on the appreciation. Where the General Utilities rule applied, assets generally were permitted to leave corporate solution and to take a stepped-up basis in the hands of the transferee without the imposition of a corporate-level tax.60 Thus, the effect of the rule was to grant a permanent exemption from the corporate income tax.

Anti-tax Avoidance Provisions

In repealing the General Utilities rule, which provided for nonrecognition of losses as well as gains on distributions, Congress was concerned that taxpayers might utilize various means (including other provisions of the Code or the Treasury regulations) to circumvent repeal of the rule or, alternatively, might exploit the provision to realize losses in inappropriate situations or inflate the amount of the losses actually sustained. For example, under the general rule permitting loss recognition on liquidating distributions, taxpayers might be able to create artificial losses at the corporate level or to duplicate shareholder losses in corporate solution through contributions of property having previously accrued (“built-in”) losses. In an effort to prevent these potential abuses, Congress included in the Act regulatory authority to prevent circumvention of the purposes of the amendments through use of any provision of law or regulations. In addition, it included specific statutory provisions designed to prevent avoidance of tax on corporate-level gains through conversions to subchapter S corporation status and unwarranted recognition of losses at the corporate level.

Conforming Changes to Provisions Relating to Nonliquidating Distributions

The tax treatment of corporations with respect to nonliquidating distributions of appreciated property historically has been the same as liquidating distributions. In recent years, however, nonliquidating distributions have been subjected to stricter rules than liquidating distributions, and corporations have generally been required to recognize gain as a result of nonliquidating distributions of appreciated property. Consistent with this relationship, the Act generally conforms the treatment of nonliquidating distributions with liquidating distributions.

Relief from Repeal of the General Utilities Rule

Several exceptions to the recognition requirement are provided in the Act. The first relates to distributions of the stock and securities of a controlled subsidiary which under prior law (as under the Act) the distribute shareholder may receive tax-free pursuant to section 355. Congress felt that the same policy rationale that justifies nonrecognition by the shareholder on receipt of the stock— namely, that the transfer merely effects a readjustment of the shareholder’s continuing interest in the corporation in modified form and subject to certain statutory and other constraints—also justifies nonrecognition of gain (or loss) to the distributing corporation in this situation. Similarly, certain distributions pursuant to a plan of reorganization also are not subject to recognition.61

Another exception relates to certain section 332 liquidations in which an 80-percent corporate shareholder receives property with a carryover basis. Congress believed that this exception was justified on the ground that the property (together with the other attributes of the liquidated subsidiary) is retained within the economic unit of the affiliated group. Because such an intercorporate transfer within the group is a nonrecognition event, carryover basis follows. As a result of the carryover basis, the corporate-level tax will be paid if the distributed property is disposed of by the recipient corporation to a person outside of the group. Where gain recognition with respect to the distributed property would not be preserved (e.g., certain transfers to a tax-exempt or foreign corporate parent), the exception for liquidating distributions to an 80-percent corporate shareholder does not apply.62

Election to Treat Sales or Distributions of Certain Subsidiary Stock as Asset Transfers

Congress believed it was appropriate to conform the treatment of liquidating and nonliquidating sales or distributions and to require recognition when appreciated property, including stock of a subsidiary, is transferred to a corporate or individual recipient outside the economic unit of the selling or distributing affiliated group. Thus, the Act provides that such transactions result in the recognition of gain or loss to the parent corporation on the appreciation in the stock (that is, on the “outside” gain). There is a potential multiple taxation at the corporate level of the same economic gain, which may result when a transfer of appreciated corporate stock is taxed without providing a corresponding step-up in basis of the “inside” assets of the corporation. (In many cases, however, the “outside” gain may be less than the “inside” gain; furthermore, the deferral of such “inside” gain may significantly reduce any actual economic multiple corporate taxation effect.) Congress believed it was appropriate to permit an election to recognize the inside gain immediately in lieu of the outside gain, thus in effect treating the transaction as a transfer of the underlying assets. Such an election was already available under prior law in some circumstances under section 338(h)(10).63 However, this election was not available, for example, when the subsidiary did not file a consolidated return with the selling shareholder, or when the stock of the subsidiary was distributed to shareholders.64 Congress granted regulatory authority to the Treasury Department to expand the scope of the election to treat the sale of a corporation’s stock as a sale of its underlying assets to include sales not covered by section 338(h)(10) and distributions of stock in a controlled subsidiary.

Explanation of Provisions

Overview

The Act provides that gain or loss generally is recognized by a corporation on liquidating distributions of its property as if the property had been sold at fair market value to the distributee. Gain or loss is also recognized by a corporation on liquidating sales of its property. Exceptions are provided for distributions in which an 80-percent corporate shareholder receives property with a carryover basis in a liquidation under section 332, and certain distributions and exchanges involving property that may be received tax-free by the shareholder under subchapter C of the Code.

The Act also makes certain conforming changes in the provisions relating to nonliquidating distributions of property to shareholders, and in the provisions relating to corporations taxable under subchapter S.

Distributions in Complete Liquidation

General rule

The Act provides that, in general, gain or loss is recognized to a corporation on a distribution of its property in complete liquidation. The distributing corporation is treated as if it had sold the property at fair market value to the distributee-shareholders.

If the distributed property is subject to a liability, the fair market value of the property for this purpose is deemed to be no less than the amount of the liability. Thus, for example, if the amount of the liability exceeds the value of the property that cures it, the selling corporation will recognize gain in an amount equal to the excess of the liability over the adjusted basis of the property.65 Likewise, if the shareholders of the liquidating corporation assume liabilities of the corporation and the amount of liabilities assumed exceeds the fair market value of the distributed property, the corporation will recognize gain to the extent the assumed liabilities exceed the adjusted basis of the property. However, the provision does not affect, and no inference was intended regarding, the amount realized by or basis of property received by the distributee-shareholders in these circumstances.

Exceptions

Section 332 liquidations66

An exception to the recognition rule is provided for certain distributions in connection with the liquidation of a controlled subsidiary into its parent corporation. Under new section 337 of the Code, no gain or loss is generally recognized with respect to property distributed to a corporate shareholder (an “80-percent distributee”) in a liquidation to which section 332 applies. If a minority shareholder receives property in such a liquidation, the distribution to the minority shareholder is treated in the same manner as a distribution in a nonliquidating redemption. Accordingly, gain (but not loss) is recognized to the distributing corporation.67

The exception for 80-percent corporate shareholders does not apply where the shareholder is a tax-exempt organization unless the property received in the distribution is used by the organization in an activity, the income from which is subject to tax as unrelated business taxable income (UBTI), immediately after the distribution. If such property later ceases to be used in an activity of the organization acquiring the property, the income from which is subject to tax as UBTI, the organization will be taxed at that time (in addition to any other tax imposed, for example, on depreciation recapture under section 1245) on the lesser of (a) the built-in gain in the property at the time of the distribution, or (b) the difference between the adjusted basis of the property and its fair market value at the time of the cessation.

The exception for liquidations into a controlling corporate shareholder is also inapplicable where the parent is a foreign corporation. The Act amends section 367 of the Code to require recognition in a liquidation into a controlling foreign corporation, unless regulations provide otherwise. Congress expected that such regulations may permit nonrecognition if the potential gain on the distributed property at the time of the distribution is not being removed from the U.S. taxing jurisdiction prior to recognition.

If gain is recognized on a distribution of property in a liquidation described in section 332(a), a corresponding increase in the distributee’s basis in the property will be permitted.68

The Act relocates the provisions of section 332(c) to section 337(c) of the Code. Distributions of property to the controlling parent corporation in liquidations to which section 332 applies in exchange for debt obligations of the subsidiary are treated in the same manner as distributions in exchange for stock of the subsidiary, as under prior law section 332(c).

Tax-free reorganizations and distributions

The general rule requiring gain or loss recognition on liquidating distributions of property is inapplicable to transactions governed by Part III of subchapter C of the Code, relating to corporate organizations and reorganizations, to the extent the recipient may receive the property without recognition of gain (i.e., to the extent the recipient does not receive “boot”).69 In addition, the provision is not intended to apply to nonreorganization transactions described in section 355 of the Code to the extent the recipient may receive the distribution without recognition of gain under Part III of subchapter C.70 Thus, on a liquidating distribution of boot in a transaction qualifying under section 355 that is not pursuant to a plan of reorganization, the distributing corporation recognizes gain (but not loss) with respect to any “boot” distributed to shareholders.71

Limitations on recognition of losses

The Act includes two provisions designed to prevent inappropriate corporate-level recognition of losses on liquidating dispositions of property. In enacting these provisions, Congress did not intend to create any inference regarding the deductibility of such losses under other statutory provisions or judicially created doctrines, or to preclude the application of such provisions or doctrines where appropriate.72

Distributions to related persons

Under the first loss limitation rule, a liquidating corporation may not recognize loss with respect to a distribution of property to a related person within the meaning of section 267,73 unless (i) the property is distributed to all shareholders on a pro rata basis and (ii) the property was not acquired by the liquidating corporation in a section 351 transaction or as a contribution to capital during the five years preceding the distribution.

Thus, for example, a liquidating corporation may not recognize loss on a distribution of recently acquired property to a shareholder who, directly or indirectly, owns more than 50 percent in value of the stock of the corporation. Similarly, a liquidating corporation may not recognize a loss on any property, regardless of when or how acquired, that is distributed to such a shareholder on a non–pro rata basis.

Dispositions of certain carryover basis property acquired for tax-avoidance purposes

Under the second loss limitation rule, recognition of loss may be limited if property whose adjusted basis exceeds its value is contributed to a liquidating corporation, in a carryover basis transaction, with a principal purpose of recognizing the loss upon the sale or distribution of the property (and thus eliminating or otherwise limiting corporate level gain). In these circumstances, the basis of the property for purposes of determining loss is reduced, but not below zero, by the excess of the adjusted basis of the property on the date of contribution over its fair market value on such date.74

This provision was not intended to override section 311(a). Thus, if property is distributed in a nonliquidating context, the entire loss (and not merely the built-in loss) will be disallowed.

If the adoption of a plan of complete liquidation occurs in a taxable year following the date on which the tax return including the loss disallowed by this provision is filed, except as provided in regulations, the liquidating corporation will recapture the disallowed loss on the tax return for the taxable year in which such plan of liquidation is adopted. In the alternative, regulations may provide for the corporation to file an amended return for the taxable year in which the loss was reported.75

Example

The application of the basis reduction rule can be illustrated by the following example:

Assume that on June 1, 1987, a shareholder who owns 10 percent of the stock of a corporation (which is a calendar year taxpayer) participates with other shareholders in a contribution of property to the corporation that qualifies for nonrecognition under section 351, contributing nondepreciable property with a basis of $1,000 and a value of $100 to the corporation. Also assume that a principal purpose of the acquisition of the property by the corporation was to recognize loss by the corporation and offset corporate-level income or gain in anticipation of the liquidation. On September 30, 1987, the corporation sells the property to an unrelated third party for $200, and includes the resulting $800 loss on its 1987 tax return. Finally, the corporation adopts a plan of liquidation on December 31, 1988.

For purposes of determining the corporation’s loss on the sale of the property in 1987, the property’s basis is reduced to $100—that is, $1,000 (the transferred basis under section 362) minus $900 (the excess of the property’s basis over its value on the date of contribution). No loss would be realized on the sale, since the corporation received $200 for the property. Likewise, the corporation would recognize no gain on the sale, since its basis for purposes of computing gain is $1,000. Congress expected that regulations might provide for the corporation to file an amended return for 1987 reflecting no gain or loss on the sale of the property. Otherwise, the corporation would be required to reflect the disallowance of the loss by including the amount of the disallowed loss on its 1988 tax return.76

Presumption of tax-avoidance purpose in case of contributions within two years of liquidation

For purposes of the loss limitation rule, there is a statutory presumption that the tax-avoidance purpose is present with respect to any section 351 transfer or contribution to capital of built-in loss property within the two-year period prior to the adoption of the plan of liquidation (or at any time thereafter). Although Congress recognized that a contribution more than two years before the adoption of a plan of liquidation might have been made for such a tax-avoidance purpose, Congress also recognized that the determination that such purpose existed in such circumstances might be difficult for the Internal Revenue Service to establish and therefore as a practical matter might occur infrequently or in relatively unusual cases.

Congress intended that the Treasury Department will issue regulations generally providing that the presumed prohibited purpose for contributions of property within two years of the adoption of a plan of liquidation 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.

A clear and substantial relationship between the contributed property and the conduct of the corporation’s business enterprises would generally include a requirement of a corporate business purpose for placing the property in the particular corporation to which it was contributed, rather than retaining the property outside that corporation. If the contributed property has a built-in loss at the time of contribution that is significant in amount as a proportion of the built-in corporate gain at that time, special scrutiny of the business purpose would be appropriate.

As one example, assume that A owns Z Corporation which operates a widget business in New Jersey. That business operates exclusively in the northeastern region of the United States and there are no plans to expand those operations. In his individual capacity, A had acquired unimproved real estate in New Mexico that has declined in value. On March 22, 1988, A contributes such real estate to Z and six months later a plan of complete liquidation is adopted. Thereafter, all of Z’s assets are sold to an unrelated party and the liquidation proceeds are distributed. A contributed no other property to Z during the two-year period prior to the adoption of the liquidation. Because A contributed the property to Z less than two years prior to the adoption of the plan of liquidation, it is presumed to have been contributed with a prohibited purpose. Moreover, because there is no clear and substantial relationship between the contributed property and the conduct of Z’s business, Congress did not expect that any loss arising from the disposition of the New Mexico real estate would be allowed under the Treasury regulations.

However, Congress expected that such regulations will permit the allowance of any resulting loss from the disposition of any of the assets of a trade or business (or a line of business) that are contributed to a corporation where prior law would have permitted the allowance of the loss and the clear and substantial relationship test is satisfied. In such circumstances, application of the loss disallowance rule is inappropriate assuming there is a meaningful (i.e., clear and substantial) relationship between the contribution and the utilization of the particular corporate form to conduct a business enterprise. If the contributed business is disposed of immediately after the contribution, it is expected that it would be particularly difficult to show that the clear and substantial relationship test was satisfied. Congress also anticipated that the basis adjustment rules will generally not apply to a corporation’s acquisition of property as part of its ordinary start-up or expansion of operations during its first two years of existence. However, if a corporation has substantial gain assets during its first two years of operation, a contribution of substantial built-in loss property followed by a sale or liquidation of the corporation would be expected to be closely scrutinized.

Conversions from C to S Corporation Status

The Act modifies the treatment of an S corporation that was formerly a C corporation. A corporate-level tax is imposed on any gain that arose prior to the conversion (“built-in” gain) and is recognized by the S corporation, through sale, distribution, or other disposition77 within ten years after the date on which the S election took effect. The total amount of gain that must be recognized by the corporation, however, is limited to the aggregate net built-in gain of the corporation at the time of conversion to S corporation status.78 Congress expected that the Treasury Department could prevent avoidance of the built-in gain rule by contributions of built-in loss property prior to the conversion for the purpose of reducing the net built-in gain.

Gains on sales or distributions of assets by the S corporation are presumed to be built-in gains, except to the extent the taxpayer establishes that the appreciation accrued after the conversion, such as where the asset was acquired by the corporation in a taxable acquisition after the conversion. Built-in gains are taxed at the maximum corporate rate applicable to the particular type of income (i.e., the maximum rate on ordinary income under section 11 or, if applicable, the alternative rate on capital gain income under section 1201) for the year in which the disposition occurs. The corporation may take into account all of its subchapter C tax attributes in computing the amount of the tax on recognized built-in gains. Thus, for example, it may use unexpired net operating losses, capital loss carryovers, and similar items to offset the gain or the resulting tax.79

Congress intended that in a carryover basis transfer of property with built-in gain to an S corporation from a C corporation, the built-in gain with respect to property will be preserved in the hands of the transferee for the 10-year period. Similarly, in the case of a transfer of built-in gain property in a substituted basis transaction, the property received by the transferor will assume the built-in gain taint of the transferred property. If a C corporation converts to S status and is subject to the built-in gain rule, built-in gain assets that such corporation transfers to another S corporation in a carryover basis transaction will retain their original 10-year taint in the hands of the transferee.

Regulatory Authority to Prevent Circumvention of General Utilities Repeal

The repeal of the General Utilities rule is designed to require the corporate level recognition of gain on a corporation’s sale or distribution of appreciated property, irrespective of whether it occurs in a liquidating or nonliquidating context. Congress expected the Treasury Department to issue, or to amend, regulations to ensure that the purpose of the new provisions (including the new subchapter S built-in gain provisions) is not circumvented through the use of any other provision, including the consolidated return regulations or the tax-free reorganization provisions of the Code (Part III of subchapter C) or through the use of other pass-through entities such as regulated investment companies (RICs) or real estate investment trusts (REITs). For example, this would include rules to require the recognition of gain if appreciated property of a C corporation is transferred to a RIC or a REIT in a carryover basis transaction that would otherwise eliminate corporate-level tax on the built-in appreciation.

Application of Other Statutory Rules and Judicial Doctrines

In providing for recognition of gain on liquidating distributions, Congress did not intend to supersede other existing statutory rules and judicial doctrines, including (but not limited to) section 1245 and 1250 recapture, the tax benefit doctrine, and the assignment of income doctrine. Accordingly, these rules will continue to apply to determine the character of gain recognized on liquidating distributions where they are otherwise applicable.

Nonliquidating Distributions

The Act makes certain conforming changes to the provisions relating to nonliquidating distributions of property. For purposes of determining the amount realized on a distribution of property, the fair market value of the property is treated as being no less than the amount of any liability to which it is subject or which is assumed by the shareholder under the principles applicable to liquidating distributions. The prior-law exceptions to recognition that were provided for nonliquidating distributions to ten percent, long-term noncorporate shareholders, and for certain distributions of property in connection with the payment of estate taxes or in connection with certain redemptions of private foundation stock, are repealed. As under prior law, no loss is recognized to a distributing corporation on a nonliquidating distribution of property to its shareholders.

Election to Treat Sale or Distribution of Subsidiary Stock as Disposition of Subsidiary’s Assets

The Act generally conforms the treatment of liquidating sales and distributions of subsidiary stock to the prior-law treatment of nonliquidating sales or distributions of such stock; thus, such liquidating sales or distributions are generally taxable at the corporate level. Congress believed it was appropriate to conform the treatment of liquidating and nonliquidating sales or distributions and to require recognition when appreciated property, including stock of a subsidiary, is transferred to a corporate or individual recipient outside the economic unit of the selling or distributing corporation.

However, Congress believed it was appropriate to provide relief from a potential multiple taxation at the corporate level of the same economic gain, which may result when a transfer of appreciated corporate stock is taxed without providing a corresponding step-up in basis of the assets of the corporation. In addition to retaining the election available under section 338(h)(10) of prior law, the Act permits the expansion of the concept of that provision, to the extent provided in regulations, to dispositions of a controlling interest in a corporation for which this election is currently unavailable. For example, the election could be made available where the selling corporation owns 80 percent of the value and voting power of the subsidiary but does not file a consolidated return with the subsidiary. Moreover, the Act provides that, under regulations, principles similar to those of section 338(h)(10) may be applied to taxable distributions of controlled corporation stock.80

Congress intended that the regulations under this elective provision will account for appropriate principles that underlie the liquidation-reincorporation doctrine. For example, to the extent that regulations make available an election to treat a stock transfer of controlled corporation stock to persons related to such corporation within the meaning of section 368(a)(2)(H) (i.e., section 304(c)), it may be appropriate to provide special rules for such corporation’s section 381(c) tax attributes so that net operating losses may not be used to offset liquidation gains, earnings and profits may not be manipulated, or accounting methods may not be changed.

Congress did not intend this election to affect the manner in which a corporation’s distribution to its shareholders is characterized for purposes of determining the shareholder-level income tax consequences.

Treasury Study of Subchapter C

The Act directs the Treasury Department to consider whether changes to the provisions of subchapter C (relating to the income taxation of corporations and their shareholders) and related sections of the Code are desirable, and to report to the tax-writing committees of Congress no later than January 1, 1988.

Effective Dates

In General

The repeal of the General Utilities rule is generally effective for liquidating sales and distributions after July 31, 1986. The Act provides a number of general transitional rules, some of which are based on action before November 20, 1985 (the date of action by the House Ways and Means Committee), some of which are based on action before August 1, 1986 (the date of action by the conference committee), and some of which are based on actions after July 31, 1986, and before January 1, 1987. The amendments made by the Act are inapplicable to transactions covered by these general transitional rules.

In addition to these general transitional rules, the Act provides a special delayed effective date for transactions involving certain closely held corporations of limited size. With certain modifications, these transactions are also subject to prior-law rules.

General Transitional Rules Based on Pre–November 20, 1985 Action

The amendments made by the Act do not apply to distributions or sales and exchanges made pursuant to a plan of liquidation adopted before November 20, 1985, provided the liquidation is completed before January 1, 1988. Special rules apply in determining whether a plan of liquidation was adopted for purposes of these transitional rules81 and whether a distribution, sale, or exchange is made pursuant to such a plan of liquidation. In general, the rules are intended to provide relief in situations in which a decision to liquidate has clearly been made regarding an acquisition, or a decision regarding acquisition has been made and the essential terms have been determined. Some transactions may qualify for relief under more than one provision. A liquidation will be treated as completed under the same standard that is applied under the general transitional rules for liquidations before January 1, 1987.

First rule

The first rule under which a distribution, sale, or exchange is treated as pursuant to a plan of liquidation adopted before November 20, 1985, looks to action taken by the liquidating company before the November 20 date. If the board of directors of that company adopted a resolution to solicit shareholder approval for a transaction described in section 336 or 337 of prior law82 or if the shareholders or board of directors of the liquidating company have approved such a transaction, then distributions, sales and exchanges that occur pursuant to the transaction are not subject to the Act provided that the liquidation is completed before January 1, 1988.

Pre-November 20 action

For purposes of this first rule, certain actions taken before November 20, 1985, were intended to constitute implicitly the necessary board of directors or shareholder approval even though formal board or shareholder approval may not otherwise have occurred before that date. Congress intended the requisite board or shareholder approval will be deemed to have occurred if, before November 20, 1985, there was sufficient written evidence to establish that a decision to liquidate has been approved by the board of directors or shareholders, even though the approval may have been given informally, as may occur, for example, in a closely held setting. Examples of sufficient written evidence include written contacts with third parties indicating the decision to liquidate and seeking any necessary approvals for asset transfers or for other actions in connection with the liquidation.

Congress also intended that the requisite board or shareholder approval would be deemed to have occurred, if a company had, before November 20, 1985, entered into a binding contract to sell substantially all of its assets, or entered into a letter of intent with a buyer specifying the essential terms of such a contract.83 Similarly, the requisite approval would be deemed to have occurred if, before the relevant date, the board of directors of a corporation adopted a resolution approving or recommending the grant by its shareholders of an option to purchase a majority of the stock of the corporation; or if the shareholders granted such an option before the relevant date, if the option in each case would be a binding option as to the seller, enforceable by the optionee (purchaser).

“Pursuant to” requirement

To qualify for transitional relief, distributions, sales, or exchanges must be pursuant to the transaction that the board of directors approved, or for which it solicited shareholder authority (as described above). This will generally be presumed to be the case if a formal plan of liquidation is adopted and the distributions, or sales and exchanges pursuant to such plan commence within one year of the original shareholder or board action. If such action is not taken within a year of such time, all the facts and circumstances must be considered, including, for example, a decision to seek a ruling request from the Internal Revenue Service or the need to obtain governmental rulings or approvals, or third party approvals for asset transfers. If the requisite shareholder or board approval is reflected in a binding contract or letter of intent, the specified sale must thereafter be consummated in accordance with the contract or letter of intent and the formal plan of liquidation be adopted as required above.

Second rule

Under a second rule relating to pre-November 20, 1985 action, sales or distributions pursuant to a plan of liquidation (which includes, for purposes of this purpose, a section 338 election) are not affected by the Act if, before November 20, 1985, (i) there was an offer to purchase a majority of the voting stock of the liquidating corporation, or (ii) the board of directors of the liquidating corporation has adopted a resolution approving an acquisition of the company or recommending the approval of an acquisition of the company to the shareholders; provided in each case the sale or distribution is pursuant to or was contemplated by the terms of the offer or resolution, and a complete liquidation occurs (or the section 338 acquisition date, with respect to which a section 338 election is made) before January 1, 1988. The term “liquidating corporation” includes an acquired corporation (and affiliates) with respect to which a section 338 election is made.

Pre-November 20 action

An offer to purchase a majority of the stock of a corporation is intended to include a tender offer or a binding option given by the offeror and enforceable by the offeree. An offer also includes a letter of intent entered into by the purchaser and seller specifying the essential terms of an acquisition. Any binding contract to acquire a corporation presupposes an offer (as well as the approval and acceptance of the required corporation’s shareholders or board of directors). Congress did not intend that a nonbinding offer, as to which there has been no implicit or explicit approval by the board of directors or shareholders of the corporation to be acquired, would be within the scope of the transition rule.

“Pursuant to” requirement

For purposes of these transitional rules, in determining whether a sale or distribution is pursuant to or was contemplated as part of a transaction, Congress intended that deemed sales or exchanges pursuant to a timely section 338 election made with respect to a qualified stock purchase will be presumed to be pursuant to and contemplated by the terms of a pre-November 20, 1985 offer or of a board-approved or recommended acquisition that resulted in the purchase. For example, if, prior to November 20, 1985, the board of directors of a corporation adopted a resolution approving the acquisition of that corporation and if, after November 20, 1985, the acquisition occurs and a timely section 338 election is made prior to January 1, 1988 with respect to the acquired company and its affiliates, the deemed sales pursuant to the section 338 election will not be affected by the Act. In addition, if a corporation qualifies for this transitional rule by virtue of a letter of intent or binding contract, the acquisition must occur in accordance with the letter or contract.

Congress also intended that distributions, sales or exchanges will generally be considered pursuant to and contemplated by an acquisition transaction if a formal plan of liquidation is adopted within one year after the acquisition is consummated and the distributions, sales, or exchanges commence within that time. However, Congress intended that if such actions commence more than one year after the acquisition, a determination whether the distributions, sales, or exchanges are pursuant to or were contemplated by the terms of the offer will be determined on the basis of all the facts and circumstances. Such circumstances include, but are not limited to, references to or statements regarding the possibility of a liquidation made in the acquisition documents, proxy material, or other correspondence with shareholders, public announcements, or requests for governmental approvals, as well as internal documentation and correspondence with attorneys or others involved in the acquisition.

Third rule

Under the third rule relating to pre-November 20, 1985 action, distributions, sales, or exchanges in a liquidation (including a section 338 election) are not affected by the amendments under the Act if, prior to that date, a ruling request was submitted to the Internal Revenue Service with respect to a transaction (which transaction includes or contemplates a transaction described in section 336 or 337 of prior law (including a section 338 election)), and, pursuant to the transaction described in the ruling request, a plan of complete liquidation is adopted (or a sec. 338 election made) and the liquidation is completed (or the section 338 acquisition date occurs before January 1, 1988).

Related corporations

In applying the foregoing rules, action (as described above) taken by the board of directors or shareholders of a corporation with respect to a subsidiary of such corporation is treated as taken by the board of directors or shareholders of such subsidiary. For example, if the board of directors of a parent corporation adopted a resolution approving the sale of substantially all the assets and subsequent liquidation of the subsidiary, that action will be considered action of the shareholders and board of the subsidiary regardless of how many tiers below the parent the subsidiary may be (so long as the parent has effective control over the subsidiary).

In certain instances involving a group of several tiers of subsidiaries, even though the parent corporation has not formally adopted such a resolution, the action of a lower-tier subsidiary may be considered evidence of implicit action by the parent. For example, in the case of the liquidation of a group of corporations constituting an affiliated group involving sales under prior-law section 337, all distributee members of the group must liquidate within one year. If one member of such group has prior to November 20, 1985, taken board or shareholder action of the type qualifying for transition relief (as described above) and if that member and the other members do liquidate within the required one year period, it was intended that timely approval by the board or shareholders of the parent corporation of the group will generally be presumed. In other situations involving pre-November 20 action by only one member of a group of commonly controlled corporations, whether that action can be attributed to members of the group other than an effectively controlled subsidiary of the acting corporation will be determined on the basis of all the facts and circumstances.

General Transitional Rules Based on Pre–August 1, 1986 or Pre–January 1, 1987 Action

The amendments made by the Act also do not apply to transactions which do not meet the requirements of the general transitional rules based on pre-November 20, 1985 action, but which are described in one or more of the following categories:

Rules applicable in determining when plan of liquidation adopted

A plan of liquidation is adopted if the plan has been approved by the shareholders (see Treas. Reg. sec. 1.337-2(b)). If a plan of liquidation would have been considered adopted for purposes of commencing the twelve-month period under prior-law section 337, it will be deemed adopted for this purpose.

Rules applicable in determining whether binding contract in effect of August 1, 1986

For purposes of determining whether there was a binding contract or contracts to sell substantially all of the assets of a corporation before August 1, 1986, the term “substantially all of the assets” shall generally mean 70 percent of the gross fair market value and 90 percent of the net fair market value of the assets. In addition, even though the contract or contracts cover a lesser amount of assets, if such contract or contracts would require shareholder approval under the applicable state law that may require such approval for a sale of substantially all of such corporation’s assets, then they will qualify as contracts to sell substantially all the assets and will be considered binding even though shareholder approval has not yet been obtained.

An acquisition of stock or assets will be considered made pursuant to a binding written contract even though the contract is subject to normal commercial due diligence or similar provisions and the final terms of the actual acquisition may vary pursuant to such provisions.

For purposes of these rules, a liquidation is completed by a required date if it would be considered completed for purposes of section 337 of prior law by that date. For example, there may be a distribution of assets to a qualified liquidating trust (See, e.g., Rev. Rul. 80-150, 1980-1 C.B. 316).

Amendments to Provisions Relating to Nonliquidating Distributions

In general, the conforming amendments to section 311 are effective for distributions after July 31, 1986.

Amendments to Provisions Relating to Subchapter S Corporations

The provisions relating to S corporations that were formerly C corporations are generally effective with respect to returns filed pursuant to S elections made after December 31, 1986.85 Thus, in the case of S corporations whose election was made before January 1, 1987, the prior-law version of section 1374 will apply. For example, if such an S corporation is liquidated after December 31, 1986, and within 3 years of converting from C to S status, new section 1363 and new section 336 will apply (subject to special transition rules for certain closely held corporations) to require the recognition of gain on the liquidation. If there is capital gain of sufficient amount, prior law section 1374 will impose a corporate level tax on that gain in liquidation.

Delayed Effective Dates for Certain Closely held Corporations

In general

Special delayed effective dates are provided for certain closely held corporations that are limited in size.86 Corporations eligible for this rule are generally entitled to prior-law treatment with respect to liquidating sales and distributions occurring before January 1, 1989, provided the liquidation is completed before that date. A liquidation will be treated as completed under the same standard that is applied under the general transitional rules. However, this special transitional rule requires the recognition of income on distributions of ordinary income property (appreciated property that would not produce capital gain if disposed of in a taxable transaction) and short-term capital gain property. Thus, the failure of an eligible closely held corporation to complete its liquidation by December 31, 1986, or otherwise to satisfy the general transitional rules, will result in the loss of nonrecognition treatment for the distribution of appreciated ordinary income and short-term capital gain property. It will also require recognition on distributions of installment obligations that are received in exchange for such property. Congress did not intend to require corporate level recognition on distribution of installment obligations that are received in exchange for long-term capital gain property (including section 1231 property the disposition of which would produce long-term capital gain) where the distribution of such obligations would not have caused recognition under prior law sections 337 and 453B(d)(2).

Corporations eligible for this rule may also make an S election prior to January 1, 1989, without becoming subject to the new rules under section 1374 relating to built-in gains except with respect to ordinary income and short-term capital gain property (it is not necessary that such a corporation liquidate prior to January 1, 1989).87 However, a corporation having a value in excess of $5 million (but not in excess of $10 million), is subject to a phase-out of this relief. Thus, in such circumstances new section 1374 will apply to a portion of the built-in long-term capital gain. Prior law section 1374 will apply to any portion of the built-in long-term capital gains not subject to new section 1374. In addition, to the extent a corporation is eligible for relief under the small corporation rule, a portion of any other long-term capital gain that would be covered by prior law section 1374 (whether or not built-in at the time of conversion) will continue to be covered by that section.

A taxpayer that purchases the stock of a qualified corporation in a qualified stock purchase prior to that date is entitled to apply prior-law rules (modified as in the case of actual liquidations) with respect to an election under section 338, even though in the hands of the acquiring corporation the qualified corporation no longer satisfies the stock holding period requirements and may not satisfy the size or shareholder requirements due to the size or shareholders of the acquiring corporation.88

Although the Act repeals section 333, in the case of a liquidating distribution to which section 333 of prior law would apply a shareholder of a qualified corporation electing such treatment is entitled to apply section 333 without any phase-out of shareholder level relief under the Act. However, an increase in shareholder-level gain could result from an increase in corporate earnings and profits resulting from application of the corporate-level phase-out of relief from repeal of General Utilities.

Finally, for distributions prior to January 1, 1989, qualifying corporations continue to be eligible for relief under prior-law rules relating to nonliquidating distributions with respect to qualified stock (sec. 331(d)(2)). However, this relief does not apply to distributions of ordinary income property or short-term capital gain property.

Requirements for qualification

A corporation is eligible for these special delayed effective dates if it was in existence on August 1, 1986, its value does not exceed $10 million, and more than 50 percent (by value) of the stock89 in such corporation is owned by ten or fewer individuals who have held such stock for five years or longer (or the life of the corporation, if less than five years).90 Full relief is available under this rule only if the corporation’s value does not exceed $5 million; relief is phased out for corporations with values between $5 million and $10 million. For purposes of this rule, a corporation’s value will be the higher of the value on August 1, 1986, or its value as of the date of adoption of a plan of liquidation (or, in the case of a nonliquidating distribution, the date of such distribution).

Congress intended that, where stock passes to an estate, the holding period of the estate includes that of the decedent. Also, it was intended that the “look-through” attribution rules, generally applicable where stock is held by an entity, would not apply in the case of trusts qualifying under section 1361(c)(2)(ii) or (iii) just as they do not apply under the statute in the case of estates. Thus, stock held by such entities, like stock held by an estate, is to be treated as held by a single qualified person, so that the 10 shareholder test will not cease to be satisfied merely because a decedent’s stock passes to such a trust. (In the case of other trusts holding stock, it was intended that the “look-through” attribution rules would apply to determine whether more than 10 qualified persons ultimately own stock.) It was also intended that the holding period of a decedent’s estate (or a 1361(c)(2)(ii) or (iii) trust) would be tacked with that of a beneficiary who would have been treated as “one person” with the decedent under the applicable attribution rules. Technical corrections may be needed so that the statute reflects such intent.

In the case of indirect ownership attributed through another entity (for example, a corporation or a partnership), Congress did not intend the rules of section 1223 to apply in all cases for purposes of determining the holding period of the qualified person. In such cases, the qualified person’s holding period is the lesser of (1) the period during which the entity held the stock in the qualified corporation, or (2) the period during which the qualified person held the interest in the entity. In the case of holdings through tiers of entities, similar rules apply at each level in determining the holding period of intermediate entities. A technical correction may be necessary so that the statute reflects this intent.

Aggregation rules similar to those in section 1563 apply for purposes of determining the value of the corporation on the relevant date, except that control is defined as more than 50 percent rather than 80 percent. Thus, the value of a corporation for purposes of this transitional rule includes the value of other corporations that are (or were) members of its controlled group on the relevant date, including corporations that were completely liquidated prior to January 1, 1987. In providing that all members of the same controlled group of corporations are treated as a single corporation for purposes of this rule, however, Congress did not intend to require that all corporations in a controlled group that would qualify for relief be liquidated in order for the liquidation of any one or more corporations in the group to qualify for relief.

Revenue Effect

These provisions are estimated to increase fiscal year budget receipts by $15 million in 1987, $180 million in 1988, $348 million in 1989, $460 million in 1990, and $551 million in 1991.

CANCELLATION OF INDEBTEDNESS FOR SOLVENT TAXPAYERS (SEC. 822 OF THE ACT AND SEC. 108 OF THE CODE)91

Prior Law

Under both present and prior law, gross income includes “income from discharge of indebtedness” (sec. 61(a)(12)). A discharge of indebtedness is considered to occur whenever a taxpayer’s debt is forgiven, cancelled, or otherwise discharged by a payment of less than the principal amount of the debt. The amount of indebtedness discharged is equal to the difference between the face amount of the debt, adjusted for any unamortized premium or discount, and any consideration given by the taxpayer to effect the discharge. Both present and prior law contain exceptions to the general rule in cases where the discharge occurs in a case arising under Title 11 of the United States Code (relating to bankruptcy) or when the taxpayer is considered to be insolvent.

Prior law also provided an exception where the indebtedness discharged was qualified business indebtedness (sec. 108(a)(1)). Qualified business indebtedness was indebtedness that was incurred or assumed by a corporation or indebtedness that was incurred or assumed by an individual in connection with property used in the individual’s trade or business. A taxpayer was required to elect to have the indebtedness treated as qualified business indebtedness (sec. 108(d)(4)).

In the case of a discharge of qualified business indebtedness, the amount of the discharge that would have been included in gross income had the discharge not been of qualified business indebtedness was instead applied to reduce the basis of depreciable property of the taxpayer (sec. 108(c)(1)). An election was available to treat inventory as depreciable property for this purpose. The amount of discharge income that could have been excluded as a discharge of qualified business indebtedness was limited to the basis of the taxpayer’s depreciable property. If the amount of discharge income exceeded the basis of depreciable property, the excess was required to be included in gross income for the year in which the discharge occurred.

Reasons for Change

The Congress believed that the prior law treatment of the discharge of qualified business indebtedness was too generous. Income from such a discharge generally was deferred by reducing the basis of depreciable assets, regardless of the capacity of the taxpayer to currently pay the tax. In addition, the provision produced disparate results among taxpayers depending upon the makeup of their depreciable assets. For taxpayers without sufficient amounts of inventory or depreciable assets, the full benefit of the deferral was not available.

Explanation of Provision

The Act repeals the provision of prior law (sec. 108(a)(1)(C)) which provided for the exclusion from gross income of income from the discharge of qualified business indebtedness. The effect of the Act is to require that any discharge of indebtedness, other than a discharge in title 11 cases and a discharge that occurs when the taxpayer is insolvent, results in the current recognition of income in the amount of the discharge.

The Congress did not intend to change the present law treatment of a discharge of indebtedness that occurs in a title 11 case or when the taxpayer is insolvent.92 The Congress also did not intend to change the provision of prior and present law (sec. 108(e)(5)) that treats any reduction of purchase-money debt of a solvent debtor as a purchase price adjustment, rather than a discharge of indebtedness.

Effective Date

The provision is applicable to discharges of indebtedness occurring after December 31, 1986.

Revenue Effect

The provision is estimated to increase fiscal year budget receipts by $60 million in 1987, $85 million in 1988, $67 million in 1989, $57 million in 1990, and $46 million in 1991.

1 For legislative background of the provision, see: H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 706; S.Rep. 99-313, pp. 271–272; Senate floor amendment, 132 Cong. Rec. S7827 (June 18, 1986); and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 115–116 (Conference Report).

2 The amount of a taxpayer’s insolvency is the excess of its liabilities over the fair market value of its assets.

3 The reduction in basis is limited to the excess of the aggregate bases of the taxpayer’s property over the taxpayer’s aggregate liabilities immediately after the discharge.

4 As under prior law, discharges of nonrecourse “loans” made by the Commodity Credit Corporation in connection with governmental crop price support programs, or other similar transactions that in substance constitute a sale of a farm product, are not within the scope of section 108 and hence are ineligible for relief under this provision.

5 A technical amendment may be necessary to clarify that this was the intended operation of the gross receipts test.

6 A technical amendment may be necessary to conform the Congress’ intent that the relief for solvent farmers be as described above.

7 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 321; H. Rep. 99-426, pp. 250–273; H.R. 3838, as reported by the Senate Committee on Finance on May 29, 1986, sec. 621; Rep. 99-313, pp. 224–248; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 170–196 (Conference Report).

8 H.R. Rep. No. 1337, 83d Cong., 2d sess. 27 (1954).

9 The legislative history of the 1976 Act amendments to section 382—discussed below—specifically provided that Libson Shops would have no application to years governed by those amendments. See S. Rep. 938, 94th Cong., 2d Sess. p. 206 (1976).

10 Prior law section 368(a)(3)(D)(ii) provided nonrecognition treatment to thrift reorganizations that would otherwise qualify as G reorganizations, provided the Federal Home Loan Bank Board, the Federal Savings and Loan Insurance Corporation (“FSLIC”), or an equivalent State authority certified that the thrift was insolvent, could not meet its obligations currently, or would be unable to meet its obligations in the immediate future.

11 343 F.2d 713 (9th Cir. 1965).

12 Cf. Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179 (1942) (“When the equity owners are excluded and the old creditors become the stockholders . . . , it conforms to reality to date [the creditors] equity ownership from the time when they invoked the processes of the law to enforce their rights of full priority”).

13 Unless specifically identified as a taxable year, all references to any period constituting a year (or multiple thereof) means a 365-day period (or multiple thereof).

14 The regulatory authority provided by section 382(g)(3)(B) should not be construed to limit the scope of section 382(g)(4)(C), as augmented by section 382(m)(5). See discussion in text following Example 8 supra.

15 A different result would occur if the public offering were performed by an underwriter on a “firm commitment” basis, because the underwriter would be a 5-percent shareholder whose percentage of stock (66.67 percent) has increased by more than 50 percentage points over the lowest percentage of stock owned by the underwriter at any time during the testing period (0 percent prior to public offering). See Rev. Rul. 78-294, 1978-2 C.B. 141.

16 The attribution rules apply to stock or other interests in a manner consistent with the basic definition of an ownership change under the Act. Thus, section 318 is applied only to “stock” that is taken into account for purposes of section 382. For example, assume a corporation owns both common stock and stock described in section 1504(a)(4) of a type which is not counted in determining whether there has been an ownership change (referred to as “pure preferred”) in a holding company. The pure preferred represents 55 percent of the holding company’s value. The holding company’s only asset consists of 100 percent of the common stock—the only class outstanding—in an operating subsidiary that is a loss corporation. The sale of the pure preferred would not constitute an ownership change because no stock in the loss corporation may be attributed through such stock. On the other hand, assume 100 percent of the stock in a loss corporation is transferred in a section 351 exchange, in which the loss corporation’s sole shareholder receives pure preferred representing 51 percent of the transferee’s value, and an unrelated party receives 100 percent of the transferee’s common stock. Here, an ownership change would result with respect to the loss corporation.
Similar rules would apply where a loss corporation is owned directly or indirectly by a partnership (or other intermediary) that has outstanding ownership interests substantially similar to a pure preferred stock interest.

17 The Act contemplates that regulations may provide rules to allow a widely held loss corporation to establish the extent, if any, to which there is overlapping stock ownership between an acquiring widely held corporation and such loss corporation.

18 Thus, except as provided in regulations, the stock underlying an option or other interest subject to the rule in section 382(1)(3)(A)(iv) may be taken into account on and after the date on which the interest is acquired or is later transferred, for purposes of determining whether an ownership change occurs following any transaction (including such acquisition of transfer). It is expected that the Treasury Department may consider whether there are circumstances in which it may be appropriate to limit the operation of this rule to transactions occurring during any three-year period that includes the date the option or other interest is issued or transferred.

19 The types of rights to acquire stock that are subject to this rule thus may extend beyond those rights that have been treated as options under section 318(a)(4) as applied for other purposes. For example, it is intended that a right to acquire unissued stock of a corporation would (except as pro vided in regulations) be treated as exercised if an ownership change would result, without regard to how such a right may have been treated under section 318(a)(4). Compare Rev. Rul. 68-601, 1968-2 C.B. 124; J. Milton Sorem v. Commissioner, 335 F.2d 275 (10th Cir. 1964); W.H. Bloch v. United States, 261 F. Supp. 597 (S.D. Tex. 1967), aff’d per curiam, 386 F.2d 531 (5th Cir. 1968). It is expected that Treasury will exercise its regulatory authority, however, to prevent the use of this rule in appropriate cases—as one example, where options or other interests subject to the rule are issued shortly after a corporation has incurred a de minimis amount of loss.

20 The rules described above aggregate all less-than-5-percent shareholders of any corporation. These aggregation rules are to be applied after taking into account the attribution rules. In the above example, the old loss corporation and new loss corporation are properly treated as the same corporation. Thus, even though L does not survive the reorganization, Public/L is properly treated as a continuing 5-percent shareholder of Newco, the new loss corporation. The same result would be appropriate if the transaction had been structured as a reverse triangular merger under section 368(a)(2)(E).

21 It was intended that the redemption provisions would apply to transactions that effectively accomplish similar economic results, without regard to formal differences in the structure used, or the order of events by which similar consequences are achieved. Thus, the fact that a transaction might not constitute a “redemption” for other tax purposes does not determine the treatment of the transaction for purposes of this provision. As one example, a “bootstrap” acquisition, in which aggregate corporate value is directly or indirectly reduced or burdened by debt to provide funds to the old shareholders, could generally be subject to the provision. This may include cases in which debt used to pay the old shareholders remains an obligation of an acquisition corporation or an affiliate, where the source of funds for repayment of the obligation is the acquired corporation. See section 382(m)(4), relating to corporate contractions.

22 Similarly, Section 382 does not provide relief for built-in income other than gain on disposition of an asset.

23 For example, a supervisory conversion of a mutual thrift into a stock thrift qualifying under section 368(a)(3)(D)(ii), followed by an issuance of stock for cash, would come within this special rule. The issuance of stock would not be regarded as a second ownership change for purposes of the bankruptcy exception.

24 A technical correction may be needed so that the statute reflects this intent. Such a correction was included in H. Con. Res. 395 as passed by the House and Senate in the 99th Congress. Also, under a literal interpretation of the statute, in order to meet the requirements of section 1504(a)(2), the shareholders and creditors of the old loss corporation must meet the 20-percent test in terms of value and voting power. New section 382(1)(5)(F)(ii)(III) provides a rule for determining the deemed value, but there is no similar rule for measuring voting power. It was not intended that the voting power requirement would apply in this situation to cause a failure of the 20-percent test solely because deposits do not carry adequate voting power. A technical correction may be needed so that the statute reflects this intent.

25 A reorganization pursuant to a 1986 plan is thus treated under the Act as if the reorganization (and any ownership change resulting from the plan) occurred in 1986 when the plan was adopted. Other shifts in ownership in 1987 before completion of a 1986 plan are not protected.

26 The Congress intended the May 6, 1986 date to apply for purposes of determining whether an ownership change occurred after May 5, 1986 but before January 1, 1987.

27 A technical correction may be needed so that the statute reflects this intent.

28 No inference is intended as to how pre-May 6, 1986 options or other interests would be treated.

29 See Floor statements by Mr. Rostenkowski, 132 Cong. Rec. H8363 (September 25, 1986) and 132 Cong. Rec. E 3390 (October 2, 1986); and Senators Dole and Packwood, 132 Cong. Rec. S 13958 (September 27, 1986).

30 For legislative background of the provision, see: H.R. 3838, as reported by the House Committee on Ways and Means on December 7, 1985, sec. 331; H.Rep. 99-426, pp. 274–291; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 198–207 (Conference Report).

31 General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935).

32 Taxable gain may result on disposition of property even if the property’s economic value remains constant (or decreases) over the taxpayer’s holding period, due to tax depreciation and other downward adjustments to basis. The term “appreciated property” as used herein refers to prop erty whose fair market value or sales price exceeds its adjusted (and not necessarily its original) basis in the hands of the transferor corporation.

33 Unless otherwise indicated, all section references in this section (“Prior Law”) are to the Internal Revenue Code of 1954, as in effect immediately prior to the effective date of the amendments made by the Act.

34 284 U.S. 1 (1931).

35 324 U.S. 331 (1945).

36 338 U.S. 451 (1950).

37 Id. at 454–455.

38 This exception for partial liquidations is discussed below under the heading “Nonliquidating distributions.”

39 Treas. Reg. sec. 1.311-1(a).

40 The statute (sec. 311(d)(1)(A)) by its terms applied only to “distribution[s] to which subpart A [of subchapter C, part I] applies. . . .”

41 See secs. 311(d)(2)(A) and 302(b)(4) and (e). The Treasury Department was granted regulatory authority to prevent taxpayers not eligible for this special partial liquidation treatment from obtaining these benefits through the use of section 355, 351, 337, or other provisions of the Code or the regulations (sec. 346(b)).

42 Sec. 311(e)(3).

43 Sec. 311(e)(2)(B)(i).

44 Sec. 311(d)(2)(B).

45 Sec. 311(d)(2)(C), (D), (E).

46 In the case of a distribution of property that was subject to a liability that was not assumed by the shareholder, the gain recognized was limited to the excess of the property’s fair market value over its adjusted basis (sec. 311(c)). If the liability was nonrecourse, however, fair market value was treated as being not less than the amount of the liability (sec. 7701(g)).

47 Sec. 311(b). Under the last-in, first-out or “LIFO” method of accounting, goods purchased or produced most recently are deemed to be the first goods sold. “FIFO” (first-in, first-out) accounting assumes that the first goods purchased or produced are the first goods sold. The LIFO recapture and installment obligation rules were applied before the recognition rules of section 311(d)(1).

48 Sec. 453B. Installment obligations received by a corporation in a sale or exchange qualifying for nonrecognition under section 337 could be distributed to shareholders without recognition at the corporate level. Sec. 453B(d)(2).

49 Sec. 453B(d).

50 A shareholder would under the subchapter S rules be entitled to a basis increase equal to the amount of gain recognized by the corporation.

51 These rules applied not just to corporate distributions but to sales and other dispositions of property, other than in tax-free reorganizations.

52 In the case of sales or exchanges of property in taxable transactions, the effect of this provision was to convert a portion of what would otherwise be capital gain into ordinary income. In the case of nonrecognition transactions, the effect was to require recognition of gain that would otherwise have gone unrecognized.

53 Sec. 1245(a)(5). See also sec. 291(a), subjecting a portion of the straight-line depreciation on real estate to recapture in the case of corporations.

54 It was possible for gain on sales of capital or section 1231 assets in a section 337 liquidation of a collapsible corporation to be eligible for taxation at capital gains rates. A sale in liquidation could produce corporate level income that eliminated the collapsible status of the corporation, so that the shareholders were eligible for capital gains treatment on any gain realized on relinquishment of their shares in the liquidation.

55 Prior to TEFRA, a step-up could be achieved through a partial liquidation of the target as well as a complete liquidation under sections 332 and 334(b)(2).

56 Exceptions are provided for assets acquired in the ordinary course of business, acquisitions in which the basis of property is carried over, and other asset acquisitions as provided in regulations.

57 See, e.g., Bliss Dairy v. United States, 460 U.S. 370 (1983) and Tennessee Carolina Transportation, Inc. v. Commissioner, 65 T.C. 440 (1975), aff’d, 582 F.2d 378 (6th Cir. 1978) (liquidating distribution of previously expensed items); Estate of Munter v. Commissioner, 63 T.C. 663 (1975) (sale of previously de ducted items pursuant to plan of liquidation).

58 Bliss Dairy, supra.

59 E.g., Commissioner v. First State Bank, 168 F.2d 1004 (5th Cir.), cert. denied, 335 U.S. 867 (1948) (a decision rendered prior to the enactment of sec. 311); Siegel v. United States, 464 U.S. 891 (1972), cert. dism’d, 410 U.S. 918 (1973).

60 The price of this basis step up was, at most, a single, shareholder-level capital gains tax (and perhaps recapture, tax benefit, and other similar amounts). In some cases, moreover, payment of the capital gains tax was deferred because the shareholder’s gain was reported under the installment method.

61 See secs. 311 and 336 as amended by the Act. See also 361 as amended by the Act.

62 In amending section 311 in 1984, Congress determined that the existence of a carryover basis in the hands of a corporate distributee, even where the distributee was a member of the same affiliated group, did not justify nonrecognition for nonliquidating distributions. Nonliquidating distributions present opportunities for selective transfer of gain or loss that were not believed to be present in a corporate liquidation qualifying for relief. See H. Rep. 98-861 (June 23, 1984), p. 821.

63 As discussed above, section 338(h)(10) permits an election under which the selling corporation’s gain on the sale of its subsidiary’s stock is ignored, and gain is recognized by the subsidiary as if it had sold its assets in a taxable sale and then liquidated in a section 332 liquidation.

64 Distributions of subsidiary stock may qualify for nonrecognition at both the corporate and share holder levels if the requirements of section 355 are met. However, specific statutory requirements, including a five-year active business test, must be met before section 355 is applicable.

65 See also section 7701(g) of the Code, providing that an identical rule for nonrecourse debt applies with respect to any Code provision (including secs. 336 and 311) in which the amount of gain realized with respect to certain transfers or dispositions is determined by specific reference to the fair market value of the property directly or indirectly disposed of. Treas. Reg. secs. 1.1001-1 and 1.1001-2 also provide generally for the treatment of transfers in which recourse or nonrecourse liabilities are involved. As under these provisions, Congress did not intend to require that any liabilities incurred by reason of the acquisition of property that were not taken into account in determining the transferor’s basis for such property be taken into account in determining the amount of gain or loss under this provision.

66 Congress anticipated that, in a consolidated return context, the Treasury Department will consider whether aggregation of ownership rules similar to those in sec. 1.1502-34 of the regulations should be provided for purposes of determining a corporation’s status as an 80-percent distributee.

67 See sec. 336(d)(3) of the Code, as amended by the Act.

68 A technical correction may be needed so that the statute reflects this intent.

69 Section 361 provides rules governing the treatment of certain distributions in a reorganization. Under amended section 361, sections 336 and 337 do not apply to distributions of property pursuant to a plan of reorganization.

70 A technical correction may be needed so that the statute reflects this intent.

71 A technical correction may also be needed to clarify that the distributing corporation recognizes gain but not loss on a distribution of boot in these circumstances.

72 See, e.g., section 482 and Treas. Reg. section 1.482-1(d)(5); National Securities Corp. v. Comm’r, 137 F.2d 600 (3d Cir. 1943), affg 46 B.T.A. 562 (1942), cert. denied, 320 U.S. 794 (1943) (loss on sale by subsidiary of securities transferred by parent in nonrecognition transaction reallocated to parent, where purpose of transfer was to shift unrealized loss on securities to subsidiary); Court Holding Co. v. U.S., 324 U.S. 321 (1945) (corporation treated as true seller of property distributed to share holders and purportedly sold by them to third party); and Gregory v. Helvering, 293 U.S. 465 (1935) (in addition to meeting literal requirements of statute, transaction must have valid business purpose to qualify for nonrecognition).

73 This was intended to refer to a person having a relationship to the distributing corporation that is described in section 267(b).

74 The effect of the rule is to deny recognition to the liquidating corporation of that portion of the loss on the property that accrued prior to the contribution, but to permit recognition of any loss accruing after the contribution. In the event that a transaction is described both in section 336(d)(1) and section 336(d)(2), section 336(d)(1) will prevail.

75 A technical correction may be needed so that the statute reflects the intention that recapture in the year of liquidation is required unless regulations provide otherwise.

76 See footnote 87 supra.

77 For the particular purposes of this built-in gain tax under new section 1374, Congress intended the term “disposition of any asset” to include not only sales or exchanges but other income- recognition events that effectively dispose of or relinquish the taxpayer’s right to claim or receive income. For instance, the term “disposition of any asset” for purposes of this provision will include the collection of accounts receivable by a cash method taxpayer and the completion of a long-term contract performed by a taxpayer using the completed contract method of accounting.

78 Congress intended that the recognized built-in gains taken into account for any taxable year shall not exceed the excess, if any, of (a) the net unrealized built-in gain at the time of the conversion, over (b) the amount (if any) by which recognized built-in gains for prior taxable years beginning in the recognition period exceed recognized built-in losses for such years.

79 A technical correction may be needed so that the statute reflects this intent in the case of capital loss carryovers and similar items.

80 The Act provides in the case of a sale or distribution of stock of a subsidiary by a qualifying parent corporation, that under regulations “such corporation” may make the election. Congress did not intend to require the election to be made unilaterally. Compare section 338(h)(10).

81 These special rules do not apply, however, for purposes of the transitional rules based on pre–August 1, 1986, action.

82 For purposes of these transitional rules generally, transactions described in section 336 or 337 of prior law include complete liquidations and the related distributions, sales, or exchanges de scribed in those sections.

83 As an example, if prior to November 20, 1985, the company had entered a letter of intent specifying that either substantially all the assets of the company will be sold to a particular purchaser or purchasers for a particular price, or that all the stock of the company will be sold to such persons (who may then liquidate the corporation or make a section 338 election), it will generally be considered that the requisite shareholder or board approval of a transaction described in section 337 of prior law occurred if the contract to sell assets was in fact entered and the corporation liquidates in a transaction described in section 337 before 1988. The same transaction could qualify under the transitional rule for an offer to acquire stock if the contract to sell stock were entered into (and the purchaser made a section 338 election with respect to a pre-1988 acquisition date, or liquidated the corporation before 1988).

84 If the “acquisition date” under section 338 occurs before the relevant transition date, the prior law provision allowing additional stock to be purchased within a year after the section 338 “acquisition date” is also available. Thus, if there is a qualified stock purchase of 80 percent of the stock of a qualified corporation on December 1, 1986, followed by purchase of the remaining 20 percent on February 1, 1987, the nonrecognition percentage for purposes of section 337 of prior law would be 100 percent. See section 338(c)(1) and Prop. Treas. Reg. section 1.338-4T(k)(5).

85 For purposes of the transition provisions, if a corporation was a C corporation at any time before December 31, 1986, any “S” status of such a corporation prior to its “C” corporation status is disregarded in determining whether under the statute the first taxable year for which the corporation is an S corporation is pursuant to an S election made after December 31, 1986.

86 See Act section 633(d).

87 A technical correction may be needed to clarify that the election need only be made (not become effective) by this date. Such a correction was included in H. Con. Res. 395 as passed by the House and Senate in the 99th Congress.

88 A technical correction may be needed so that the statute reflects this intent.

89 See Act section 633(d)(5)(A).

90 A technical correction may be needed so that the statute reflects the holding period requirement. A similar correction was included in H. Con. Res. 395 as passed by the House and Senate in the 99th Congress.

91 For legislative background of the provision, see: H.R. 3838 as reported by the Senate Committee on Finance on May 29, 1986, sec. 323; S.Rep. 99-313, pp. 161-162; and H.Rep. 99-841, Vol. II (September 18, 1986), pp. 324-325 (Conference Report).

92 Sec. 405 of the Act provides special rules for certain solvent farmers for the purpose of determining whether there is income from the discharge of indebtedness. (See Title IV., Part A.4.)