U sually attorneys and accountants can identify those financial instruments that qualify as corporate stock and then apply the appropriate tax rules. The decision becomes more complicated if the corporation is insolvent or in bankruptcy. For example, in these situations debt may be treated as stock, which can lead to unexpected outcomes. This article discusses the special rules and issues surrounding the classification of stock ownership of those corporations.
Definition of Stock
Sec. 7701(a)(3) states: “The term ‘corporation’ includes associations, joint-stock companies, and insurance companies.” This is followed by Sec. 7701(a)(7), which defines stock. It states: “The term ‘stock’ includes shares in an association, joint-stock company, or insurance company.”
These very general provisions caused the Ninth Circuit in Affiliated Government Employees Distribution Co. 1 to conclude that Congress did not specifically define the term stock. As a result, the court adopted the following general definition of stock:
the interest or right which the owner who is called the “shareholder” or “stockholder” has in the management of the corporation, and in its surplus profits, and, on dissolution in all of its assets remaining after the payment of its debts. 2
Comparing the attributes listed above with the ones contained in the instrument in question, the court concluded the item at issue was not stock because of the absence of some of the stated attributes. However, the court also stated that the absence of one or more of these attributes does not mandate that the instrument not be stock.
In Stockton, 3 the appeals court described stock as providing the owner with rights to a corporation’s management, profits, and assets. These are the same attributes listed by the Ninth Circuit in Affiliated Government Employees. Based on these cases, an instrument will usually be considered stock if it shares in the corporation’s profits and its assets in liquidation.
This rule does not always apply. In Paulsen, 4 the Supreme Court had to decide if the passbook savings account and certificate of deposit (CD) received in a merger of a stock savings and loan association into a mutual savings and loan association qualified as stock. The Court noted that the savings account and CD were entitled to a share of dividends and assets in liquidation. However, the Court decided that these items had minimal value because a reasonable person would not have purchased them for more than their face amount. The Court concluded that they did not qualify as stock—just because an instrument contains the attributes of stock does not make it stock if these attributes have minimal value.
Nonstock Treated as Stock
There have been situations in which stock options and debt have been treated as stock. The characterization can depend on the instrument as well as the type of transaction (e.g., reorganization and ownership change) that occurred.
Stock options are generally defined as a financial instrument that gives the holder the right to buy or sell a specific number of shares of a specific corporation at a stated price and by a stated date. As a general rule, stock rights and options are not included in the definition of stock. Regs. Sec. 1.351-1(a)(1)(ii) states that stock rights and warrants are not stock for purposes of Sec. 351. The Tax Court in Bateman 5 and the Second Circuit in Gordon 6 ruled that stock rights and warrants are not stock for purposes of Sec. 354. More recently, the Tax Court in Gantner 7 ruled that stock options were not stock for purposes of the Sec. 1091 short-sale rule. 8 In 2010, the Tax Court cited Gantner as authority for rejecting a taxpayer’s attempt to treat a stock option as stock for purposes of Sec. 1202. 9 This decision was recently affirmed by the Ninth Circuit. 10
However, there are situations in which options will be treated as stock. In Rev. Rul. 82-150, 11 B formed a corporation by contributing $100,000 in exchange for 100% of its stock. B sold an option to purchase all the stock to A for $70,000. The option price was $30,000. The ruling concludes that A was the real owner of the corporation since A bears the risk of ownership. The IRS cited this revenue ruling as authority for concluding warrants were stock in Letter Ruling 9747021 12 and Field Service Advice (FSA) 200201012. 13 In the letter ruling, the warrants had a minimal exercise price ($0.01). In the FSA, the warrants were so deep in the money that the IRS concluded that the holders of the warrants were the only ones who would gain or lose from the corporation’s appreciation or depreciation. Based on the above cases and rulings, options are not equity unless the holder bears the benefits and detriments of owning the corporation.
The Code also contains specific exceptions in which stock options will be treated as stock. For example, Sec. 305(d)(1) treats options as stock to ensure that corporate distributions that affect the ownership of different shareholders are taxable. In addition, the holder of an option will be treated as owning stock under the constructive ownership rules of Sec. 318(a)(4) (options are considered stock for constructive ownership of stock rules), Sec. 544(a)(3) (constructive ownership rules for personal holding companies), and Sec. 1563(e)(1) (effect of ownership of options on consolidated group rules).
Congress enacted Sec. 385, which authorizes the Treasury Department to issue regulations that distinguish stock from debt (or treat the instrument as part stock and part debt). The section lists five factors that Treasury may include in the regulations, which Treasury has never completed issuing (it withdrew regulations issued in the last attempt 30 years ago). Lacking that guidance, the courts have analyzed the cases based on various factors. For example, the Ninth Circuit used 11 factors in Hardman. 14 Included in this group of factors are the intent of the parties, the source of the payments, the adequacy of capitalization, and participation in management.
Recently, the Tax Court has considered this issue in three different cases. 15 It pointed out that a simple fixed set of factors for determining if an instrument is debt or equity remains elusive. Therefore, the court will determine that the instrument is debt if the parties intended to create debt, there is a reasonable expectation of repayment, and the parties’ intent comports with the economic reality of creating a debtor/creditor relationship. These conclusions are based on the factors identified by the appellate courts to which the cases are appealable. 16 Given the Tax Court’s approach to the issue, that the different courts apply different factors, that none of the factors are mandatory, and that the weight to be given each factor has not been stated, it is difficult to apply Sec. 385 for solvent corporations and almost impossible to apply it if the corporation is insolvent or in bankruptcy.
For many corporations that are insolvent or in bankruptcy, the current shareholders and creditors are interested in continuing the business in a reorganized form. The reorganization transaction will be tax free if in addition to meeting the requirements of Sec. 368, it meets the continuity-of-interest rule contained in Regs. Sec. 1.368-1(e). Under Regs. Sec. 1.368-1(e)(6), a creditor of a target corporation may be considered a shareholder if the corporation is insolvent or in bankruptcy. The regulation goes on to state that, for purposes of the continuity-of-interest rule, if any debt is treated as equity, creditor claims of the same or of a junior class are also treated as equity.
There have been no cases or rulings that discuss this regulation, but cases that addressed the issue of creditor as shareholder for the continuity-of-interest rule were decided before the regulation was issued. The Supreme Court addressed the issue in Helvering v. Alabama Asphaltic Limestone Co. 17 The Court granted certiorari on the grounds that the Fifth Circuit decision in Alabama Asphaltic 18 was in conflict with the Ninth Circuit decision in Palm Springs Holding Corp. 19 and the Eighth Circuit decision in Helvering v. New President Corp. 20 Although it is possible to distinguish the reasoning of the three courts, the Court’s decision directly addresses the question of creditors as shareholders of a corporation undergoing a reorganization during bankruptcy.
The specific issue before the Court in Alabama Asphaltic was the basis of acquired property. The taxpayer argued it was entitled to a carryover basis because the acquisition was a nontaxable reorganization. The government argued that it was not a reorganization and therefore that the basis should be cost.
The assets in question were owned by a subsidiary of a parent corporation attempting a reorganization. The creditors would not agree to accept the subsidiary’s stock as payment for their claims. A creditor committee formulated a plan for a new corporation to acquire the subsidiary’s assets and to distribute its stock to the creditors in sat isfaction of most of the outstanding obligations. To effectuate the plan, an involuntary bankruptcy proceeding was instituted in which the creditors received stock of the new corporation that owned the subsidiary’s assets in exchange for the outstanding obligations (with creditors who had not agreed to the plan receiving cash).
The government argued that the transaction was not a reorganization since it did not meet the continuity-of-interest requirement articulated by the Court in Pinellas 21 and LeTulle. 22 Specifically, it argued that the shareholders of the new corporation were creditors and not shareholders of the old corporation; therefore, continuity of interest did not exist.
The Court rejected this argument. Even though the creditors did not obtain actual ownership until after the transfer, the Court recognized that the creditors became shareholders when they took control of the old insolvent corporation by instituting the bankruptcy proceedings. In doing so, they had the right to exclude the old shareholders, which eliminated the need for the old shareholders to have ownership of the new corporation. The bottom line is that there was the necessary continuity of ownership because the creditors were deemed to be shareholders.
The Court went on to distinguish the case from LeTulle. In that case, the sole owner of a corporation exchanged his stock in the corporation for bonds and cash of the acquiring corporation. The Court stated that “a bondholder interest in a solvent company plainly is not the equivalent of a proprietary interest, even though upon default the bondholders could retake the property transferred.” In the current case, the corporation was insolvent and the creditors had effective control of the corporation.
Alabama Asphaltic ’s scope has recently been examined by the Tax Court in Ralphs Grocery. 23 The case involved an insolvent parent corporation that filed for voluntary bankruptcy under Chapter 11. As part of the workout plan, it created a new corporation to which it transferred the Ralphs Grocery stock, which was a solvent subsidiary, to Newco in exchange for 100% of Newco’s stock. It then transferred the Newco stock to some of its creditors in cancellation of its debt to the creditors.
Parent and the creditors filed a Sec. 338(h)(10) election, which treated the transfer of Ralphs Grocery stock as a sale of Ralphs Grocery’s assets, resulting in a basis step-up. The IRS argued that the transaction did not qualify under Sec. 338 because the transfer was not a qualified purchase and was instead a nontaxable reorganization. The IRS and the taxpayer agreed that the transaction would be a reorganization if the creditors were deemed to be shareholders under Alabama Asphaltic and thereby met the continuity-of-interest requirement. And both sides agreed that if the creditors were not deemed to be shareholders, then the transaction was a qualified purchase and the Sec. 338(h)(10) election was valid.
Before addressing the rules contained in Alabama Asphaltic, the Tax Court had to decide if the enactment of the G reorganization 24 as part of the 1980 Bankruptcy Act 25 changed or overruled the Supreme Court’s decision. The IRS argued that the creation of the G reorganization reinforced the Alabama Asphaltic decision and expanded it to cover junior creditors who become shareholders after bankruptcy. Since the taxpayers did not disagree, the Tax Court accepted the IRS’s argument. Therefore, the decision in Alabama Asphaltic still applied after G reorganizations were created.
The Tax Court then turned to the question of whether Alabama Asphaltic applied to the current case. According to the IRS, the Supreme Court’s decision is very straightforward. To qualify as a reorganization, the corporation needs to be insolvent, and the creditor needs to receive the stock as part of a reorganization plan. Since the parent in Ralphs Grocery was in bankruptcy and the creditors received the stock as part of a plan, the transaction met the continuity- of-interest requirement and, the IRS argued, was a nontaxable reorganization.
The Tax Court did not accept this simplified view of the Supreme Court decision in Alabama Asphaltic. The court agreed with the taxpayer that, in addition to the two requirements stated by the government, the creditors must have effective control over the insolvent corporation’s assets. Thus, the real issue was whether the creditors exerted the necessary control.
Looking at the cases leading up to Alabama Asphaltic, the court found that the determinative fact was whether the creditor took proactive steps to obtain effective control over the insolvent corporation’s property. Examples of those steps from these cases cited by the court included:
- The creditors file for involuntary bankruptcy;
- The creditors file for foreclosure of mortgages securing the debt;
- The insolvent corporation’s assets are sold under an indenture;
- The creditors file a receivership action against the insolvent corporation; or
- The creditors take possession and operate the property of the insolvent corporation.
In Ralphs Grocery, the insolvent corporation filed for voluntary bankruptcy, and the creditors did not engage in any of the actions on the above list or otherwise take any proactive steps to control the insolvent corporation. Thus, the creditors did not exert control over the insolvent corporation and thereby prevent the actual shareholders from controlling the corporation. Consequently, the creditors were not shareholders, the transaction was not a reorganization because there was no continuity of interest, and the Sec. 338(h)(10) election was valid.
Having decided that the continuity-of-interest requirement was not met, the Tax Court left unanswered other issues in the case. Specifically the Tax Court stated:
We need not resolve the parties’ disputes over (1) whether or not under Alabama Asphaltic the insolvent corporation over whose property its creditors must have “effective command” must be the target corporation in the purported reorganization and (2) whether or not under that case the direct creditors of that insolvent target corporation must receive the stock of the company that acquired the stock of that target corporation or its property. 26
These questions will remain open until future litigation. What was resolved is that not all the creditors of all insolvent corporations will be deemed to be shareholders. To be shareholders, the creditors must exert effective control over the insolvent corporation, allowing them to exclude the existing shareholders if they want.
Given that the IRS and the Tax Court accepted the conclusion that the enactment of the G reorganization adopted and expanded Alabama Asphaltic, another potential question arises. After the creditors become deemed shareholders by exerting control and the bankrupt corporation follows through with the reorganization plan, does the transaction qualify as a G reorganization? The issue arises because the transaction could meet the requirements of a B or C reorganization as well as a Sec. 351 transaction.
Sec. 368(a)(3)(C) provides that if the transaction qualifies as both a G reorganization and another type, it will be treated as a G reorganization. Sec. 351(e)(2) provides that transfers under Sec. 368(a)(3)(A) cannot qualify as Sec. 351 transactions. The result appears to be that the transaction is a G reorganization. Under Sec. 361, distributing the stock of the acquiring corporation to the creditors of the insolvent corporation who are deemed shareholders as well as distributions to the other creditors will be nontaxable. Of course, the distributing corporation may have to recognize cancellation of debt (COD) income under Sec. 108.
If the creditors, or a group of creditors, are treated as shareholders in a reorganization, the regulations contain another potential issue. Under Regs. Sec. 1.368-1(e)(1)(ii), if any of the creditors receive payment before the reorganization but as part of the acquisition plan, the payment can be considered boot, which might affect whether the transaction meets the continuity-of-interest requirement and therefore qualifies as a tax-free reorganization. Since there is no guidance as to when a payment before a reorganization will be considered part of the transaction and therefore boot, it is difficult to be certain of the outcome if some of the creditors receive cash prior to the reorganization. However, if the payment is to a creditor or group of creditors whose claims are more senior to those of the creditors that are treated as shareholders, this should not be an issue since the regulations treat creditors as shareholders if their claims are in the same class or a junior class of those creditors treated as shareholders. In other words, the more senior creditors will be treated as creditors and not shareholders.
Sec. 382 Following a Reorganization
Currently Sec. 382, which was enacted to restrict the sale of net operating losses (NOLs), limits the use of NOL carryforwards following an ownership change. The existence of an ownership change is determined by examining the change in ownership of the loss corporation’s stock as a result of a stock sale, reorganization, or similar transaction. Although a loss company does not have to be insolvent or in bankruptcy, many are.
Sec. 382(k)(6)(B)(i) gives Treasury the authority to classify nonstock interests as stock for purposes of Sec. 382. The two most significant nonstock interests that can be reclassified as stock are stock options and debt.
Temp. Regs. Sec. 1.382-2T(h)(4)(i) states that on any testing date an owner of an option to buy stock of a loss corporation will be treated as having acquired the stock if it results in an ownership change. This rule applies without regard to whether the option was issued for tax avoidance purposes. The fact that the option cannot be exercised currently or is contingent is disregarded. 27 The rule is applied separately for each class of options and each 5% shareholder.
The regulations expand the general definition of a stock option. Specifically Temp. Regs. Sec. 1.382-2T(h)(4)(v) states that options include but are not limited to:
a warrant, a convertible debt instrument, an instrument other than debt that is convertible into stock, a put, a stock interest subject to risk of foreclosure, and a contract to acquire or sell stock.
Options are not treated as stock if the precharge loss is de minimis. 28 A de minimis loss is a loss that is less than twice the value of the corporation multiplied by the long-term tax-exempt rate. In other words, if the loss is less than twice the Sec. 382 limit, it is de minimis.
If the options that were treated as stock lapse or are forfeited, the loss corporation is permitted to file amended returns deducting the NOL carryforwards without a Sec. 382 limit. 29 If the options are exercised within 120 days of the ownership change, the loss corporation may elect to take into account only the acquisition of loss corporation stock resulting from the actual exercise of the option. This election has no effect on the determination of whether an ownership change occurs and applies only for the purpose of determining the date on which the change date occurs. 30 As previously discussed, debt can be treated as stock.
Treasury has exercised the authority granted by Sec. 382(k)(6)(B)(i) to reclassify certain debt as equity. Specifically, Temp. Regs. Sec. 1.382-2T(f)(18)(iii) says that debt will be reclassified as stock if, at the time of issue or transfer, the debt has the potential for significant participation in the growth of the corporation, treating the debt as stock will result in an ownership change, and the loss carryforward is more than twice the value of the corporation times the long-term tax-exempt interest rate (the de minimis rule discussed above). As a general rule, the only time a creditor would have a potential to share in corporate growth is if the corporation was insolvent or in bankruptcy. If the corporation is solvent, the creditor would be entitled solely to the face amount of the debt at maturity.
The New York State Bar Association recently discussed this regulation in a request to Treasury to modify it. 31 The Bar Association report (1) points out that the regulation does not discuss when debt would significantly participate in corporate growth; (2) argues that the regulation conflicts with the intent of Congress as evidenced by Secs. 382(l)(5) and (6); and (3) requests the regulation be rewritten to provide that the determination of debt as equity should occur solely at the time debt is issued.
The report includes a discussion of the relevant authorities that cite or explain the rules from the regulation. It points out that the only ones that exist are private letter rulings and a field service advice. One of the rulings that it refers to is FSA 199910009. 32 In this FSA, the IRS concluded that a significant modification of a debt as defined in Regs. Sec. 1.1001-1 should be treated as a transfer for purposes of Sec. 382. If the modified debt is reclassified as stock, this could result in a significant increase in the number of financially distressed corporations having these NOL carryforwards restricted by Sec. 382.
Fortunately, the FSA goes on to state that the fact that the corporation is insolvent does not mean that the creditors are going to share in the corporate appreciation. If they do not share in the growth, the debt is not treated as stock. Therefore, insolvency followed by debt modification alone will not trigger Sec. 382. In addition, Regs. Sec. 1.382-9(d)(5)(iv) provides that the creditor that receives the new debt can tack the holding period of the old debt to the new for purposes of determining if it is qualified debt. Under Sec. 382(l)(5), owners of qualified debt are eligible to receive stock in a bankruptcy reorganization without triggering Sec. 382(a). Given this, debt modification should not affect the application of Sec. 382.
When will creditors share in appreciation? The most likely scenario is when they have exerted control over the loss company and are attempting to exclude the actual shareholders. In this situation, the debt would likely be reclassified as stock under the regulations, making the regulations consistent with Alabama Asphaltic as clarified in Ralphs Grocery . If this is the correct interpretation, then the potential for debt to be reclassified as stock is not a material issue. This appears to be the correct interpretation according to the private letter rulings discussed in the Bar Association report. In all of them, the IRS concluded that the creditors are not shareholders, 33 including FSA 199910009, in which the taxpayers wanted the creditors to be deemed to be shareholders. These prior rulings suggest that it is unlikely that creditors will be treated as shareholders.
The Bar Association report argues that treating a debt transfer as an ownership change before a corporation files for a bankruptcy reorganization conflicts with congressional intent. Secs. 382(l)(5) and (l)(6) are designed to allow post-bankruptcy reorganized corporations to use some or all of their prior NOLs, and treating this prior debt transfer as an ownership change would impose a low Sec. 382 limit on the reorganized corporation’s use of these NOL carryforwards, which is not what Congress intended.
The Bar Association report’s discussion of a potential conflict with congressional intent is very reasonable if debt is treated as stock prior to the bankruptcy filing. Given the decisions in Alabama Asphaltic and Ralphs Grocery, it is highly unlikely that debt will be treated as stock before a bankruptcy filing. Therefore, applying the regulation as currently written to debt transfers should not result in an actual conflict with congressional intent.
It would be helpful if Treasury modified Temp. Regs. Sec. 1.382-2T(f)(18)(ii) to explain when debt will be treated as sharing in corporate growth rather than leave it unanswered. As pointed out in the Bar Association report, one possible solution would be for the regulation to adopt or refer to existing rules involving earning sharing, as the regulations under Sec. 305 do. An alternate approach would be for Treasury to adopt a more specific rule for when debt is deemed to share in corporate growth.
Stock Deemed Not Stock
Just as there are situations in which a variety of financial instruments are treated as stock, there are situations in which stock is treated as not being stock. These situations can affect insolvent and bankrupt corporations.
There are no Code provisions that reclassify existing stock as nonstock of a corporation that is undergoing a reorganization. As previously discussed, debt may be treated as equity for insolvent and bankrupt corporations under Alabama Asphaltic. Even if this occurs, the actual stock should still be classified as stock. The more relevant question is whether the stockholders of a corporation in which debt is treated as equity can claim a deduction for worthless stock, and if so, in which tax year? A discussion of this issue is beyond the scope of this article.
However, it is possible that certain stock issued as part of the reorganization will be reclassified as nonstock. Specifically, Sec. 354(a)(2)(C) provides that nonqualified preferred stock (defined in Sec. 351(g)(2)) is not treated as stock or securities. There is an exception for recapitalizations (Sec. 368(a)(1)(E) reorganizations) of family-owned corporations.
Sec. 351(g)(2) defines nonqualified preferred stock as preferred stock that is redeemable (mandatory redemption or more likely than not to be redeemed) or has a dividend that varies based on interest rates, commodity prices, or similar indices. Sec. 351(g)(3) defines preferred stock as stock that is limited and preferred as to dividends and does not participate in corporate growth to any significant extent. To participate in growth, there must be a real and meaningful likelihood that the stock will actually participate in earnings and growth of the corporation.
There are no regulations under Sec. 351 that explain the requirement for participating in corporate growth. Recently, the Tax Court examined this issue in Gerdau Macsteel Inc. 34 Since no Sec. 351 regulations apply, the court decided that the Sec. 305 regulations, which have a similar provision, should apply in determining nonqualified preferred stock. 35 Under those regulations, the fact that the stock is permitted to share in growth is not sufficient. There must be a reasonable potential for sharing. According to the Tax Court, the way to determine the potential is to examine the possibility that the preferred stock will receive more than its preferred amount in liquidation. In this case, the court concluded that, even though the preferred stock contained a provision for sharing in the growth, the potential for sharing in growth was not reasonable and therefore the stock in question was nonqualified preferred stock.
Application of Sec. 382 in Nonreorganization Transactions
Sec. 382(k)(6) contains a specific provision that permits stock to be reclassified as not stock. This change can greatly affect whether a transaction qualifies as an ownership change or not. Therefore, it is important to identify which shares of stock are to be disregarded.
According to the Senate Finance Committee report 36 on the 1986 Tax Reform Act, 37 this section was designed to address transactions in which the beneficial ownership of the NOL carryforward did not follow actual stock ownership. As an example, the report cites Maxwell Hardware Co . 38 The bill addressed the problem by excluding stock that does not participate in the corporation’s growth to a significant extent from the definition of stock.
The actual enacted provision modified the Senate’s approach. Sec. 382(k)(6)(A) provides that, except as contained in regulations, stock does not include preferred stock described in Sec. 1504(a)(4). As a general rule, this stock is plain vanilla preferred stock that does not participate materially in corporate growth. 39
In addition to omitting preferred stock, Sec. 382(k)(6)(B)(ii) authorizes Treasury to issue regulations that “treat stock as not stock.” The Joint Committee on Taxation report on the 1986 act explains this provision as giving Treasury the authority to disregard voting preferred stock and common stock in determining participating stock in cases in which their share of corporate growth is disproportionately small compared to the total value of all stock when issued or transferred. 40 In addition, the regulations can omit outstanding stock in cases similar to Maxwell Hardware . Finally, the regulations can omit preferred stock that is voting because dividends are in arrears.
The complex facts in Maxwell Hardware can be simplified to demonstrate the tax shelter transaction that Congress wished to prevent. The corporation had a significant NOL carryforward. Two individuals who were real estate professionals agreed to contribute money to the corporation in exchange for special preferred stock. The value of the preferred stock was less than the value of the outstanding common stock but was entitled to 90% of the income and appreciation related to the contribution, which was to be invested in specific real estate.
After six years, the corporation could redeem or the owners could require the corporation to redeem the preferred stock in exchange for the real estate associated with it. The Ninth Circuit ruled that the NOL carryforward could offset the income from the real estate even though it was assigned to the preferred stock. Thus, the new investors used the existing NOL to reduce or eliminate the tax on the income generated by the real estate purchased with their contributed funds.
Treasury adopted regulations that implement part of the congressional intent as explained in the congressional reports. Regs. Sec. 1.382-2(a)(3)(i) states that preferred stock that is not described in Sec. 1504(a)(4) solely because it is voting as a result of dividends in arrears shall be treated as nonstock.
The only other regulatory provision that treats stock as nonstock is contained in Temp. Regs. Sec. 1.382-2T(f)(18)(ii). This provision treats stock as nonstock if three conditions are met. First, at the time of issuance or transfer, the stock is likely to participate in a disproportionately small share of corporate growth as compared to its value in relation to the value of all outstanding stock; second, by excluding this stock, the transaction will result in an ownership change; and, third, the NOL carryforward (including built-in loss) exceeds twice the value of the loss corporation times the long-term tax-exempt rate.
The first requirement is the exact requirement stated in the conference report, and the other two were added by Treasury. They are very reasonable: there is no reason to invest a great deal of time in making these determinations unless it will result in an ownership change of a loss corporation with more than a de minimis loss. In addition, it is consistent with the rules for debt. As previously discussed, the regulations treat a debt instrument as stock for purposes of Sec. 382 if it shares significantly in corporate growth, would cause an ownership change, and the loss exceeds twice the value of the corporation times the tax-exempt rate. Note that the last two requirements are the same for both rules. The first condition asks if the instrument shares significantly in corporate growth. If it does, it is stock. If it does not, it is not stock.
This exclusion would not prevent a taxpayer from following the transaction in Maxwell Hardware . The regulation excluded only stock that was issued or transferred and does not share in corporate growth. In Maxwell Hardware , the preferred stock that was issued was entitled to almost all of the corporate growth and therefore would count as stock under this rule. As explained in the conference report, it is the stock owned by the original shareholders in Maxwell Hardware (i.e., the outstanding stock, not the issued stock) that would not share in the growth and should be excluded from the definition of stock and the calculation of the ownership change. The result is that Treasury did not fully implement the congressional intent as described in the Blue Book and committee reports.
Even though the rule does not apply to transactions similar to Maxwell Hardware , it is interesting to analyze which transactions are covered by the rule. Since Sec. 382(k)(6)(A) provides that plain vanilla preferred stock as defined in Sec. 1504(a)(4) is excluded from the definition of stock, the rule would apply only to common stock and nonexcluded preferred stock. The most likely items to be covered by this rule are nonexcluded preferred stock. For example, to be excluded, preferred stock must be nonvoting. If a corporation previously issued a significant amount of voting preferred stock or preferred stock that is currently voting because of a stated contingency that has occurred, this preferred stock may not be treated as stock under this rule if a transfer of some of the common stock along with a limited amount of the preferred stock would result in an ownership change by excluding this preferred stock . Although possible, this would not be a common transaction.
It is less likely that common stock will not be treated as stock. It is difficult to imagine a situation in which common stock that makes up the majority of the outstanding equity would be entitled to a minimum share of corporate growth. One possibility would be if the corporation issued two classes of common stock with one entitled to a minimum share of corporate growth. If the amount of this class’s total value is significant in relation to the class that is entitled to the growth, it could meet the requirements for exclusion. Looking at these possibilities, there will be few cases in which stock will be classified as nonstock under these rules.
As previously discussed,
preferred stock that is described in Sec.
is not stock for purposes of Sec. 382. It is also excluded stock under Secs. 338 and 355.
Preferred stock excluded under Sec. 1504 is stock that:
- Is nonvoting;
- Is limited and preferred as to dividends and does not participate in corporate growth to a significant extent;
- Has redemption and liquidation rights equal to issue price plus a reasonable premium; and
- Is not convertible.
Because the regulations do not discuss these rules, there is no specific guidance on the meaning of participation in corporate growth or reasonable redemption premium. As previously mentioned, one possible av enue of approach to defining these terms would be to consider how they are defined under other Code sections. For example, Sec. 305(c) also refers to reasonable redemption premium. In Chief Counsel Advice (CCA) 201152016, 41 the IRS considered this possibility, pointing out that in the past the IRS applied the Sec. 305 safe-harbor rule in its Sec. 1504 rulings. The CCA then states that the safe-harbor rule no longer exists under Sec. 305 and therefore does not apply to Sec. 1504. The CCA goes on to state:
Today, it remains unclear what constitutes an “unreasonable redemption premium” for purposes of applying § 1504(a)(4)(C). In fact, commentators have advised taxpayers to request a private letter ruling in advance of any transactions relying on the operation of § 1504(a)(4)(C) in order to obtain more definitive guidance on the status of what constitutes a [sic] unreasonable redemption premium.
Two aspects of this CCA are disconcerting. First, although the IRS repealed the old safe-harbor rule under Sec. 305, it added a new one in Regs. Sec. 1.305-5(b)(3)(ii). Therefore, stating that the safe harbor no longer exists is limited to the safe harbor used in old private letter rulings. Second, and more importantly, this CCA appears to conclude that the definitions of reasonable redemption premium are different for the different Code sections because Congress had different intents when enacting these different sections. Because the IRS believes that Congress intended different outcomes, it is unknown to what extent it will try to limit rulings under one Code section from being applied to another.
For tax and legal purposes, stock generally provides the holder with the right to participate in management and to receive a share of distributions and a share of assets in liquidation. Congress and Treasury have modified this definition of stock under specific Code sections to prevent abuse.
Most of these changes result in stock options and debt being treated as stock. Although there are no consistent rules for this treatment, most require these financial instruments to share in corporate appreciation before they will be considered stock. In certain cases, stock will be treated as not being stock. For most of these, the denial of treatment as stock occurs because the instruments labeled as stock do not share in future corporate appreciation.
Whenever a corporation has outstanding options, is in financial difficulty, or has outstanding debt that is entitled to more than just interest and principal, taxpayers should analyze the possibility that a special definition of stock applies.
1 Affiliated Government Employees Distribution Co., 322 F.2d 872 (9th Cir. 1963).
2 Id. at 877.
3 Stockton v. Lucas, 482 F.2d 979 (Temp. Emer. Ct. App. 1973).
4 Paulsen, 469 U.S. 131 (1985).
5 Bateman, 40 T.C. 408 (1963).
6 Gordon, 424 F.2d 378 (2d Cir. 1970).
7 Gantner, 91 T.C. 713 (1988).
8 Congress modified Sec. 1091 to now include options under this provision.
9 Natkunanathan, T.C. Memo. 2010-15.
10 Natkunanathan, 479 Fed. Appx. 775 (9th Cir. 2012), aff’g T.C. Memo. 2010-15.
11 Rev. Rul. 82-150, 1982-2 C.B. 110.
12 IRS Letter Ruling 9747021 (11/21/97).
13 FSA 200201012 (1/4/02).
14 Hardman, 827 F.2d 1409. It is interesting to note that the court cited Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders, ¶4.05 (1986 Cumm. Supp. No. 3), for the idea that Treasury would likely request Congress to repeal Sec. 385.
15 Pepsico Puerto Rico, Inc., T.C. Memo. 2012-269, NA General Partnership, T.C. Memo. 2012-172, and Hewlett-Packard Co., T.C. Memo. 2012-135.
16 Pepsico was appealable to the Second Circuit; NA General Partnership and Hewlett-Packard to the Ninth.
17 Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179 (1942).
18 Alabama Asphaltic Limestone Co., 119 F.2d 819 (5th Cir. 1941).
19 Palm Springs Holding Corp., 119 F.2d 846 (9th Cir. 1941).
20 Helvering v. New President Corp., 122 F.2d 92 (8th Cir. 1941).
21 Pinellas, 287 U.S. 462 (1933).
22 LeTulle, 308 U.S. 415 (1940).
23 Ralphs Grocery Co., T.C. Memo. 2011-25.
24 Sec. 368(a)(1)(G), governing a transfer by a corporation of all or part of its assets to another corporation in a bankruptcy case.
25 Bankruptcy Tax Act of 1980, P.L. 96-589, §4.
27 Temp. Regs. Sec. 1.382-2T(h)(4)(iii). The regulations contain rules that certain options are not deemed exercised, such as options exercisable only upon death or disability (Temp. Regs. Sec. 1.382-2T(h)(4)(x)).
28 Temp. Regs. Sec. 1.382-2T(h)(4)(ix).
29 Temp. Regs. Sec. 1.382-2T(h)(4)(viii).
30 Temp. Regs. Sec. 1.382-2T(h)(4)(vi)(B).
31 New York State Bar Ass’n, Report on Application of Treasury Regulation Section 1.382-2T(f)(18)(iii) With Respect to Trading in Distressed Debt Instruments, available at 2012 TNT 15-21 (Jan. 24, 2012).
32 FSA 199910009 (3/12/99).
33 IRS Letter Ruling 200938010 (9/18/09), IRS Letter Ruling 200445020 (11/5/04), FSA 199910009 (3/12/99), and IRS Letter Ruling 9441036 (10/14/94).
34 Gerdau Macsteel Inc., 139 T.C. No. 5 (2012).
35 The court noted that the definition of preferred stock in Sec. 351(g) mirrored the definition in Sec. 1504. This definition will be discussed later in the article.
36 S. Rep’t 99-313, 99th Cong., 2d Sess. 235 (1986).
37 Tax Reform Act of 1986, P.L. 99-514.
38 Maxwell Hardware Co., 343 F.2d 713 (9th Cir. 1965).
39 Sec. 1504(a)(4) will be discussed in more detail later.
40 Joint Committee on Taxation, General Explanation of the Tax Reform Act of 1986 (JCS-10-87), p. 301 (May 15, 1987).
41 CCA 201152016 (12/30/11).
Edward Schnee is the Hugh Culverhouse Professor of Accounting at the University of Alabama in Tuscaloosa, Ala. Eugene Seago is the R.B. Pamplin Professor of Accounting at Virginia Tech University in Blacksburg, Va. For more information about this article, please contact Prof. Schnee at firstname.lastname@example.org.