There is little dispute that Subchapter C and Subchapter K of the Internal Revenue Code have difficulty coexisting in certain circumstances. Despite lawmakers' efforts to coordinate the subchapters' interaction, many areas of uncertainty remain. This item examines one such area: the potential application of Sec. 304 to transfers of interests in a partnership that owns corporate stock.
Overview of Sec. 304
Sec. 304 is intended to prevent the bailout of corporate earnings through a sale of the stock of one corporation (Issuing) to another corporation (Acquiring) in exchange for property.
Under Sec. 304(a)(1), if (1) one or more persons are in control of each of two corporations (Acquiring and Issuing), and (2) in return for property, one of the corporations (Acquiring) acquires stock in the other corporation (Issuing) from the person (or persons) in control, the exchange is treated as though Acquiring distributed the property in redemption of Acquiring's stock.
The tax consequences of the deemed redemption are determined by reference to Sec. 302. Specifically, if the deemed redemption satisfies any of the tests in Sec. 302(b) with respect to Issuing, then the deemed redemption qualifies for sale-or-exchange treatment under Sec. 302(a) (Secs. 304(b)(1) and 302(a)). If, however, the deemed redemption fails the tests in Sec. 302(b), then the deemed redemption is treated as a dividend to the extent of the earnings and profits (E&P) of Acquiring and Issuing (Secs. 304(a)(1), 302(d), and 304(b)(2)). Characterizing a transaction as a sale or exchange versus as a dividend distribution used to have greater significance (in the form of differing tax rates for capital gain and dividend income), but important reasons remain for preferring sale-or-exchange treatment. For example, dividend treatment defers basis recovery until E&P is exhausted, while sale-or-exchange treatment effectively front-loads basis recovery.
For purposes of Sec. 304, "control" of a corporation is defined as the ownership of stock representing at least 50% of the total combined voting power of all classes of stock entitled to vote or of the total value of all classes of stock (Sec. 304(c)(1)). Additionally, several special rules apply when determining control. First, the constructive ownership rules of Sec. 318 apply, with certain modifications (Sec. 304(c)(3)). Second, control of Acquiring is determined after taking into account stock of Acquiring received in exchange for stock of Issuing (Sec. 304(c)(2)(A)).
Sec. 304 also contains a coordination rule with Sec. 351. Specifically, in a transaction described in Sec. 304(a) that also qualifies under Sec. 351, Sec. 304(a) (and not Sec. 351) applies to the receipt of property in the exchange (Sec. 304(b)(3)(A)).
The example below illustrates a straightforward application of Sec. 304(a)(1):
Example 1: A and B are each 50% shareholders in X, a corporation. In a transaction that qualifies under Sec. 351, A and B transfer all their stock in X to Y, a newly formed corporation, in exchange for all the stock of Y and cash. A and B each own 50% of Y following the transaction.
The result of Example 1 is that A and B are in control of X and, taking into account the stock of Y received in exchange for the stock of X, are in control of Y. Additionally, Y has acquired stock of X from A and B in exchange for cash. Sec. 304(a)(1) applies to the exchange of the stock of X for cash. Thus, the receipt of cash in exchange for the stock of X is treated as a distribution of the cash by Y in redemption of its stock. Because the deemed redemption is unlikely to satisfy any of the tests under Sec. 302(b) (A and B continue to each own 50% of X indirectly through Y), the cash received by A and B is a dividend to the extent of the E&P of Y andX.
Overview of Situation 2 of Rev. Rul. 99-6
Generally, Sec. 741 treats the sale of a partnership interest as the sale of a capital asset. Furthermore, Regs. Sec. 1.741-1(b) applies Sec. 741 to all members of a partnership when they sell their interests to one or more persons outside the partnership.
In McCauslen, 45 T.C. 588 (1966), one partner purchased the partnership interest of another, causing the partnership to terminate. The Tax Court held that the acquiring partner was treated not as purchasing the other partner's interest but, rather, as purchasing the assets of the partnership attributable to the interest. As a result, the acquiring partner could not succeed to the partnership's holding period for the assets deemed purchased.
Rev. Rul. 99-6 addresses the tax treatment of the partners of a partnership and the acquirer of the partnership interests in a transaction that causes the partnership to become an entity that is disregarded as separate from its owner for federal tax purposes (and thus to terminate). In effect, Rev. Rul. 99-6 provides a disconformity of treatment between the seller of a partnership interest and the acquirer, representing a combination of the rules stated in Sec. 741 and the Treasury regulations on the one hand, and the holding of McCauslen on the other.
In Situation 2 of Rev. Rul. 99-6, C and D are equal partners in CD, a limited liability company that is treated as a partnership for federal tax purposes. C and D sell all their interests in CD to E, a third party, for cash. C and D are treated as selling their partnership interests and must report gain or loss under Sec. 741. In contrast, for purposes of classifying the acquisition by E, CD is deemed to make a liquidating distribution of its assets to C and D, and E is deemed to acquire by purchase the assets of CD from C andD.
Interaction of Sec. 304 and Situation 2 of Rev. Rul. 99-6
Situation 2 of Rev. Rul. 99-6 specifies neither the identity (e.g., tax classification (i.e., corporation, individual, or partnership) and relatedness) of E nor the assets of CD, possibly because the ruling was intended to apply generally and thus did not depend on either the acquirer's identity or the nature of the partnership's underlying assets. In contrast, the identity of the acquirer (a corporation controlled by the shareholders of Issuing) and the nature of the assets transferred (the stock of Issuing) are critical considerations in determining whether Sec. 304 applies. As a result, it is unclear whether Sec. 304 applies when (1) a partnership owns the stock of Issuing, and (2) the partners transfer their interests in the partnership to Acquiring in exchange for property.
Example 2: A and B are each 50% partners in PRS, a partnership that is respected as such under the anti-abuse rule of Regs. Sec. 1.701-2. PRS owns all the stock of X, a corporation. In a transaction that qualifies under Sec. 351, A and B transfer all their interests in PRS to Y, a newly formed corporation, in exchange for all the stock of Y and cash. A and B each own 50% of Y following the transaction. PRS terminates and becomes an entity that is disregarded as separate from Y for federal tax purposes.
Applying Rev. Rul. 99-6 to Example 2, A and B would each recognize gain under Sec. 351(b) and Sec. 741 to the extent of the lesser of the cash received or the built-in gain in their partnership interests. From Y's perspective, however, PRS is deemed to make a liquidating distribution of the stock of X to A and B, and then Y is deemed to acquire, in exchange for its stock and cash, all the stock of X from A andB.
Does Sec. 304 apply to Example 2?
A and B are in control of X (through PRS) and, taking into account the stock of Y received in exchange for the stock of X (as the transaction is characterized from Y's perspective), are in control of Y. Additionally, Rev. Rul. 99-6 treats Y as acquiring stock of X from A and B for cash. Thus, based on the transactions that are deemed to occur in Rev. Rul. 99-6, the requirements of Sec. 304(a)(1) appear to be met. If Sec. 304 applies to Example 2, the result is the same as in Example 1.
However, Rev. Rul. 99-6 states that the deemed transactions occur for the purpose of determining the federal income tax consequences to Y (e.g., tax basis, holding period). Consistent with this view, Rev. Rul. 99-6 plainly provides that A and B are taxed as though they transferred their interests in PRS, not the underlying assets of PRS, to Y. Furthermore, even though A and B are treated as owning the stock of X under the constructive ownership rules of Sec. 318, these rules apply only for purposes of determining control, not for determining whether Y has acquired the stock of X from A and B. Thus, from A's and B's perspectives, Example 2 does not fit the literal requirements of Sec. 304(a)(1).
Example 2 also does not appear susceptible to recharacterization as a transaction described in Sec. 304(a). Regs. Sec. 1.304-4 contains an anti-abuse rule that disregards the use of related corporations to reduce or eliminate the amount treated as a dividend by reason of Sec. 304. This anti-abuse rule cannot, however, apply to disregard PRS because PRS is a partnership, not a corporation.
Should Sec. 304 Apply to Example 2?
Example 2 appears to present the same earnings bailout potential as Example 1—a transaction squarely within the policy of Sec. 304. The question may therefore be whether the presence of a partnership can transform a transaction that is undoubtedly subject to Sec. 304 into a transaction that escapes Sec. 304 entirely. Given the anti-abuse nature of Sec. 304, it could be argued that Sec. 304 should apply, notwithstanding the fact that Example 2 does not fit within the literal requirements of Sec. 304(a)(1).
In a number of exceptions, Sec. 304 is not applied (or its application is modified) even where the transaction satisfies the literal requirements of Sec. 304(a). These exceptions are generally based on the premise that the mechanical application of Sec. 304 can produce results that are contrary to policy. For example, exceptions relate to assumptions of acquisition indebtedness, the use of non-U.S. corporations, and downstream transactions (Sec. 304(b)(3)(B); Sec. 304(b)(5); and Rev. Rul. 74-605). Outside these exceptions, however, Sec. 304 is generally applied mechanically, even when such a mechanical application produces results contrary to policy (e.g., a reverse merger in exchange for grandparent stock). Because no specific exception or special rule relates to a transaction like the one described in Example 2, it could be argued that Sec. 304 should be applied mechanically to Example 2 (thus resulting in the transaction's not being subject to Sec. 304).
Given the well-settled authority on each side of the issue and the absence of a specific coordination rule, it is unclear in this context whether the rules of Subchapter C or the rules of Subchapter K should apply. If Subchapter K were to prevail, a transaction like the one in Example 2 would present a significant opportunity for partners to extract substantial value when incorporating a partnership. If Subchapter C were to prevail, then Sec. 304 would be a trap for the unwary when, upon incorporating a partnership, Acquiring assumes liabilities of the partnership that were not incurred by the partnership to acquire the stock of Issuing.
Mary Van Leuven is a director, Washington National Tax, at KPMG LLP in Washington.
For additional information about these items, contact Ms. Van Leuven at 202-533-4750 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
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