Final Basis Regs. Provide Deferral Opportunities in Tax-Free Exchanges

Co-Editors: Michael Metz, CPA; Nick Gruidl, CPA, MBT

Final regulations addressing basis and boot in reorganizations provide interesting and unexpected results. Secs. 358 and 356 address allocation of basis to property received in a reorganization and gain recognition on receipt of boot, respectively.

Proposed regulations (REG-116564-03, 5/3/04) provided a tracing method for allocating basis under Sec. 358 in Sec. 368 reorganizations and Sec. 355 distributions. Under this method, each share of stock received is traced to the share surrendered for Sec. 368 reorganizations; each share received in a Sec. 355 distribution is allocated basis from a share of stock of the distributing corporation.

The preamble to the final regulations explains that the IRS and Treasury adopted the tracing method because they felt the averaging of bases of stock that may have been purchased at different times and different prices was not justified under the substituted-basis rule of Sec. 358; see TD 9244 (1/23/06). They were also concerned that averaging would not allow taxpayers to properly arrange their affairs and might create opportunities for tax avoidance.

Final Regs.

The final regulations retain the tracing method and provide that if the parties to a reorganization specify in the terms which particular share or class of stock is being exchanged for another particular share or class, and the allocation is economically reasonable, the terms of the agreement control.

For example, if common stock is exchanged for common and preferred stock of another corporation or stock and boot, the terms of the agreement could specify which blocks (shares acquired at different dates or prices) were exchanged for common stock and which shares were exchanged for preferred stock or boot; see Regs. Sec. 1.358-2(a)(2)(ii). If economically reasonable, the terms would control. If the terms are not specified, a pro-rata portion of shares of each class is received in exchange for each share of stock surrendered, in accordance with the fair market value (FMV) of the stock surrendered.

Allocating boot: The regulations also provide rules for allocating boot received when determining gain recognition. As with qualifying consideration, boot may be allocated consistent with the rules above—i.e., if the terms specify the allocation of boot received in the exchange and the allocation is economically reasonable, it will be respected; see Regs. Sec. 1.356-1(b). If the terms do not specify, a pro-rata portion of boot is treated as received in exchange for each share surrendered, in accordance with the FMV of the stock surrendered.

Designations: In addition, the regulations provide that if a shareholder who receives shares in a transaction to which the regulations apply cannot identify which particular share is exchanged for which particular share, the shareholder may designate such if it is consistent with the transaction’s terms; see Regs. Sec. 1.358-2(a)(2)(vii). The designation must be made before the security is received or deemed received (or, for a transaction under Sec. 355, before the security is relevant).

The final regulations do not apply to transactions to which Sec. 351 or 1036 applies, unless Sec. 354 or 356 also applies; see Regs. Sec. 1.358-2(a)(2)(viii) and (ix).

Example 1 (based on Regs. Sec. 1.358-2, Example (4)): J, an individual, acquired 10 shares of Class A stock of X Corp. on date 1 for $2 each, 10 shares of Class A stock of X on date 2 for $4 each and 20 shares of Class B stock of X on date 3 for $6 each. On date 4, Y Corp. acquired X’s  assets in an A reorganization. Under the reorganization plan’s terms, J surrendered all his X shares for 40 shares of Y stock and $200. On the exchange date, the FMV of each share of X Class A stock was $10, the FMV of each share of X Class B stock was $10 and the FMV of each share of Y stock was $5. The terms of the exchange do not specify which shares of Y stock or cash were received in exchange for which shares of X Class A or Class B stock.

Because the terms of the exchange do not specify which shares are exchanged for which shares or cash, a pro-rata portion of the shares of Y stock and cash received will be treated as received in exchange for each share of X Class A and Class B stock surrendered, based on the FMV of such stock.

Thus, because the FMV of class A and class B stock is the same, J is treated as receiving one share of Y stock and $5 in exchange for each share of X Class A and Class B stock. J realizes $140 gain on the exchange of shares of X Class A stock, $100 of which is recognized to the extent of boot received, under Regs. Sec. 1.356-1(a). J realizes $80 gain on the exchange of X Class B stock, all of which is recognized under Regs. Sec. 1.356-1(a). Under the regulations, J has 10 shares of Y stock, each of which has a $2 basis and is treated as having been acquired on date 1; 10 shares of Y stock, each of which has a $4 basis and is treated as having been acquired on date 2; and 20 shares of Y stock, each of which has a $5 basis and is treated as having been acquired on date 3. J may designate which of the shares of Y stock received have a $2 basis, which have a $4 basis and which have a $5 basis. J’s total realized gain on the transaction was $220; his total recognized gain was $180.

Example 2 (based on Regs. Sec. 1.358-2(c), Example (5)): The facts are the same as in Example 1, except the reorganization plan’s terms specify that J receives 40 shares of Y stock in exchange for his X Class A stock and $200 in exchange for his X Class B stock. (Such terms are economically reasonable.)

In Example 2, J realizes $140 gain on the exchange of shares of X Class A stock, none of which is recognized under Regs. Sec. 1.356-1(a) (because stock was transferred solely for stock). J realizes $80 gain on the exchange of shares of X Class B stock, all of which is recognized under Regs. Sec. 1.356-1(a). Again, J had a total realized gain of $220, but recognized only $80.

Example 3: T, an individual, acquired 10 shares of Class A stock (the only class of stock issued and outstanding) of Z Corp. on date 1 for $2 each and 10 shares of Class A stock of Z Corp. on date 2 for $20 each. On date 3, V Corp. acquired Z’s assets in an A reorganization. Under the reorganization plan’s terms, T surrendered all the Z shares for 40 shares of V stock and $200. On the exchange date, the FMV of each share of Z Class A stock was $20, and the FMV of each share of V stock was $5. The plan’s terms specify that T receives 40 shares of V stock in exchange for his shares of Z Class A stock acquired on date 1, and $200 in exchange for his shares of Z Class A stock acquired on date 2. (Such terms are economically reasonable.)

In Example 3, T realizes $180 gain on the exchange of shares of Class A stock acquired on date 1, none of which is recognized under Regs. Sec. 1.356-1(a), because T transferred stock solely for stock, and realizes no gain on the exchange of shares of Z Class A stock acquired on date 2.

In Example 3, the agreement called for a different allocation of consideration between shares of the same class of stock for which the shareholder’s basis in the respective blocks is the only difference between the shares. (This example is not included in the final regulations.)

Summary

Under the appropriate facts, the final regulations allow a taxpayer to defer gain recognition on the receipt of boot in a reorganization through allocations in the transaction agreement. However, caution is warranted, as the term “economically reasonable” has not been defined by the IRS, Treasury or the courts as to these regulations.