The following example,which involves a distributing and a controlled corporation, can help illustrate whether a transaction qualifies under the active trade or business requirement or would trigger the “hot stock” rule.
Example: D, Inc., is a widget manufacturer that has operated the same widget plant for 20 years as its only active trade or business. Recently, D purchased C, Inc., a competitor in the widget business, in a cash deal for 100% of C’s stock. Three years after the acquisition, D settles an antitrust action. The terms of settlement require D to separate from C.
Under recently issued proposed regulations, D and C both would qualify under the active trade or business requirement of Sec. 355 for a tax-free separation (see Prop. Regs. Sec. 1.355-3(b)(3)). However, an otherwise tax-free distribution that satisfies that requirement may trigger tax under the “hot stock” rule of Sec. 355(a)(3)(B), which provides that controlled corporation stock acquired within five years of the distribution of such stock in a transaction in which gain or loss was recognized will be treated as boot. This item explores this potential tax trap for the unwary and suggests a potential way to avoid this trap.
Before exploring the hot stock problem, it is essential to understand recent statutory changes to Sec. 355 and the IRS’s response. In 2006, the Tax Increase Prevention and Reconciliation Act, P.L. 109-222 (TIPRA), amended Sec. 355(b) by adding a special rule designed to treat all members of a corporation’s separate affiliate group (SAG) as one corporation in determining whether the active trade or business test is satisfied.
In proposed regulations interpreting the TIPRA amendment (REG-123365-03), the IRS concluded that a transaction resulting in a corporation’s becoming a subsidiary SAG member would be treated as an acquisition of any assets (or activities) that are owned (or performed) by the acquired corporation. In addition, the proposed regulations indicate that when a corporation currently involved in the active conduct of one trade or business during the predistribution period (the original business) purchases the stock of another trade or business (the acquired business) in the same line of business and the acquisition of the acquired business’s stock results in the acquired business being a member of the original business’s SAG, the stock purchase will be treated as an asset purchase for purposes of Sec. 355(b)(3). The IRS concludes that the deemed asset sale results in the expansion of the original business, which would be treated as having been actively conducted by the acquiring corporation during the predistribution period.
Returning to the above example, under the proposed regulations, D’s purchase of all of C’s outstanding shares would be treated as an asset acquisition that is viewed as an expansion of D’s original business. Under this view, a subsequent distribution of C’s stock would satisfy the five-year active trade or business requirement of Sec. 355 even though C’s stock was acquired in a taxable transaction within five years of the distribution in apparent violation of Sec. 355(b)(2)(D). The IRS would look to D’s activities during the predistribution period, since the acquisition of C would be viewed as an expansion of D’s original business. Assuming the remaining requirements of Sec. 355 are satisfied, it would appear that D could distribute its interest in C in a tax-free spin-off.
However, the stock acquisition is only disregarded for purposes of the active trade or business test. If C’sstock were distributed by D, the stock apparently would fall within the hot stock rule and would be treated as other property, taxable to D’s shareholders under Sec. 356. Under Sec. 355(a)(3)(B), a distribution of a controlled corporation’s stock is treated as taxable boot when a distributing corporation acquires a controlled corporation’s stock in a taxable transaction within five years of the distribution. As applied to D, its cash purchase of C’s shares would fall within the scope of the hot stock rules as a taxable transaction occurring within five years before the distribution of C’s stock.
The proposed active trade or business regulations recognize the hot stock issue, and the IRS has requested taxpayer comments. While the issue is under consideration, the IRS has not yet addressed how a taxpayer in D’s position should determine its potential exposure to the hot stock issue. Three potential options exist:
1. 80% of the purchase of C stock could be treated as the purchase of control, leaving the remaining 20% as hot stock;
2. All of the C stock could be treated as hot stock; or
3. None of the C stock could be treated as hot stock.
A literal reading of Sec. 355(a)(3)(B) might indicate that the entire amount of stock purchased should trigger the hot stock rule since C’sstock was purchased within five years. In addition, the deemed asset purchase treatment under Sec. 355(b)(3) and the proposed regulations is limited to the active trade or business test and does not reference or incorporate Sec. 355(a)(3)(B). Furthermore, the hot stock rule has not been interpreted as requiring symmetry with Sec. 355(b) (see Dunn Trust, 86 TC 745 (1986)). Thus, barring future taxpayer-favorable guidance from the IRS, D could face a situation in which 100% of C stock is potentially treated as hot stock because of its original acquisition, even though the stock purchase is ignored and deemed to be an asset purchase for the purpose of the active trade or business test.
Ironically, the very case refusing to read the hot stock rule in tandem with the active trade or business requirement of Sec. 355(b), which in a sense creates the planning dilemma, provides a possible solution to D’s problem. In Dunn Trust, AT&T responded to an antitrust action by spinning off Pacific Telephone & Telegraph after acquiring control in Pacific following a cash and stock merger, followed by a recapitalization of Pacific’s preferred shares. The merger was not tax free. Thus, a direct distribution by AT&T would have triggered hot stock gain. Instead, AT&T contributed its stock in Pacific into new company N and distributed the N stock to its shareholders.
The taxpayer in Dunn Trust conceded that AT&T’s direct distribution of Pacific stock would have resulted in taxable boot under the hot stock rule but defended its structure based on a literal reading of Sec. 355(a)(3)(B), which requires that the distributing corporation had acquired the controlled corporation’s stock in a taxable transaction within five years of the distribution. As a result of AT&T dropping down the Pa-cific stock to N, N was the controlled corporation, and AT&T had not acquired the stock of a controlled corporation in a transaction where gain or loss was recognized.
The Tax Court adopted the taxpayer’s interpretation of Sec. 355(a)(3)(B), holding that the legislative history of Sec. 355 showed that the provision need not be read in symmetry with the active business provisions in Sec. 355(b). It further stressed that because only 3% of the Pacific stock could potentially be treated as hot stock and those shares remained in a corporate solution, not reading Secs. 355(a)(3)(B) and 355(b) in symmetry would not frustrate the overall purposes of the statute. The Tax Court explained that the correct course of action for the IRS would be to challenge the transaction as a “device” under Sec. 355(a)(1)(B), although it noted that the IRS did not do that in this case because AT&T undertook the transaction to satisfy an antitrust decree and an FCC order.
In the above example, assuming D satisfied the additional requirements of Sec. 355—specifically the device requirement—the introduction of N, holding 100% of C’s stock, may alleviate any potential hot stock problem. As was the case in Dunn Trust, N would become the controlled corporation and would not become the attributed owner of C’s hot stock. The IRS has acquiesced to the result in Dunn Trust; however, it indicated that similar transactions would require as compelling a business purpose as AT&T’s (Action on Decision CC-1997-007 (5/5/97)).
The IRS may argue that the percentage of potential hot stock in the above example exceeds the amount in Dunn Trust; however, the Tax Court stresses that the device requirement rather than the hot stock construct applies. Thus, taxpayers in D’sposition that are able to point to substantial anti-device factors may consider taking more beneficial positions under Dunn Trust in the absence of future regulations mitigating the hot stock trap created under the proposed active trade or business regulations.
Annette B. Smith is with Washington National Tax Services PricewaterhouseCoopers LLP in Washington, DC
Unless otherwise noted, contributors are members of or associated with PricewaterhouseCoopers LLP.
If you would like additional information about these items, contact Ms. Smith at (202) 414-1048 or firstname.lastname@example.org.