Editor: Mary Van Leuven, J.D., LL.M.
Sec. 1245 recapture rules require a taxpayer to characterize gain on the disposition of certain depreciable property as ordinary income to the extent of previously taken depreciation deductions. But those rules can also apply to a disposition of stock. This item discusses how a reduction in a debtor’s stock basis through application of the Sec. 108 attribute reduction rules can result in Sec. 1245 recapture on a disposition of that stock. It also examines how the consolidated return rules in certain circumstances eliminate, in whole or in part, the potential Sec. 1245 recapture on a disposition of stock of a subsidiary member.
Sec. 108 Attribute Reduction
If a creditor discharges a debt due from a debtor, the debtor is generally required to include the amount of the cancellation of debt (COD) in gross income (Sec. 61(a) (12)). Under certain circumstances, the debtor excludes COD income from gross income under Sec. 108. For example, COD income is excluded from the debtor’s gross income if the discharge occurs when the debtor is in title 11 bankruptcy proceedings. If the debtor is insolvent, COD income is excluded from gross income to the extent of the debtor’s insolvency.
There is, however, a price to be paid for excluding COD income from gross income: The debtor must reduce certain tax attributes in a specified order, generally starting with net operating losses, with basis in assets being near the middle of the tax attribute reduction list (Sec. 108(b)(2)). Sec. 108(b)(5) allows the debtor an election to first reduce basis in depreciable property before returning to the general ordering rules of Sec. 108(b)(2) (a Sec. 108(b)(5) election). Any amount of COD income remaining after the debtor’s tax attributes have been reduced as required disappears—i.e., the remaining amount is not included in income and does not reduce any future tax attributes (that amount is often referred to as “black hole” COD income).
Note: The American Recovery and Reinvestment Act of 2009, P.L. 111-5, allows taxpayers to elect to defer recognition of certain COD income from re-acquisitions of certain debt instruments (Sec. 108(i)). The attribute reduction rules (and therefore the Sec. 1245 recapture rules discussed in this item) do not apply to COD income subject to this new deferral election.
Whether the debtor reduces basis in property by the general ordering rules of Sec. 108(b)(2) or a Sec. 108(b)(5) election, Sec. 1017 governs the tax treatment. Sec. 1017(d) applies the Sec. 1245 recapture rules when the property (even a capital asset) is later disposed of, resulting in ordinary income up to the amount of the basis reduction (except for property subject to the Sec. 1250 recapture rules, generally real property). Furthermore, Sec. 1017(b) (3)(D) treats stock in a subsidiary as depreciable property for purposes of the Sec. 108(b)(5) election, provided the debtor and subsidiary are members of the same consolidated group and the subsidiary consents to a corresponding reduction in basis of its depreciable property (the Sec. 1017 lookthrough rule).
Sec. 1245 Recapture
Characterization of property, including stock, as Sec. 1245 property has at least two potential results when that property is disposed of. First, the character of gain recognized is ordinary to the extent of previous prescribed reductions in the basis of the property (the Sec. 1245 recapture amount). Second, the Sec. 1245 recapture amount is generally recognized notwithstanding any other provision of subtitle A (income taxes) (Sec. 1245(a)(1) and Regs. Sec. 1.1245-6(a)). As a result, a taxpayer generally is required to recognize the Sec. 1245 recapture amount even if the disposition is in an otherwise nonrecognition transaction. An exception in Sec. 1245(b)(3) provides that “[i]f the basis of property in the hands of a transferee is determined by reference to its basis in the hands of the transferor by reason of the application of section 332, 351, [or] 361,” Sec. 1245(a) is applicable only to the extent of gain otherwise recognized in the transaction (the Sec. 1245(b)(3) exceptions).
Among the Sec. 1245(b)(3) exceptions are cases in which Sec. 1245 property is distributed by a subsidiary to its parent in a Sec. 332 liquidation, contributed by a parent to its subsidiary in a Sec. 351 transaction, or transferred by a target corporation to an acquiring corporation under Sec. 361 in a Sec. 368 asset reorganization. In each of these cases, the transferee’s basis is determined by reference to the transferor’s basis (see Secs. 334(b) (1), 362(a), and 362(b), respectively). The reason for the Sec. 1245(b)(3) exceptions appears to be that the Sec. 1245 recapture amount has not disappeared: The Sec. 1245 property distributed in a Sec. 332 liquidation, contributed in a Sec. 351 transaction, or transferred in a Sec. 368 reorganization continues to exist, and the Sec. 1245 recapture amount is now generally subject to recapture in the hands of the transferee (Regs. Sec. 1.1245-2(c)(2)).
Notably, a parent corporation’s exchange of the stock of a subsidiary in a Sec. 332 liquidation is not covered by the Sec. 1245(b)(3) exceptions, apparently because the parent’s basis in the subsidiary’s stock disappears, and the Sec. 1245 recapture amount is therefore not preserved in the hands of a transferee. Thus, a liquidation to which Sec. 332 applies (that generally results in no recognition of gain or loss to the parent corporation) could result in the parent corporation’s recognizing gain if:
- The basis of the subsidiary stock was reduced under Sec. 1017;
- As a result, the stock is treated as Sec.1245 property; and
- The value of the stock at the time of the liquidation exceeds the parent’s basis in the subsidiary.
However, as discussed below, if the parent and the subsidiary are part of a consolidated group, the Sec. 1245 recapture amount with respect to subsidiary stock may be eliminated in whole or in part.
Also excluded from the Sec. 1245(b)(3) exceptions is another common disposition of stock in an otherwise tax-free transaction: a Sec. 354 exchange of stock of a target corporation for stock of an acquiring corporation. For policy reasons, one might think that the Sec. 1245 recapture amount could carry over to the stock in the acquiring corporation received in a Sec. 354 exchange. Alternatively, similar to a Sec. 351 exchange of stock that is Sec. 1245 property, one might think that in the case of a Sec. 368(a)(1)(B) reorganization (a transaction in which the target stock continues to exist) the Sec. 1245 recapture amount could carry over to the acquiring corporation. The reason for the exclusion of Sec. 354 from the Sec. 1245(b)(3) exceptions may simply be that the drafters of Sec. 1245 did not focus on the application of Sec. 1245 to stock. Thus, a Sec. 354 exchange (that generally results in no recognition of gain or loss to the target shareholder) could result in the target shareholder’s recognizing gain if:
- The basis of the target stock was reduced under Sec. 1017;
- As a result, the target stock is treated as Sec. 1245 property; and
- The value of the target stock at the time of the Sec. 354 exchange exceeds the target shareholder’s basis in the target stock.
Consolidated Attribute Reduction
Regs. Sec. 1.1502-28 sets forth rules for the application of Sec. 108(a) and the reduction of tax attributes under Sec. 108(b) when a member of a consolidated group realizes COD income that is excluded from the member’s gross income under Sec. 108(a).
There are three main consolidated attribution reduction rules:
- First, the debtor reduces its own tax attributes (the debtor-first rule).
- Second, to the extent the debtor member reduces basis in stock of a subsidiary as part of the debtor-first rule, this subsidiary reduces its tax attributes (the consolidated lookthrough rule). The subsidiary reduces basis in its depreciable property first if the Sec. 1017 lookthrough rule applies because the debtor member elects to treat stock of such subsidiary as depreciable property.
- Third, if the amount of COD income exceeds the tax attributes of the debtor member reduced under the debtor-first rule, the remaining COD income reduces certain other consolidated tax attributes (the fan-out rule).
Absent a special rule discussed below, there is a potential for “double” Sec. 1245 recapture. For example, as described above, a liquidation to which Sec. 332 applies could result in the parent corporation’s recognizing gain if:
- The basis of the subsidiary stock was reduced under Sec. 1017;
- As a result, the stock is treated as Sec. 1245 property; and
- The value of the stock at the time of the liquidation exceeds the parent’s tax basis in the subsidiary.
In addition, if the basis of the subsidiary’s assets was reduced under either of the two lookthrough rules (the Sec. 1017 look-through rule or the consolidated look-through rule), any asset of the liquidated subsidiary (in which the parent takes a carryover basis under Sec. 334(b)(1)) could be subject to Sec. 1245 recapture again in the hands of the parent.
The consolidated regulations contain a special rule to prevent double Sec. 1245 recapture when asset basis is reduced because of stock basis reduction. Regs. Sec. 1.1502-28(b)(4) prevents the potential for double recapture by providing that a reduction of the basis of subsidiary stock is treated as a deduction allowed for depreciation (and thus subject to Sec. 1245) only to the extent that the amount by which the basis of the subsidiary stock is reduced exceeds the total amount of the attributes of the subsidiary that are reduced under the Sec. 1017 lookthrough rule or the consolidated lookthrough rule (the no double recapture rule).
Regs. Sec. 1.1502-28 is generally effective for COD income that occurs after March 21, 2005. However, taxpayers may apply this section in whole (but not in part) to COD income that occurs after August 29, 2003. Consolidated groups may use the no-double-recapture rule for COD income that occurs on or before August 29, 2003, in cases in which the Sec. 1017 lookthrough rule applied (Regs. Sec. 1.1502-28(d)).
A reduction in a debtor’s basis in stock through application of the Sec. 108 attribute reduction rules generally results in the stock being treated as Sec. 1245 property. As a result, a disposition of that stock may result in all or a portion of the Sec. 1245 recapture amount being recognized (as ordinary income) to the extent there is gain in the stock, even if the disposition otherwise qualifies as a nontaxable transaction. Importantly, the consolidated return rules in certain circumstances eliminate, in whole or in part, the potential Sec. 1245 recapture on stock of a subsidiary member. Because stock treated as Sec. 1245 property generally retains the Sec. 1245 recapture “taint” until there has been a recapture event, taxpayers should take care to identify and monitor stock that is Sec. 1245 property, including as part of due diligence when acquiring a target group.
Mary Van Leuven is Senior Manager, Washington National Tax, at KPMG LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with KPMG LLP.
This article represents the views of the author or authors only, and does not necessarily rep-resent the views or professional advice of KPMG LLP. The information contained herein is of a general nature and based on authorities that are subject to change. Applicability of the information to specific situations should be determined through consultation with your tax adviser.
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For additional information about these items, contact Ms. Van Leuven at (202) 533-4750 or firstname.lastname@example.org.