Regulations Eliminate “Hot Stock” Rule for Certain Reorgs.

On December 15, 2008, the IRS issued final, temporary, and proposed regulations that generally hold that the so-called hot stock rule is inapplicable in reorganizations where a subsidiary is a member of the distributing corporation’s separate affiliated group (DSAG) (T.D. 9435, REG-150670-07).

Before the issuance of these regulations, under the hot stock rule of Sec. 355 (a)(3)(B), controlled corporation stock acquired within five years of the distribution of such stock in a transaction in which gain or loss was recognized would be treated as boot. However, this treatment could conflict with the Sec. 355(b) (3)(A) rule that members of a corporation’s separate affiliated group (SAG) will be treated as one corporation for purposes of determining whether a corporation meets the active trade or business requirements of Sec. 355(b)(2)(A).

For example, if a distributing corporation acquired all of a controlled corporation’s stock in a taxable transaction that qualified as an expansion of the distributing corporation’s existing trade or business under the SAG regime, and later distributed all such stock within five years of the acquisition in an unrelated transaction, the distribution would satisfy the active trade or business requirement but could be fully taxable under the hot stock rule.

Therefore, the temporary regulations generally provide that controlled stock acquired by the DSAG within the predistribution period in a taxable transaction constitutes hot stock, except if the controlled corporation is a DSAG member at any time after the acquisition (but prior to the distribution of controlled).

The regulations also address distributions among members of a DSAG. According to the regulations’ preamble, “transfers of controlled stock owned by DSAG members immediately before and immediately after the transfer are disregarded and are not treated as acquisitions for purposes of the hot stock rule.”

The temporary regulations exempt from the hot stock rule transactions in which a distributing corporation acquires controlled stock from a member of its own affiliated group. However, the IRS says it will continue to study the impact of such transfers.

The final and temporary regulations were effective December 15, 2008. The IRS is also contemplating further guidance, which would be in addition to, rather than a replacement for, the temporary and final regulations.

Look for more on these regulations in next month’s Tax Clinic.