The reorganization provisions of the Internal Revenue Code, located primarily in Secs. 354, 355, and 368, allow a variety of tax-free transactions in the form of combinations, divisions, and recapitalizations. These provisions are concerned with the form, rather than the substance, of the transaction. Therefore, it is extremely important to document that the correct procedures have been followed. Regs. Sec. 1.368-3 sets forth which records are to be kept and which information needs to be filed with tax returns for the year that such a transaction is completed.
A reorganization plan must be adopted by each corporate party to a reorganization. The acts of the corporation’s officers must show that they adopted the plan, and its adoption must appear in the official records (minutes) of the corporation. Each corporate party to a reorganization must file a statement with its tax return for the year in which the reorganization occurred that contains:
- The names and employer identification numbers (EINs) of all parties to the reorganization;
- The date of the reorganization;
- The aggregate fair market value (FMV) of the assets, stock, or securities of the target corporation transferred in the transaction; and
- The date and control number of any private letter rulings issued by the IRS in connection with the reorganization (Regs. Sec. 1.368-3(a)).
In addition, noncorporate significant holders that receive stock and other securities in a reorganization must file a statement of all facts relating to the exchange with their tax returns for the year of the exchange (Regs. Sec. 1.368-3(b)). A significant holder is a person who receives stock or securities in a Sec. 354 exchange if immediately before the exchange that holder (1) owns at least 1% by vote or value (5% if the stock is publicly traded) of the corporation’s outstanding stock; or (2) owns securities in the target corporation with a basis of $1 million or more.
The statement must include the following information:
- The names and EINs of the parties to the reorganization;
- The date of the reorganization; and
- The FMV of all the target corporation’s stock or securities held by the significant holder that are transferred in the transaction and the shareholder’s basis in the target corporation’s stock or securities.
All parties to a reorganization (corporate or noncorporate) must maintain permanent records to substantiate the cost (or other basis) of the properties transferred and the amount and FMV of stock, securities, or other property or money received. The records should include information on all liabilities assumed or any liabilities to which the property received was subject (Regs. Sec. 1.368-3(d)).
There are no statutory penalties for failure to comply with the reporting requirements. However, the IRS has argued that failure to comply with the requirements indicates that a transaction was a sale and not a reorganization (Wilson, T.C. Memo. 1961-135). Although the IRS did not prevail in that case, it is possible that it might raise this argument whenever taxpayers fail to comply with the reporting requirements.
For a spin-off, the regulations state that every corporation that makes a distribution of a controlled corporation’s stock or securities, as described in Sec. 355, must attach to its return for the year of distribution a detailed statement containing (Regs. Sec. 1.355-5(a)):
- The name and EIN of the controlled corporation;
- The name and taxpayer identification number of every significant distributee;
- The distribution date of the controlled corporation’s stock or securities;
- The aggregate FMV and basis, determined immediately before the distribution or exchange, of the stock, securities, or other property (including money) distributed by the distributing corporation in the transaction; and
- The date and control number of any private letter ruling(s) issued by the IRS in connection with the transaction.
A significant distributee is a holder of a distributing corporation’s stock that receives in a Sec. 355 transaction stock of a corporation controlled by the distributing corporation, if immediately before the exchange the holder (Regs. Sec. 1.355-5(c)):
- Owns at least 1% by vote or value (5% if the stock is publicly traded) of the distributing corporation’s outstanding stock; or
- Owns securities in the distributing corporation with a basis of $1 million or more.
In addition, significant distributees of a spin-off must file a statement with their return that includes the following information (Regs. Sec. 1.355-5(b)):
- The names and EINs of the distributing and controlled corporations;
- The date of the distribution of the controlled corporation’s stock or securities;
- The aggregate basis, determined immediately before the exchange, of any stock or securities transferred by the significant distributee in the exchange; and
- The aggregate FMV, determined immediately before the distribution or exchange, of the stock, securities, or other property (including money) received by the significant distributee in the distribution or exchange.
Sec. 6043(c) requires the reporting of changes in control or substantial changes in the capital structure of a corporation. Under Regs. Sec. 1.6043-4, the Sec. 6043(c) reporting requirement is met by filing Form 8806, Information Return for Acquisition of Control or Substantial Change in Capital Structure. Generally, a corporation that is required to file Form 8806 must also file an information return on Forms 1096, Annual Summary and Transmittal of U.S. Information Returns, and 1099-CAP, Changes in Corporate Control and Capital Structure, for each shareholder of record in the corporation (before or after the change in control or the substantial change in capital structure) who receives cash, stock, or other property pursuant to the change in control or the substantial change in capital structure (Regs. Sec. 1.6043-4(b)).
Observation: Regs. Sec. 1.6043-4 exempts from the reporting requirement transactions in which less than $100 million of consideration changes hands. Thus, the reporting requirement does not apply to most small business transactions.
In addition to Sec. 6043(c), Sec. 6043A requires information reporting by an acquiring corporation in any taxable acquisition, according to the forms and rules prescribed by Treasury. Penalties for failure to comply with the information reporting requirements are contained in Sec. 6721.
This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 22d Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, Mary C. Danylak, Timothy Fontenot, James A. Keller, and Brian B. Martin, published by Thomson Tax & Accounting, Ft. Worth, TX, 2009 ((800) 323-8724; ppc.thomson.com ).
Albert Ellentuck is of counsel with King & Nordlinger, L.L.P., in Arlington, VA.