Corporations & Shareholders
In October, Treasury issued final regulations that deal with the application of the Sec. 355(a)(3)(B) “hot stock” rule (T.D. 9548). The final regulations replace temporary regulations, originally issued in December 2008 (REG-150670-07), without changes. The final regulations apply to distributions occurring after October 20, 2011.
Background
Sec. 355(a) provides that, under certain circumstances, a corporation (Distributing) can distribute stock and securities in a corporation that it controls (Controlled) to the shareholders of Distributing with no recognition of income, gain, or loss to the involved parties.
Pursuant to this general rule, a Sec. 355 transaction provides a mechanism for either: (1) the division of one corporation into two or more corporations; or (2) the division of an existing parent corporation from one or more subsidiary corporations in a wholly or partially tax-free transaction commonly referred to as a “spinoff” or “split-off.” An example of a spinoff is where Distributing drops the assets of one line of business it operates into newly formed Controlled in exchange for stock of Controlled in a Sec. 368 type D reorganization. Distributing then distributes the stock of Controlled to the Distributing shareholders in a pro rata distribution, resulting in the same shareholders’ owning stock directly in both corporations. A split-off involves the same facts, except that the stock of Controlled is distributed in exchange for certain Distributing stock, resulting in a separation of the shareholders between the two corporations.
A Sec. 355 transaction is a powerful tool that can provide a corporation with the means to separate lines of business or realign its ownership structure while deferring the recognition of income or gain. In an attempt to curb potential abuses in applying the Sec. 355 rules, numerous requirements, exceptions, and special rules in the Code and regulations create an extremely high standard that taxpayers must achieve for a transaction to qualify as tax free under Sec. 355. A nonexhaustive list of some of the more salient rules and requirements includes:
- Distributing must have Sec. 368(c) control (80% of all voting shares and 80% of each other class) of Controlled immediately prior to the distribution.
- Immediately following the distribution, both Distributing and Controlled must be engaged in a trade or business that has been actively conducted for at least five years prior to the distribution and that was not acquired by Distributing or Controlled during that period in a transaction that was taxable in whole or in part.
- The transaction must not be used principally as a device to distribute earnings and profits of Distributing or Controlled.
- There must be a corporate business purpose for the separation of Distributing and Controlled.
- Distributing must not have acquired control of Controlled within the preceding five years in a wholly or partially taxable transaction.
Final Regulations
If a transaction qualifies under Sec. 355, still other hurdles exist that can result in the transaction’s being partially taxable. One such exception to the tax-free treatment described above is found in Sec. 355(a)(3)(B) (the “hot stock rule”). This section provides that, if Distributing acquires stock of Controlled by reason of any transaction that occurs within five years of the distribution of Controlled stock and that is a taxable transaction, such acquired stock will not be treated as stock of Controlled, but instead it will be treated as other property (i.e., boot). This stock is referred to as “hot stock.”
Congress’s intent for the hot stock rule was to prevent the conversion by Distributing of excess, liquid funds, such as cash and marketable securities, into additional Controlled stock that could then be distributed tax free in a spinoff. Although this rule is a logical means of preventing abusive behavior by Distributing, it created an inconsistency with the active trade or business requirement under Sec. 355(b) in light of statutory changes in 2007. The active trade or business rule requires that both Distributing and Controlled be engaged in the operation of an active trade or business for the five years preceding the transaction. This rule attempts to limit a taxpayer’s ability to distribute appreciated passive assets, such as investments or real estate, to its shareholders in a tax-free transaction. Under the active trade or business rule, the determination of an active trade or business is made by treating all members of Distributing’s separate affiliated group (DSAG) as one taxpayer. This was a new rule resulting from the 2007 statutory amendment. However, Congress did not statutorily modify the hot stock rule in light of this change. This led to the possibility that a transaction could meet the requirements of the active trade or business rule but still trigger boot gain under the hot stock rule.
Fortunately for taxpayers, Regs. Sec. 1.355-2(g) now provides for parity with the active trade or business rule by providing an exception to the application of the hot stock rule. Pursuant to the final regulations, if Distributing acquires Controlled such that it becomes a member of a DSAG and the transaction otherwise qualifies for Sec. 355 treatment, the hot stock rule will not apply to such otherwise hot stock. For Controlled to become a member of a DSAG, Distributing must acquire stock ownership described in Sec. 1504(a)(2) (i.e., 80% ownership of total voting shares and outstanding value).
Thus, for example, Distributing may already own stock of Controlled (i.e., “old and cold” stock) that satisfies the Sec. 368(c) control requirements (but not Sec. 1504(a) control) allowing for a potential spinoff of Controlled. Distributing then acquires more Controlled stock so that the Sec. 1504(a) control is obtained and Controlled becomes part of the DSAG. That additionally acquired stock is cleansed of its otherwise hot stock taint and can be distributed along with the old-and-cold Controlled stock without triggering boot gain consequences.
The final regulations generally are viewed as taxpayer friendly as well as providing logical consistency between the active trade or business rule statutory changes and the hot stock rule. However, the final regulations do not provide further guidance or safe harbors with regard to the issues decided in Dunn Trust, 86 T.C. 745 (1986), a matter the IRS solicited comments on in the temporary regulations.
Dun n Trust
In Dunn Trust, a trust owned 400 shares of AT&T stock. Prior to 1982, AT&T owned the stock of a number of other subsidiaries, including Pacific Telephone and Telegraph Company (Pacific). Specifically, AT&T owned 91.5% of the voting common stock and 78.2% of the voting preferred stock of Pacific but none of the Pacific nonvoting preferred stock. As a result, AT&T did not have Sec. 368(c) control of Pacific. In 1982, AT&T created a wholly owned subsidiary for purposes of effectuating a merger with Pacific to acquire Pacific’s remaining voting stock—and therefore Sec. 368(c) control—in a taxable transaction.
In 1983, AT&T reached a settlement with the U.S. government in an antitrust suit in which AT&T agreed to divest itself of certain assets, including Pacific stock. AT&T transferred the Pacific stock, along with other AT&T assets, to its newly formed subsidiary, Pacific Telesis Group (PacTel), a holding company, in a nontaxable exchange for PacTel stock. Then, in 1984, AT&T distributed the PacTel stock in what it classified as a tax-free spinoff under Sec. 355.
Upon examination, the IRS asserted that a portion of the PacTel distribution should be taxable as a result of AT&T’s acquisition of additional Pacific shares, pursuant to the hot stock rule, since AT&T acquired a portion of the Pacific stock within five years of the distribution (the Purchased Stock). The IRS argued that the “by reason of any transaction” language in Sec. 355(a)(3)(B) should be read to relate not only to direct distributions of Purchased Stock but also to indirect distributions (i.e., the portion of the PacTel stock equal in value to the value of the Pacific Purchased Stock). The trust countered that the hot stock rule did not apply to this transaction because AT&T distributed the PacTel stock, and not the Purchased Stock of Pacific.
The Tax Court conceded that a literal reading of the hot stock rule supported the trust’s argument that the rule applied only to a direct distribution of stock of Controlled. However, the court felt that there was enough ambiguity in the wording to permit a review of the legislative history of the Code section.
The hot stock rule was first addressed in 1954 by the Senate Finance Committee and Conference Committee. After examining these panel’s reports, the court held that the “by reason of any transaction” language was added to prevent a distributing corporation from avoiding taxation by acquiring controlled corporation stock via a purchase by a related entity coupled with some type of a tax-free combination. The court also noted that the legislative history provided no clear statement of intent to look through the stock of Controlled, such as the IRS suggested that the court should look through PacTel to the underlying stock of Pacific.
Based on the plain reading of the Code section and based on its review of the legislative history, the court ruled that the hot stock rule did not apply to this transaction. Further, the court identified three key facts it considered in coming to its conclusion.
First, the court said the IRS could have challenged the distribution as a device to distribute earnings and profits if it thought the distribution was abusive. However, the facts of this case and the requirement for the distribution as a result of the settlement of the antitrust suit made it apparent that this was not an abusive transaction. Second, the court pointed out that AT&T stock was used to acquire the additional Pacific stock, and therefore AT&T was not attempting to convert excess, liquid assets into additional Pacific stock to distribute tax free. Third, and what the court called the “most significant” fact, the Pacific stock stayed in corporate solution when distributed (i.e., the Pacific stock did not pass directly to the AT&T shareholders, but rather it was owned by PacTel). This further demonstrated that the transaction was not a device to bail out earnings and profits.
Eleven years later, the IRS released Action on Decision 1997-007 in which it agreed with the court’s decision that the hot stock rule did not apply in this situation and acquiesced in result only. The IRS concluded that the Dunn Trust court reached the correct result because: (1) PacTel was a corporation much larger and different than Pacific; and (2) AT&T had good business and economic reasons for incorporating PacTel and distributing PacTel stock rather than Pacific stock. However, the IRS maintained that the court’s decision interpreted the hot stock rule too narrowly and was “unduly limited.” The IRS has stated that it may challenge a transaction with facts different from Dunn Trust, such as a transaction in which purchased stock is transferred to a holding company to avoid the application of the hot stock rule.
Conclusion
The final regulations provide a mechanism that gives taxpayers a measure of certainty with regard to application of the hot stock rule. If a distributing corporation acquires Sec. 1504(a) control of the to-be-spun-off corporation such that it joins the DSAG, all prior hot stock taints are cleansed. Thus, the hot stock rule only lives on where taxpayers acquire Sec. 368(c) control but lack Sec. 1504(a) control or in a situation where the IRS may feel it has firmer legal footing to raise a Dunn Trust–style challenge. The practical advice is that, given all the heightened technical requirements for effectuating a Sec. 355 spinoff, if only Sec. 368(c) control is present, the distributing company may want to acquire Sec. 1504(a) control to extinguish any hot stock concerns.
EditorNotes
Greg Fairbanks is a tax senior manager with Grant Thornton LLP in Washington, DC.
For additional information about these items, contact Mr. Fairbanks at (202) 521-1503 or greg.fairbanks@us.gt.com.
Unless otherwise noted, contributors are members of or associated with Grant Thornton LLP.
