In Tseytin, T.C. Memo. 2015-247, the Tax Court discussed the application of the "boot" rules under Sec. 356 in a tax-free reorganization where one block of shares had an unrealized gain and another block of shares had an unrealized loss.
Generally, no gain or loss is recognized if stock or securities in a corporation that is a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in that corporation or in another corporation that is a party to the reorganization (Sec. 354). If a corporation distributes to a shareholder with respect to its stock, or to a security holder in exchange for its securities, solely stock or securities of another corporation that it controls immediately before the distribution, and certain other requirements are satisfied, generally, no gain or loss is recognized by the shareholder or security holder upon the receipt of the controlled corporation's stock or securities pursuant to Sec. 355. ("Control" is defined in Sec. 368(c) as ownership of at least 80% of the total combined voting power and 80% of the total number of shares of all other classes of stock.) The distributing corporation also receives nonrecognition treatment on the distribution of that stock or securities.
The reorganization in Tseytin involved a considerable amount of boot (i.e., consideration other than stock in the acquirer, including cash), which triggered substantial capital gain recognition. The taxpayer, Michael Tseytin, attempted to offset this gain with a loss on another block of stock that he purchased immediately before the reorganization.
Sec. 356(a) provides that if the nonrecognition rules under Sec. 354 or 355 would apply to an exchange but for the fact that the property received in the exchange consists of property other than stock or securities (i.e.,boot), then the gain, if any, to the recipient shall be recognized to the extent of the sum of money received and/or the fair market value (FMV) of any other property received. Sec. 356(c) disallows recognition of a loss on an exchange or distribution if the nonrecognition rules of Sec. 354 or 355 would apply to the exchange or distribution but for the fact that property other than stock or securities is also received in the exchange.
In Rev. Rul. 68-23, the IRS determined that if a taxpayer holds blocks of stock that have different tax bases, for purposes of Sec. 356, the taxpayer must compute gain or loss on a transaction separately for each block. If the taxpayer realizes a loss on one block of stock, the realized loss may not offset or reduce a gain recognized on the other block of stock.
In Tseytin, the taxpayer owned 750 shares (Block 1 shares) in US Strategies Inc. (USSI), which amounted to 75% of the issued and outstanding stock of USSI and carried a tax basis of zero. USSI had a majority interest in two limited liability companies organized under the laws of Russia that operated Pizza Hut and Kentucky Fried Chicken franchises throughout Russia. Archer Consulting Corp. (Archer) owned the remaining 250 issued and outstanding shares (Block 2 shares) in USSI (or 25%).
In May 2007, Tseytin entered into an agreement with AmRest Holdings NV (AmRest) to merge USSI into a subsidiary of AmRest. Tseytin and AmRest structured the merger to qualify as a tax-free reorganization under Sec. 368. For the merger to occur, Tseytin needed to buy out Archer's interest in USSI. Accordingly, Tseytin entered into a stock purchase agreement with Archer, acquiring the Block 2 shares for $14 million. Tseytin was to receive "all right, title and interest in and to the Block 2 shares, free and clear of all liens, claims and other encumbrances," and he agreed to purchase the Block 2 shares for his "own account." AmRest was not a party to the stock purchase agreement. As the sole shareholder of USSI, Tseytin amended its bylaws to appoint himself as USSI's sole director and approved the merger. The amendment was executed on July 2, 2007. As consideration for the merger, Tseytin received $23 million in cash and AmRest stock with an FMV of approximately $30.8 million. The merger agreement did not identify Archer as a party to it.
On his 2007 federal income tax return, Tseytin treated the 1,000 shares of stock in USSI as one block of stock, all owned and transferred by him to AmRest. Tseytin treated the $23 million of cash he received as taxable but reduced it by $6 million, i.e., 42.7% of the Block 2 shares' tax basis ($23 million + $30.8 million = $53.8 million total consideration; $23 million ÷ $53.8 million = 42.7% cash portion; $14 million × 42.7% = $6 million), thus reporting a net long-term capital gain of $17 million and a total federal income tax liability of $3.8 million.
In October 2009, Tseytin filed an amended federal income tax return, treating all 1,000 shares in USSI as being owned and transferred by him to AmRest but treating the Block 2 shares as separate from the Block 1 shares. He also ignored the $30.8 million value of AmRest shares that he received as part of the total merger consideration. He computed the revised long-term capital gain by treating the $23 million of cash received as being allocable 75% to Block 1 shares ($17.3 million) and 25% to Block 2 shares ($5.8 million). The amended return reported a net long-term capital gain of $9 million, which consisted of a long-term capital gain of $17.3 million for the Block 1 shares and a short-term capital loss of $8.2 million for the Block 2 shares (i.e.,cash proceeds of $5.8 million less tax basis of $14 million) and resulted in an overall reduced federal income tax liability of $2.6 million.
The IRS selected the amended return for audit. The IRS treated the Block 1 shares and Block 2 shares as separate blocks of stock, each having a different tax basis, and computed the taxable portion of the $23 million of cash received in the merger using the total $53.8 million of merger consideration. Using this amount, the IRS allocated approximately $13.5 million of the consideration to the sale of the Block 2 shares, resulting in a realized short-term capital loss of $500,000. It allocated the remaining amount of the consideration to the Block 1 shares, so the amount of long-term capital gain Tseytin realized on the transfer of Block 1 shares was $40.4 million, and his long-term capital gain recognized was $17.3 million. Per Sec. 356(c), the IRS did not net the short-term loss against the long-term gain.
Tseytin challenged the IRS's decision in Tax Court. He argued at trial that in transferring the Block 2 shares to AmRest, he acted only as a nominee or agent for Archer, that he never owned the Block 2 shares, and that the court should treat the Block 2 shares as sold directly by Archer to AmRest or redeemed by USSI or by AmRest from Archer. Accordingly, he should be entitled to treat $14 million of the $23 million cash consideration received from AmRest as not received by him but rather as received by, and taxable to, Archer. If, however, he was found to be the owner of the Block 2 shares on their transfer to AmRest, he argued that he could subtract the short-term capital loss of $527,297 realized on the transfer of the Archer shares from the $17.3 million of long-term capital gain to be recognized and taxed as cash boot.
The Tax Court rejected both of Tseytin's arguments. With respect to the argument that Archer should be treated as the owner of the Block 2 shares, the court found that he was bound by the form of the transaction he entered into. The court noted that the rule binding taxpayers to the form of their transaction is not absolute. Under the Danielson rule, absent proof of mistake, fraud, undue influence, or duress, which would be recognizable under the applicable law in a dispute between the parties to an agreement, taxpayers are generally held to the terms or the form of any agreement entered into (see Danielson, 378 F.2d 771 (3d Cir. 1967)). The court explained that the Danielson rule precludes a taxpayer from challenging the form of an agreement where such a challenge, if successful, would invalidate the foreseeable tax consequences for other parties involved, provide a one-sided reformation of the contract with an unfair result, or allow a party to use the tax laws to seek relief from an unfavorable agreement that he or she entered into.
Based on the evidence, the court found that it was evident from the stock purchase agreement between Tseytin and Archer that Tseytin had all right, title, and interest in the 1,000 shares of USSI stock. Neither AmRest nor USSI was a party to the stock purchase agreement between Tseytin and Archer; also, Archer was not a party to the merger agreement between Tseytin and AmRest. Tseytin's actions as sole shareholder of USSI were sufficient evidence that he was in control of USSI. Therefore, the court concluded that two separate transactions occurred—a taxable acquisition of corporate stock by a stockholder and a tax-free reorganization. Thus, the Tax Court found that Tseytin should be treated as the recipient of, and be taxable on, the portion of the cash boot he received on the merger that was allocable to the Archer shares.
Regarding the arguments relating to the internal netting of losses and gains realized on separate blocks of stock in a merger transaction, the court observed that, even if internal netting were allowable, Tseytin had cited no authority that would allow a loss realized to offset or be netted against a gain to be recognized. Furthermore, as the IRS had pointed out that, if (contrary to the loss disallowance rule of Sec. 356(c)) internal netting were permitted in this case, it would allow only the $527,297 loss Tseytin realized on the Block 2 shares to reduce the $40.4 million of realized gain on the Block 1 shares. This would significantly increase Tseytin's tax liability over the tax liability determined, since he would be taxed on the entire $23 million cash boot that he received as consideration for the reorganization, increasing his taxable income by $6 million. Thus, the Tax Court concluded that Tseytin could not net his realized loss on the Block 2 shares against the gain to be recognized and taxed on the Block 1 shares.
Tseytin should have considered other options when structuring the merger agreement and the acquisition of the minority interest shareholder of USSI, arranging both events as part of a single transaction to achieve a much more desirable result for federal income tax purposes. For example, assume the following facts instead:
- Tseytin did not acquire the Archer stock outright;
- Archer and Tseytin were both parties in the merger of USSI with AmRest;
- As consideration for the merger, Archer received cash of $14 million, and Tseytin received cash of $9 million and AmRest stock with a FMV of $30.8 million.
By adjusting the structure of the entire transaction as laid out above, AmRest would not be affected at all (i.e., it would still receive $14 million for its 250 shares of USSI stock), and Archer would still recognize gain or loss on the sale of its stock under Sec. 1001, depending on its tax basis in the stock. However, Tseytin would avoid loss disallowance under Sec. 356(c) by not owning two blocks of stock in USSI and would recognize a long-term capital gain of $9 million, as opposed to $17.3 million, resulting in a much lower federal income tax liability.
Taxpayers should always consult a tax adviser when structuring a reorganization of their business to ensure that the proposed structure will produce a favorable result for federal income tax purposes and, if applicable, state and/or local income tax purposes.
Kevin Anderson is a partner, National Tax Office, with BDO USA LLP in Washington.
For additional information about these items, contact Mr. Anderson at 202-644-5413 or firstname.lastname@example.org.
Unless otherwise noted, contributors are members of or associated with BDO USA LLP.