It is not uncommon for companies to either inherit or already have an organizational structure that is inefficient from a business or legal perspective as well as from a U.S. federal income (and often, state and local) taxation standpoint. Companies may seek to use a combination of tax-free mergers or liquidations to combine entities and "flatten out" their overall organizational structure. However, an often-overlooked caveat to entity simplification, if unheeded, can lead to headaches down the road and should be vetted thoroughly before undertaking any corporate, intra-group restructuring: the effect of carrying over earnings and profits (E&P) from one entity to another and the administrative burdens of the bookkeeping function of accumulated E&P with respect to those entities being merged or liquidated.
Sec. 381 requires the carryover of certain tax attributes after a tax-free Sec. 332 liquidation of a subsidiary or certain Sec. 368 reorganizations. Typical intra-group restructurings would include statutory A mergers, C mergers, and acquisitive D mergers. Included in the list of tax attributes is E&P, under Sec. 381(c)(2).
Example 1: Parent, a corporation, owns 100% of two subsidiary corporations, X and Y, as brother-sister entities. Y has historic E&P of $100x. If Y is merged with and into X, X will succeed to that $100x of E&P. On the other hand, if Y is liquidated into Parent, then Parent succeeds to that E&P.
From a bookkeeping perspective, to calculate accumulated E&P, a taxpayer must reference all its federal income tax returns going back to the date of incorporation in most cases. Typically, accumulated E&P is calculated by using those income tax returns as the base for computing E&P on an annual basis, modified by all applicable permanent and temporary differences used to modify taxable income or loss into either positive or negative E&P. It follows that the older the company, the more arduous the process can be, as it requires books and records going further back in time.
Example 2: Assume the same facts as Example 1, except Parent was formed as a new corporation in 1996, formed X in 1999, and acquired Y in 2005.
Parent would compute its E&P starting in 1996. Assuming Parent and X elected to file as a consolidated group in 1999, the E&P of X would tier-up to Parent starting in 1999. The E&P of Y would also tier-up, starting with when it joined the group in 2005. If Y had been incorporated back in 1957, it presumably would have a long and rich E&P history from 1957 through 2005. However, the E&P generated by Y does not tier-up to Parent upon acquisition (unless there is a "group structure change" within the meaning of the consolidated return rules). Instead, the E&P remains trapped in a pool at the Y level.
Taxpayers typically do not compute E&P until it is needed; for many taxpayers, E&P is most commonly needed for distributions by Parent to its shareholders. To understand whether such a distribution will be a dividend (or a return of basis, or a gain from the sale/exchange of property) under Sec. 301(c), the immediate inquiry looks at the E&P of Parent. That determination can be made without knowing any of the historic Y E&P for pre-acquisition periods. (However, if the distribution were funded by a cash sweep or borrowing at the Y level, the E&P history from 1957 through 2005 might be relevant for certain state or local tax reasons.)
However, when another corporation succeeds to E&P in a Sec. 381 transaction, the history of the entity being merged or liquidated may become relevant. If Y is liquidated or merged upstream with and into Parent, then Parent succeeds to all the E&P history from 1957 through 2005.
E&P is not tracked at the divisional level. So what previously was a more academic question regarding pre-acquisition E&P history now is crucial for any future distributions out of the Parent. Parent must now contend with obtaining almost 50 years of information for an entity that was acquired itself over a decade ago. By contrast, if Y had been merged sideways with and into X, the historic E&P pool of Y would transfer over to X. However, putting aside state and local concerns, that E&P history still would not alter the typical calculation of E&P at Parent's level for purposes of characterizing distributions to its shareholders.
While the above examples are straightforward, these issues can propagate and appear also in the context of private equity. A private-equity fund often will create a new holding corporation to acquire a legacy corporate structure. The new consolidated group may have many older pools of E&P at various points in the structure. However, if the private-equity fund seeks to make a large distribution out of the new holding company parent, the old, legacy E&P pools are not germane to determining the distribution consequences, for the same reasons discussed above (with the same caveat that those E&P pools may be relevant for state and local tax purposes if the distribution is funded by a lower-tier member of the group via a borrowing, cash sweep, etc.). Entity simplification projects can have immediate, unintended consequences where the private-equity fund may have to obtain books and records that otherwise it may not need.
Thus, before undertaking what otherwise may appear to be a straightforward project to simplify an organization's structure, companies should take care with regard to any entities that have older E&P pools, to guard against gaining an ostensibly more streamlined structure at the cost of what may be a books-and-records headache.
EditorNotes
Greg Fairbanks is a tax managing director with Grant Thornton LLP in Washington.
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.
