Editor: Howard Wagner, CPA
Corporations making stock acquisitions will often look to simplify their organizational structures by liquidating acquired subsidiaries or converting them to single-member limited liability companies. However, this can often result in unpleasant surprises when the parent subsequently makes dividend distributions, because the favorable provisions of the separate-return-limitation-year earnings and profits (SRLY E&P) rule are lost, and the parent company inherits pre-affiliation E&P of the target company.
For this reason, if a parent company acquires a target corporation and is contemplating simplification of the organizational structure via a Sec. 368 reorganization and/or a Sec. 332 liquidation, it is prudent to weigh the benefits of streamlining the organizational structure against the potential future tax cost associated with inheritance of target company tax attributes, including pre-affiliation E&P. If the target company joins the acquirer's consolidated return group with pre-affiliation positive E&P and future shareholder distributions are contemplated, the loss of SRLY E&P protection associated with a Sec. 368 reorganization or a Sec. 332 liquidation may outweigh the perceived benefits of simplifying the organizational structure. In short, the tax impact on future shareholder distributions should be considered prior to liquidating an acquired subsidiary. These matters are explored below.
The starting point
The starting point in the analysis is to determine how much of the target company's E&P is brought to the acquirer's consolidated return group. This determination is, in turn, largely driven by the target company's structure at the time of acquisition:
- If the target company is the common parent company of a consolidated return group or a stand-alone C corporation that has never been a member of a consolidated return group prior to the acquisition, the target's E&P survives and becomes E&P of the acquired subsidiary from a SRLY.
- If the target company was a member of a consolidated return group at the time of the acquisition, additional analysis is required under the E&P elimination rule contained in Regs. Sec. 1.1502-33(e). During the time when the target company was a member of its former consolidated return group, its E&P tiered up to its parent pursuant to Regs. Sec. 1.1502-33(b). When the target is acquired and leaves the seller's consolidated return group, target company E&P arguably rests in two places: (1) at the target subsidiary level, and (2) at the common parent of the seller's consolidated return group because its E&P previously tiered up. The E&P elimination rule solves this problem with the parent of the selling group retaining the previously tiered-up E&P and eliminating the duplicated E&P from the target subsidiary.
- Additional complexities in determining how much E&P the target takes with it from the group are present if the target was previously acquired by the selling affiliated group in a prior transaction. An analysis of those issues is beyond the scope of this item.
Comparing scenarios
As noted above, if a parent company decides to simplify its organizational structure by liquidating an acquired subsidiary, this action can result in an undesirable tax impact on future shareholder distributions. The following example illustrates why this is so.
Example: The parent corporation of an affiliated group acquires the stock of a target corporation that is either the common parent of a consolidated return group or a stand-alone C corporation, and the target joins the parent's affiliated group as a subsidiary (New Sub) on Jan. 1 of year 1. At the time of the acquisition, New Sub has E&P of $5 million, and the parent's accumulated E&P is $2 million. On Dec. 31 of year 2, the parent has accumulated E&P of $10 million (for simplicity, assume current E&P of the group for year 2 is less than $10 million). Of the $8 million increase, $5 million was provided by New Sub, and the remaining $3 million was provided by other members of the group.
Now consider three possible scenarios and how the taxation of future shareholder distributions would be affected.
Scenario 1: Parent-funded distribution
At the end of year 2, the parent has $10 million in cash on hand and makes a $15 million distribution to its shareholders. Even though the acquired subsidiary has E&P of $5 million at the date of acquisition, the pre-affiliation E&P from the separate return years does not tier up to the parent corporation under Regs. Sec. 1.1502-33(b). Accordingly, when the parent makes the $15 million distribution to its shareholders, the result is a $10 million dividend and a $5 million nondividend distribution.
Scenario 2: New Sub funds distribution
At the end of year 2, New Sub makes a $15 million distribution to the parent, and the parent distributes $15 million to its shareholders.
Pursuant to Regs. Sec. 1.1502-33(b)(2), the reduction in a consolidated subsidiary's E&P under Sec. 312 from a distribution of E&P accumulated in separate return years of the subsidiary that are not SRLYs does not tier up to the common parent company's E&P. Accordingly, the increase in the common parent company's E&P under Sec. 312 upon receipt of the distribution is not offset by a corresponding tier-up of reduction to the distributing subsidiary's E&P in cases involving distribution by a subsidiary to the parent company of pre-affiliation E&P generated in a non-SRLY year. On the other hand, the tiering-up principles of Regs. Sec. 1.1502-33(b)(1) would apply in the case of a distribution by a consolidated subsidiary of pre-affiliation E&P generated in a SRLY year.
The practical implications of these concepts are illustrated by Regs. Sec. 1.1502-33(b)(3)(ii), Example (1)(d):
Facts: P forms S in year 1 with a $100 contribution. S has $100 of E&P for year 1 and no E&P for year 2. During year 2, S declares and distributes a $50 dividend to P. P and S do not begin filing consolidated returns until year 2.
Analysis: S has $100 of E&P, and none of S's year 1 E&P is reflected in P's earnings and profits under Regs. Sec. 1.1502-33(b):
- S's distribution in year 2 ordinarily would reduce S's E&P but not increase P's E&P because P's $50 of E&P from the dividend would be offset by the tier-up of S's $50 reduction in E&P under Regs. Sec. 1.1502-33(b).
- However, under Regs. Sec. 1.1502-33(b)(2), the negative adjustment for S's distribution to P does not apply. Thus, S's distribution reduces its E&P by $50 but increases P's E&P by $50.
Significantly, Example (1)(d) goes on to state that if S's E&P had been accumulated in a SRLY, Regs. Sec. 1.1502-33(b)(2) would not apply and the distribution would reduce S's E&P but not increase P's E&P. Applying the regulation to Scenario 2 above, the distribution of $15 million from New Sub to parent would not result in a $5 million increase to the parent's E&P, and the result would be the same as in Scenario 1 — a $10 million dividend and a $5 million nondividend distribution.
Scenario 3: New Sub is liquidated prior to a distribution
After the acquisition of New Sub and before the end of year 2, the parent of the group has decided to simplify its structure and liquidate New Sub in a Sec. 332 liquidation. In the Sec. 332 liquidation, the E&P of New Sub becomes E&P of the parent under Sec. 381. At the end of year 2, the parent now has $15 million of E&P — its $10 million of E&P, plus the $5 million of E&P that was previously "trapped" at New Sub under the SRLY E&P rule. When the parent makes a $15 million distribution to its shareholders, the entire amount is a dividend to its shareholders, without regard to the source of the dividend within the group. Thus, an unintended result of the entity simplification is a $5 million increase in shareholder taxable income.
EditorNotes
Howard Wagner, CPA, is a partner with Crowe LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowe.com.
Contributors are members of or associated with Crowe LLP.
