The Internal Revenue Service has proposed regulations that may persuade corporations to rethink their capital structures and recordkeeping procedures in anticipation of the regulations' adoption, in order to facilitate the tracing of stock basis by their shareholders.

On January 16, 2009, the IRS released a 67-page regulations package (REG-143686-07) that proposes a comprehensive solution for the determination of the tax basis of shares involved in stock redemption transactions and in corporate reorganization transactions that case law has analogized to stock redemption transactions. If adopted in their present form, the proposed regulations would take effect prospectively.

The paradigm case that inspired these regulations is one in which shares of a corporation are redeemed in a transaction that the Internal Revenue Code treats as "dividend-equivalent." In such a transaction, the redeemed shareholder is treated as receiving a corporate distribution of cash without having surrendered any shares in exchange. Because the shareholder has in fact actually surrendered shares, a technical issue arises as to what has become of the tax basis for the shares surrendered. Current law would attach this "disappearing basis" to the shares that   the shareholder continues to own, actually or constructively, after the redemption. As will be explained in greater detail below, the proposed regulations would continue this approach for shares that the redeemed shareholder continues to own directly. However, where the retained shares are only constructively owned after the redemption, the regulations would treat the missing basis as a deferred loss to the redeemed shareholder, the recognition of which (generally as a capital loss) would be triggered at a later date when either all of the shares of the issuing corporation become worthless or events occur that would satisfy the Code conditions for treatment of the redemption as a taxable exchange (such as a complete termination of the shareholder's ownership interest in the issuing corporation).

More controversial is the proposed regulations' treatment of dividend equivalent distributions that exceed the issuing corporation's current and accumulated earnings and profits. Under the Code, this excess is not treated as dividend income but rather is applied first in reduction of basis of the retained shares and then treated as recognized gain. The proposed regulations would allocate the excess distribution pro-rata among all shares of the same class that are held by the redeemed shareholder. The amount of any gain would be determined with respect to each share without taking into account the availability of unused basis with respect to other shares. Shares of a different class, moreover, would not participate in the pro-rata allocation of the distribution, so that their basis would be wholly inaccessible in making the gain determination. This tracing rule is extended to the determination of the basis of shares that are retained after a partial redemption by adopting a recapitalization model to explain the reduction of outstanding shares. The old shares (including the redeemed shares) are treated as if they have been exchanged for new shares of a reduced number. Each block of old shares is deemed exchanged for a proportionate block of new shares with the tax basis for the old block carrying over to the new block.

Entirely different concepts govern redemptions that the Code treats as exchange-equivalent rather than dividend-equivalent distributions. In determining gain or loss from these transactions, taxpayers are permitted to select the actual shares that are redeemed for tax purposes. The proposed regulations would not alter this result.

Corporate reorganizations typically involve the surrender of shares of an acquired corporation for shares of an acquiring corporation plus "boot" (usually cash). Under the U.S. Supreme Court case of Commissioner v. Clark, 489 U.S. 726 (1989), the tax treatment of the receipt of boot as a dividend equivalent distribution or as a redemption-like exchange is to be determined from the overall effect of the transaction. Extrapolating from the Clark holding, the proposed regulations would extend the share-by-share basis tracing concept for gain determination that they have developed for redemptions to the receipt of boot in reorganization transactions (including spin-offs and split-offs). Thus, dividend equivalent boot may be recognized, with respect to individual shares, in circumstances where no net gain is realized on the overall transaction, in accordance with the principle of the proposed regulations that prorates a distribution among all individual shares within the class for which the distribution is received. Likewise, the recognition of gain from the receipt of exchange equivalent boot may be minimized under the proposed regulations by specific identification of high tax basis shares of the acquired corporation as the property deemed to be surrendered for the boot.

The proposed regulations would also extend their share basis tracing principles to transfers of property to a controlled corporation (so-called Section 351 exchanges) in which stock is among the items transferred and no liabilities are assumed by the transferee corporation. The preamble to the proposed regulations indicates that these principles include the use of a recapitalization model to determine the post-transaction basis of "old" shares held by the transferor in circumstances where the issuance of additional shares would be a "meaningless gesture." Moreover, the proposed regulations would extend the recapitalization model to a contribution of shares to the capital of a non-controlled corporation that would qualify for nonrecognition under Section 118 rather than under Section 351. The proposed regulations would also formally adopt the IRS's longstanding position that boot received in a Section 351 exchange is to be allocated among the transferred properties based on their relative fair market values for purposes of determining realized gain or loss. Thus, because Section 351 disallows losses, the proposed regulations would cause gain to be recognized with respect to the transfer of appreciated assets in circumstances where the overall exchange produced a net realized loss.

Both the text and preamble of the proposed regulations affirm that taxpayers may use their tracing principles offensively in planning redemption and reorganization transactions. In particular, the proposed regulations would amend the Section 1001 regulations to indicate that an exchange of particular property for particular property within an overall reorganization transaction would be respected as long as the terms of the exchange were "economically reasonable" -- that property of equivalent value was in fact being exchanged. Thus, within limits, the proposed regulations would permit taxpayers to structure transactions in a way that would permit an efficient use of their tax basis. By specifically identifying property that is to be exchanged, taxpayers would be able to allocate high basis property to the taxable portions of an exchange and low basis property to the tax-deferred portions, thereby ensuring that the greatest amount of taxable income would be deferred. Achievement of these favorable tax results, however, is most likely to be accomplished in transactions involving closely held corporations. Only shareholders of such entities are likely to be in a position to control the terms of the transaction with knowledge of its consequences to their particular tax situations.

The proposed regulations reserve numerous issues for future consideration. Comments are invited on the application of the deferred loss rules for dividend equivalent redemptions to shareholders that are pass-through-entities (partnerships, S corporations, estates, and trusts). The IRS also invites comments on the extension of the dividend equivalent redemption principles of the proposed regulations to redemptions of Section 306 stock, in which a redemption generally triggers an automatic dividend; on the triggering of a deferred loss upon a pro-rata split-up that is governed by Section 355 (in which the issuing corporation would cease to exist, as in a liquidation); and on basis determination issues related to "all cash" reorganizations of commonly owned corporations that are governed by Section 368(a)(1)(D) (in which shareholders of the merged corporation may or may not receive shares of the surviving entity).

The Tax Group of Ballard Spahr Andrews & Ingersoll, LLP is able to assist corporations and their shareholders in the development and submission of written comments on the proposed regulations. We also will advise companies on the revision of their capital structures in anticipation of future reorganization or redemption transactions that may be governed by the present form of these regulations. Please contact Ballard Spahr partners Wayne R. Strasbaugh, at 215.864.8328 or strasbaugh@ballardspahr.com; Wendi L. Kotzen, at 215.864.8305 or kotzenw@ballardspahr.com; or Jeffrey R. Davine, at 303.299.7312 or davine@ballardspahr.com, for additional information and assistance.


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