Allocation and Recovery of Stock Basis

Transcription

1 Proposed Regulations Provide New Rules for the Allocation and Recovery of Stock Basis SUMMARY On January 16, 2009, the IRS issued proposed regulations (the Proposed Regulations ) which provide (1) for a share-by-share (rather than an aggregate ) model for the recovery of stock basis when a distribution to shareholders, including a redemption that is treated as a distribution, exceeds the earnings and profits of the corporation and therefore is not entirely a dividend; (2) new rules with respect to stock basis after a redemption of all or a part of a class of stock; and (3) in response to comments, clarifications of the regulations proposed in 2004 with respect to the basis of shares received in a tax-free reorganization. 1 The Proposed Regulations also provide guidance on several other basis allocation and basis recovery issues and request comments on specific issues. The Proposed Regulations are generally effective for transactions occurring after the date the regulations are published as final regulations, and, in the case of changes to the 2004 proposed regulations on the basis of shares received in Section 351 contributions, Section 355 spinoffs, and other tax-free reorganizations, for transactions occurring pursuant to a written agreement binding on or before the date of publication. BACKGROUND There is limited guidance in present law on whether a shareholder that receives a distribution which is not entirely a dividend, because of the absence of sufficient earnings and profits, recovers stock basis on an aggregate or on a share-by-share basis or how a shareholder should treat the unrecovered basis of shares that are redeemed in a redemption that is treated as a distribution to shareholders but not entirely as a dividend because of the absence of sufficient earnings and profits. The Proposed Regulations address this by adopting a share-by-share model in which each share of stock is treated as a separate New York Washington, D.C. Los Angeles Palo Alto London Paris Frankfurt Tokyo Hong Kong Beijing Melbourne Sydney

2 unit of property. The same model is used if a redemption by the issuer or a related corporation is treated as a distribution but not entirely as a dividend because of the absence of sufficient earnings and profits. The Proposed Regulations also provide guidance in several additional areas related to the allocation and recovery of basis. DISTRIBUTIONS WITH RESPECT TO STOCK AND DIVIDEND EQUIVALENT TRANSACTIONS Under the Code, a distribution by a corporation to its shareholders, including a redemption by the corporation or by a related corporation that is treated as a distribution, is first treated as a dividend to the extent of current or accumulated earnings and profits. 2 Distributions in excess of current or accumulated earnings and profits are then applied against the shareholder s basis, 3 and finally treated as a gain from the sale or exchange of the shares. 4 It is unclear under current law how basis is recovered if a distribution exceeds earnings and profits and is therefore not entirely a dividend. To address this, the Proposed Regulations provide that distributions in excess of earnings and profits will be treated as received on a pro rata, share-by-share basis, with respect to the class of stock upon which the distribution is made, 5 and not by offsetting the distribution by the aggregate basis in the class of stock on which the distribution is made. As a consequence, if a shareholder owns shares of the same class that have different tax bases, the shareholder may have gain on some shares and unrecovered basis on others. The Proposed Regulations illustrate this with an example in which an individual shareholder owns 100 shares of a corporation, 25 of which were purchased for $25 (Block 1) and 75 of which were purchased for $175 (Block 2). The corporation, which has total earnings and profits of $100, makes a distribution of $300. Based on the share-by-share approach, the shareholder is treated as receiving $75 of the distribution on Block 1 and $225 on Block 2. On Block 1, the shareholder has a $25 dividend, a $25 return of capital, and $25 in gain. On Block 2, the shareholder has a $75 dividend, a $150 return of capital, and retains a $25 basis in his Block 2 shares. In contrast, if the shareholder had been able to recover his basis in the aggregate, the $200 of the distribution that exceeded the corporation s earnings and profits would have fully offset the shareholder s basis in his shares and the shareholder would have had no gain on the distribution. The Proposed Regulations also apply the share-by-share model to redemptions of shares, whether by the issuing or a related corporation, if the redemption is treated as a distribution to shareholders, 6 and also to the receipt of cash or other boot in a tax-free reorganization. 7 Generally, the share-by-share model is applied only to the shares in respect of which an actual distribution would have been received. As a consequence, basis recovery is not available for shares that are constructively owned by the shareholder at the time of the distribution. 8-2-

3 PARTIAL REDEMPTIONS DEEMED TO BE RECAPITALIZATIONS The Proposed Regulations provide for a deemed recapitalization in the case of a partial redemption that is treated as a distribution to shareholders but not entirely as a dividend because of insufficient earnings and profits. 9 Specifically, the redeemed shareholder is treated as having exchanged the pre-redemption shares owned by the shareholder for the number of shares owned after the redemption in a deemed tax-free recapitalization, and the basis of the exchanged shares, adjusted for any reduction in basis resulting from the part of the distribution not treated as a dividend, is allocated to the post-redemption shares under the tracing rules of proposed regulations issued under Section Under these rules, basis is reallocated by first assuming that each pre-redemption block of shares has been exchanged for a proportional number of the post-redemption shares, and then allocating basis such that the preredemption differences in basis among different blocks of shares are maintained. 11 The Proposed Regulations illustrate this with an example in which a shareholder of a corporation which is party to a tax-free reorganization owns 10 shares which were purchased for $2 each and another 10 shares which were purchased for $5 each. In the reorganization, the shareholder receives 1 share of the other corporation for every 2 shares it previously owned. Therefore, the shareholder receives 10 shares, 5 of which will have a basis of $4 each and be treated as purchased on the date on which the shareholder purchased shares for $2, and 5 of which will have a basis of $10 each and be treated as purchased on the date on which the shareholder purchased shares for $5. The shareholder generally may designate which distinct post-redemption shares are part of each block if it is unclear which of the postreorganization shares have been received in exchange for each block of pre-reorganization stock. DEFERRAL OF LOSS IN RESPECT OF UNRECOVERED BASIS IN COMPLETE REDEMPTIONS The Proposed Regulations also address the treatment of basis that is not recovered in a complete redemption of shares of a class of stock owned by a shareholder when the redemption is treated as a distribution to the shareholder. Absent the Proposed Regulations, the unrecovered basis may shift to shares of a different class owned by the shareholder or to shares held by a related taxpayer. 12 Under the Proposed Regulations, however, the unrecovered basis is treated as a deferred loss. 13 The shareholder will be allowed (i.e., may access ) the deferred loss only when facts and circumstances change to the extent that the redemption would have been in part or full payment in exchange for the redeemed stock had those facts and circumstances existed immediately after the redemption; when all classes of stock of the redeeming corporation or its successor become worthless; or, if the shareholder is a corporation, when it disposes of all of its assets in a transaction in which gain or loss is recognized. 14 The Proposed Regulations reserve with respect to the treatment of unrecovered basis when the shareholder is a flow-through entity, 15 such as an S corporation, partnership, estate, or trust, because of a concern that not reflecting the loss in the basis of the interests in the flow-through entity (e.g., the shares -3-

4 of an S corporation) could result in the separation of the dividend income resulting from the redemption and the loss. The Proposed Regulations also say that the IRS and Treasury continue to study issues that arise with respect to basis recovery when the redeemed shareholder is a member of a consolidated group. TREATMENT OF CASH AND BOOT IN REORGANIZATION EXCHANGES If a shareholder receives cash or other boot in a tax-free reorganization exchange, the shareholder recognizes gain, with the gain limited to the sum of the cash and the fair market value of the boot received. 16 If the cash or boot is equivalent to a dividend, the gain is treated as a dividend to the extent it does not exceed the shareholder s ratable share of the corporation s undistributed earnings and profits. 17 Dividend equivalence is determined by examining the effect of the shareholder s overall exchange. 18 If cash or other boot received in a reorganization is equivalent to a dividend, the Proposed Regulations provide that the receipt of boot is treated as received on a pro rata, share-by-share basis with respect to the class of stock upon which the distribution is made. 19 As a consequence, a shareholder receiving dividend equivalent cash or boot in a reorganization may have gain with respect to some shares and unrecovered basis in other shares. If the receipt of cash or other boot is not equivalent to a dividend, the Proposed Regulations provide that the shareholder may specify the allocation of the cash or boot among the shareholder s shares, provided the terms of the exchange are economically reasonable. 20 If the shareholder chooses to specify, within the terms of the reorganization, the allocation of boot, the shareholder will recognize gain or loss with respect to the shares to which the boot is allocated as if those shares had been sold or exchanged for the cash or boot. 21 Otherwise, gain will be recognized as if a pro rata portion of the proceeds had been received for each share of the corporation based on the fair market value of the surrendered shares. 22 OTHER ISSUES The Proposed Regulations also include other rules, including the following: The Proposed Regulations provide that, solely for purposes of apportioning interest expense for foreign tax credit limitation purposes using the tax book value method, the deferred loss that may result from a redemption of shares that is treated as a distribution but not entirely as a dividend will be added to the basis of any remaining shares in the corporation or to the basis of any shares owned by certain affiliated corporations. 23 This is intended to ensure that the basis taken into account in the tax book value method is not reduced by the unrecovered basis of redeemed shares in calculating a shareholder s foreign tax credit limitation. -4-

5 The Preamble to the Proposed Regulations provides that the new share-by-share model does not affect the basis reduction that results under the extraordinary dividend rules in Section 1059 when the shareholder receives a dividend that, by virtue of option attribution under 318(a)(4) or the application of Section 304(a), constitutes an extraordinary dividend within the meaning of Section The Proposed Regulations extend the current Section 358 basis tracing rules to all Section 351 exchanges in which no liability is assumed by the transferee corporation, 25 rather than merely, as was the case under prior law, to Section 351 exchanges that also qualify as reorganizations. The Proposed Regulations also extend the deemed recapitalization model to Section 351 exchanges if insufficient or no shares are received in exchange for the contributed property. 26 Additionally, the IRS and Treasury request comments on several issues, including the treatment of unrecovered basis in redeemed Section 306 stock, the relationship between controlled and distributing corporations in a Section 355 split-up for deferred loss inclusion purposes, and how the Proposed Regulations may affect the current treatment of all cash D reorganizations. The Proposed Regulations are generally effective for transactions occurring after the date the regulations are published as final regulations, and, in the case of changes to the 2004 proposed regulations on the basis of shares received in Section 351 contributions, Section 355 spinoffs, and other tax-free reorganizations, for transactions occurring pursuant to a written agreement binding on or before the date of publication. * * * Copyright Sullivan & Cromwell LLP

6 ENDNOTES For the text of the prior proposed regulations on the determination of basis of stock received in various tax-free reorganizations and spin-offs, see 69 FR (May 3, 2004). Section 301(c)(1); 316(a). All section references are to the Internal Revenue Code of 1986, as amended, and/or the regulations issued or proposed thereunder by the U.S. Department of the Treasury. Section 301(c)(2). Section 301(c)(3). Prop. Treas. Regs. Section (a). Prop. Treas. Regs. Section (a)(1); Prop. Treas. Regs. Section (a)(4). Prop. Treas. Regs. Section (d) Examples 3 and 4. See, e.g., Prop. Treas. Regs. Section (a)(4). Therefore, although constructive ownership of shares by a party related to the shareholder could cause the proceeds of a brother-sister sale to be treated as a distribution under Section 301, the shareholder would not be able to recover basis of shares it merely constructively owned (such as shares owned by a related party); instead, the shareholder would only be able to recover basis in respect of shares it owned directly or was deemed to own as part of the Section 351 contribution. Prop. Treas. Regs. Section (a)(2). See, e.g., Prop. Treas. Regs. Section (e) Example 1; Prop. Treas. Regs. Section (c) Example 2. See Prop. Treas. Regs. Section (b)(3). See Treas. Regs. Section (c). Prop. Treas. Regs. Sections (a)(3), (e) Examples 2 and 3. In Example 3, a corporation redeems preferred stock in a transaction which, because of the shareholder s ownership of common stock, is treated as a distribution. The unrecovered basis of the preferred that is redeemed, i.e., the excess of the basis of the shares over the amount paid in redemption that is not a dividend, is a deferred loss. Prop. Treas. Regs. Section (b)(4). Additional rules apply if the shareholder is a foreign corporation. Prop. Treas. Regs. Section (c). Section 356(a)(1). Section 356(a)(2). See Commissioner v. Clark, 489 U.S. 726, 738 (1989). See Preamble to the Proposed Regulations. Prop. Treas. Regs. Section (a). It should be further noted that the proposed regulations also do not limit the availability of this election with respect to non-reorganization redemptions under Section 302(a). See Preamble to the Proposed Regulations. Prop. Treas. Regs. Section (d) Example 4. Prop. Treas. Regs. Section (d) Example

7 Prop. Treas. Regs. Sections (c)(2)(vi), (c)(2)(vii) Example 3. See Preamble to the Proposed Regulations. Therefore, a redeeming shareholder would first reduce basis under Section 1059(e)(1)(A) and then apply the share-by-share model pursuant to the proposed regulations. Prop. Treas. Regs. Section (f)(2). Prop. Treas. Regs. Section (g)(3); Prop. Treas. Regs. Section (e). -7-

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