A recent letter ruling gives further proof of the view that taxpayers can undo just about any transaction if they can reverse it in their same tax year as the original transaction. This usually is more likely to occur when the transaction involved related parties, who will be cooperative with the reversal, but the technique can be extended to transactions with unrelated parties. The key question for taxpayers is whether to try this on their own or to seek an IRS letter ruling. Seeking the ruling is prudent, particularly in light of the seeming willingness of the IRS to go along.
In LTR 200701019 X bought Y for cash. Y owned Z. Y liquidated by merging into X, leaving X owning Z directly. Y had no assets other than the stock of Z. Then X started to have financial difficulties and decided it needed to dispose of Y’s “line of business.” Because Y had no other assets, presumably its “line of business” was its stock in Z. But X really wanted to use its recently acquired (and destroyed) basis in the stock of Y in the proposed sale so as to reduce its taxable gain.
Of course X’s problem was that upon the merger of Y into X its basis in the Y stock disappeared in the deemed liquidation of Y because the stock disappeared. This is different from the result if the merger were treated as a reorganization, in which X’s basis in the Y stock would become its basis in the stock of the surviving corporation, under section 358. Instead, X took a transferred basis in the Z stock owned by X, which presumably was lower than X’s former basis in the Y stock.
Assume X bought Y for $100. Y’s basis in the Z stock might have been $50. X might be able to “dispose of Y’s line of business” for $100. If X had sold the Y stock it would recognize no gain or loss. If it sold the Z stock it would recognize a gain of $50.
Because X was able to represent that nothing had changed between the merger and the proposed sale other than that X’s circumstances had changed, X was able to obtain from the Chief Counsel a blessing for its reversal of the original transaction. X accomplished the reversal by recreating Y in the form of a new subsidiary, New Y, into which X dropped the Z stock. The ruling ruled that New Y was old Y, which had never ceased to exist.
Compare 9100 Relief
Presumably the key to the taxpayer’s ability to reverse the transaction was that circumstances changed after the initial liquidation. In analogous contexts a change of circumstances is not helpful: when taxpayer’s seek “9100 relief” to gain permission to make a missed election they cannot rely on “hindsight.” What this means is that they cannot wait and see whether it would be better to have made the election based on future facts, but must have intended to make the election initially.
Heads I Win, Tails You Lose?
What if Y’s basis in the Z stock had been higher than X’s basis in the Y stock? And what if after X acquired Y and merged Y into X, circumstances changed (as X alleged here), and X wanted to sell Z and needed to sell it as a subsidiary; so it dropped it into a New Y? And what if all of these steps occurred in the same tax year of X? X would claim that it could use the high basis of the Z stock, replicated in its New Y stock (assuming there was no built in loss), to compute its gain on the sale of the New Y stock. X would be very grumpy if the IRS disagreed because all steps occurred in the same tax year. X would rely on the fact that “circumstances changed” after the acquisition/liquidation and so it should be impossible to step those steps together with the recreation of New Y, which otherwise might result in a reincorporation of old Y into New Y, as a reorganization.
Other Basis Planning Techniques
The letter ruling is somewhat reminiscent of Basic, Inc., 549 F. 2d 740 (Ct. Cl. 1977). X caused Y to dividend Z to X so that X could sell Z rather than Y selling Z, because the Z stock basis would be higher, due to the way the intercompany dividend/basis rules then worked. The Court of Claims nixed that effort. So maybe the “rule” is, if you could have once achieved the better result you can engineer your way back into that position, at least within the same tax year; but if you have to engineer your way into the better stock basis, it does not work?
The primary takeaway from the ruling is that a purchased basis in stock should not be lightly discarded. If the purchaser and seller did not make a section 338(h)(10) election, whereby the cost of the stock becomes the cost of the assets of the target in the “reborn” target corporation, then the cost basis in the target stock is a valuable attribute. Indeed it is so valuable that the Treasury has spend almost 15 years trying to craft a “loss disallowance rule” to prevent sellers of such stock from recognizing stock losses.
The secondary takeaway is that making a procedural footfault need not be the end of the story. Either “9100 relief” for missed IRS elections or reversal of steps relief as in the instant ruling can be ways to save the day.