LTR 201228002 involves a plain vanilla group structure change in a consolidated group owned by a foreign parent. The ruling is so obvious that one wonders why the taxpayer sought it. The explanation likely lies in the substantial tax savings that can be facilitated by the reverse acquisition. It is likely that someone at the taxpayers’ office said “this is too good to be true, no matter how clear my tax director says the results are, I don’t mind paying to get an IRS seal of approval on the transaction, no matter how many caveats it carries.”
The following example, with made up numbers, shows how tax benefits might be facilitated.
Example. FP owns all of the stock of D, with a basis of 100 and value of 600. D owns all of the stock of C, with a basis of zero and a value of 200; D also owns other property with a basis of 200 and value of 200. Therefore, D alone is worth 400 and C alone is worth 200. If FP sells D, FP will not owe U.S. tax. If D sells C, it will recognize 200 of gain. FP contributes D to new P owned by FP in a reverse acquisition. Under Reg. §1.1502-31, FP takes a basis in D equal to D’s net asset basis, which is 200, because D has no liabilities. Then D distributes the stock of C to P in a section 355 spinoff. P allocates the 200 basis of D stock according to value, and the stock of D takes a basis of 134 and the stock of C takes a basis of 66. If P sells C it will recognize gain of 134 (down from gain of 200). If FP then sells the stock of P owning only D, it will not owe any U.S. tax. By this transaction, the taxable gain inherent in the original D group stock has been reduced by 66 (one third) and FP has obtained more flexibility to dispose of C apart from D and vice versa.
Caveats and details. Now for the caveats and the details. We know that C owed money to D. That suggests C was capitalized more with loans than equity, meaning that the basis in the C stock might be low. It also sounds like C had the bigger or more active business, and so it may be substantially appreciated. Also, with D holding a lot of debt of C, D has a relatively high asset basis and probably does not own much money itself. That is why the example above supposes a low stock basis for C stock, and a high net asset basis for D.
The example above suggests that a, if not the principal, purpose for the restructuring was to put FP in a position to sell C at a lower U.S. tax cost; or to sell D and C separately. Readers will immediately note that such a sale could not occur quickly, and could not be too definitely planned, because section 355(e) could be triggered.
Be Prepared. But corporate taxpayers are wise to follow the Scout motto “Be Prepared.” There is nothing to be lost by getting subsidiaries into a position to be sold with tax efficiency. After all, most major corporate groups are run with almost as much attention to making money buying and selling subsidiaries as making and selling product.
Business Purpose? The taxpayer represented to the IRS that the spinoff was motivated by the desire to separate the risks of D and C. Let’s see how that might work out. From the facts, it is fair to assume that D is the wealthier company; it has lent money to C. So, presumably, the concern would be protecting D from C’s debts; after all, if D went broke, its creditors normally could not get at C, other than to sell C stock.
But D will remain subject to the legal risks of C to the extent D is C’s creditor. Moreover, it is highly unlikely in this day of tight credit that C’s commercial debt has not been guaranteed by D, the banker of the group. The only sort of legal risk of C that could be affected by a spinoff would be that D would no longer own a corporation that might go broke due to, say, tort liabilities. But, those tort liabilities normally cannot be collected from a parent corporation. If they could, they can now be collected from P, which now will own the valuable stock of D.
It is easy to mouth the words “separate the risks,” but the reality of the concept is elusive. The IRS has stopped reviewing documents of the taxpayer that might explain why it is concerned about risk, as evidenced by the ruling caveat as to business purpose. Therefore, this sort of ruling is sort of a free pass based on a business purpose that sounds sort of plausible so long as it is not examined.
IRS Audit. Here is where the benefit of the ruling comes in. If an IRS auditor examines the transaction, she will see a pretty standard consolidated group restructuring. She will see a letter ruling issued by chief counsel saying the transaction works. She will be facing an audit work schedule that identifies certain issues to be addressed and sets a time schedule for completion. If neither D nor C has by then been sold, she will not question the restructuring or the spinoff.
What if P has been sold? That will not even hit the audit radar. But part of FP’s plan might have been to make the D-C group a more attractive target to a buyer by pumping up the basis of the C stock.
If D or C has been sold, at most, the auditor might question whether one of the safe harbors of Reg. §1.355-7 applies, and surely one will, given the easy ability to plan into them.
Takeaway. In sum, the few thousand dollars the taxpayer spent on this obvious ruling (it was issued in two-and-a-half months) was well worth it. You can call it tax insurance.