This Month in M&A / Issue 7 / July 2015

This Month in M&A / Issue 7 / July 2015
Did you know…? p2 / Final Treasury Regulations p6 / Proposed Regulations p7 /
Private Letter Rulings p9 / Other Guidance p11
M&A tax recent guidance
This month features:

Potential gain avoidance by corporate partners addressed in Section 337(d) temporary regulations
(TD 9722 and REG-149518-03), Section 732(f) proposed regulations (REG-1398759-14)

Final Section 7874 regulations determine whether expanded affiliated group (EAG) has
substantial business activities in a foreign country (TD 9720)

Final Section 382 regulations affirms a loss corporation does not have a Section 382 ownership
change when Treasury sells stock acquired under EESA (TD 9721)

Proposed Section 1502 regulations address ‘circular basis’ issues within consolidated group
(REG-101652-10)

Pre-spin distribution of cash to Distributing creditors viewed as made pursuant to a plan of
reorganization under Sections 361(b)(1)(A), 361(b)(3) (PLR 201524005)

IRS applies “look-through approach” to determine gross receipts under Section 165(g)(3)(B)
(PLR 201524016)

Section 752 regulations found not to control whether debt is recourse or nonrecourse under
Section 1001 (CCA 201525010)
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Did You Know…?
The 23-year-old proposed regulations under Section 337(d)—commonly known as the
‘May Company’ regulations—were retired this June with issuance of new temporary and
proposed regulations under Section 337(d). On June 11, the IRS issued temporary
regulations under Section 337(d) (TD 9722 and REG-149518-03), replacing proposed
regulations (REG-208989-90) issued in 1992. The purpose of the Section 337(d)
regulations is to prevent corporate taxpayers from using a partnership to circumvent
repeal of the General Utilities doctrine; the repeal requires corporations generally to
recognize any gain in distributed property.
The temporary regulations apply to transactions occurring on or after June 12, 2015.
Observation: Taxpayers had been concerned that new May Company guidance might be
made retroactive to March 9, 1989, when the IRS issued Notice 89-37 announcing an
intent to issue proposed regulations under Section 337(d). In light of the length of time
since the 1992 proposed regulations were issued, the IRS acted reasonably in issuing
temporary regulations that became applicable on publication and that do not have
retroactive effect.
The IRS simultaneously issued proposed regulations under Section 732(f) (REG1398759-14), which, like the Section 337(d) regulations, are aimed at preventing a
corporate partner from avoiding corporate-level gain on appreciated property through
partnership transactions involving the distribution of stock to a corporate partner. These
regulations are proposed to be effective for distributions and transactions occurring on
or after the date final regulations are published final regulations. The preamble states
that no inference is implied with respect to distributions or transactions occurring before
the date final regulations are published.
May Company Regulations
Background
Prior to the Tax Reform Act of 1986, a corporation generally did not recognize gain or
loss on distributions of appreciated property to its shareholders (the General Utilities
doctrine). The 1986 Act repealed the General Utilities doctrine so that corporations
generally recognize gain on distributions of appreciated property to shareholders under
Sections 311(b) and 336(a).
The 1986 Act also added Section 337(d), providing that the IRS shall prescribe
regulations to ensure that the purposes of General Utilities repeal cannot be
circumvented through the use of any provision of law or regulations. The Section 337(d)
regulations are intended to prevent a corporate taxpayer from using a partnership to
circumvent Section 311(b), for example, by contributing appreciated property to a
partnership and receiving a distribution of its own stock without recognizing gain on the
appreciated property. Generally, a corporate partner recognizes gain under the
temporary regulations when it exchanges appreciated property for its own stock held by
the partnership in a manner that avoids gain recognition under Sections 311(b) or 336(a).
Stock of a corporate partner
The temporary regulations generally apply to a partnership that, either directly or
indirectly, owns, acquires, or distributes ‘stock of a corporate partner.’ Stock of a
corporate partner does not include stock if all the interests in the partnership are held by
members of an affiliated group of corporations (as defined in Section 1504(a)).
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The 1992 proposed regulations, which also would have applied to certain partnership
transactions involving stock of a corporate partner, defined stock of a corporate partner
to include stock or other equity interests of the corporate partner and of its ‘Section
337(d) affiliates’ (as defined in Section 1504(a) excluding Section 1504(b)). The
temporary regulations revise the definition of stock of a corporate partner to include
stock or other equity interests (including options, warrants and similar interests) of the
corporate partner and of a corporation that ‘controls’ the corporate partner within the
meaning of Section 304(c). Section 304(c) control requires an ownership of stock
possessing at least 50 percent of the total combined voting power of all classes of voting
stock or at least 50 percent of the value of the shares of all classes of stock.
Observation: While the new definition apparently was intended to narrow the scope of
transactions to which the temporary regulations apply, the reference to Section 304(c)
draws in the attribution rules of Section 318 pursuant to Section 304(c)(3), thereby
considerably broadening the scope of what qualifies as stock of a corporate partner. For
example, the definition of corporate partner stock in the temporary regulations does not
encompass stock of a sister corporation, subsidiary, or lower-tier Section 337(d) affiliate
of the corporate partner, unless, however, that corporation owns—directly or indirectly
through attribution—stock of the corporate partner or stock of a corporation that
controls (as defined in Section 304(c)) the corporate partner.
The IRS has since issued a correction to the temporary regulations to clarify that in
determining Section 304(c) control for purposes of the definition of stock of a corporate
partner, Section 318(a)(1) (attribution among family members) and Section 318(a)(3)
(attribution to corporations and other entities) shall not apply. This effectively limits the
definition of corporate partner stock under the temporary regulations to corporations
that own an interest in the corporate partner, as originally was intended by the IRS.
Deemed redemption rule
The ‘deemed redemption rule’ remains the centerpiece of the temporary regulations. A
corporate partner recognizes gain under that rule if the transaction has the effect of an
exchange by a corporate partner of its interest in appreciated property for an interest in
stock of the corporate partner owned, acquired, or distributed by a partnership. The
corporate partner must determine the amount (by value) of appreciated property (other
than stock of the corporate partner) that is deemed exchanged for stock of the corporate
partner in order to calculate the amount of taxable gain recognized.
The deemed redemption rule in the temporary regulations applies only with respect to
the corporate partner’s incremental increase in the stock of the corporate partner; this
limitation is intended to prevent duplicate gain recognition by the corporate partner. The
temporary regulations also require certain basis adjustments to be made to the
appreciated property that is treated as the subject of the Section 337(d) transaction and
to the basis of the corporate partner’s interest in the partnership in order to avoid further
duplication of gain.
Modified distribution rule
The 1992 proposed regulations contained an overly broad distribution rule that would
have required a corporate partner to recognize gain on a distribution from the
partnership of the stock of a corporate partner. The temporary regulations apply a
narrower rule, which is a modified version of the redemption rule, to partnership
distributions of stock of a corporate partner to the corporate partner.
The new deemed redemption rule applies to a partnership’s distribution only if (i) the
distributed stock of a corporate partner previously has been the subject of a Section
337(d) transaction or it becomes the subject of a Section 337(d) transaction as a result of
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the distribution and (ii) Section 732(f) does not also apply to the distribution when made.
Under the modified distribution rule, the corporate partner must recognize the gain, if
any, that it would recognize under the deemed redemption rule if the partnership had
amended its partnership agreement immediately before the distribution of the corporate
partner stock to allocate 100 percent of the distributed stock to the corporate partner and
an appropriately reduced interest in other partnership property away from the corporate
partner. Therefore, to the extent the distribution results in the exchange of appreciated
property by the corporate partner for the stock of the corporate partner, gain is
recognized under the modified distribution rule.
In addition to any gain recognized under the modified distribution rule, the temporary
regulations require the corporate partner to recognize additional gain on the distribution
of the corporate partner stock to the corporate partner to the extent the partnership’s
basis in the distributed stock of the corporate partner exceeds the corporate partner’s
basis in its partnership interest immediately before the distribution. The temporary
regulations add special basis rules under Sections 337 and 732 to cause the distributed
stock of a corporate partner to be deemed to be distributed prior to any other property
distributed in the same transaction, with the exception of cash, in order to maximize the
corporate partner’s basis in the distributed stock of a corporate partner.
De minimis and inadvertence exceptions; tiered partnerships
The temporary regulations retain the de minimis and inadvertence exceptions from the
1992 proposed Section 337(d) regulations, with minor modifications. The temporary
regulations require taxpayers to apply the regulations to tiered partnerships in a manner
consistent with the purpose of the regulations. For example, a partnership must take into
account stock held or acquired by any lower-tier partnership in determining whether a
partnership holds or acquires stock of a corporate partner.
Observations
According to the preamble, the temporary regulations aimed to narrow the definition of
stock of a corporate partner to include stock or other equity interests of any corporation
that has Section 304(c) control of the corporate partner. However, because Section
304(c) incorporates, by reference, the attribution rules of Section 318, the new definition
encompassed all affiliates of a corporate partner and could have broadened the
definition. The corrections issued by the IRS, which exclude Sections 318(a)(1) and (3)
attribution rules from applying, should limit such broadening.
Proposed Regulations under Section 732(f)
Gain elimination transactions
Section 732(f) generally requires the basis of a distributed corporation’s assets to be
reduced to the extent the basis of the distributed corporate stock is reduced upon the
distribution from the partnership and the distributee corporate partner controls (within
the meaning of Section 1504(a)(2)) the distributed corporation immediately after the
distribution or at any time thereafter. Absent the basis reduction in corporate assets, the
corporate partner could eliminate its built-in gain in the partnership by liquidating the
corporation under Sections 332 and 337.
The statute provides an exception to the application of Section 732(f) for certain
distributions in which control is later acquired by the corporate partner. Pursuant to the
exception, Section 732(f) will not apply to the distribution if the corporate partner does
not have control of the distributed corporation immediately after the distribution and the
corporate partner establishes that such distribution was not part of a plan or
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arrangement to acquire control of the distributed corporation.
The proposed regulations under Section 732(f) issued June 11 add a rule intended to
prevent eliminating gain in the stock of a distributed corporation, while avoiding the
effects of a basis step-down in transactions in which the corporate partner’s ownership of
the distributed corporation does not satisfy the control requirement. The proposed
regulations provide that if the stock of a corporation is distributed by a partnership to a
corporate partner in a transaction in which Section 732(f) does not apply (because the
‘control’ requirement is not met) and if such stock of the distributed corporation
subsequently is disposed of in a transaction in which less than all the gain is recognized
(a gain elimination transaction), then Section 732(f) would apply as though the corporate
partner acquired control (within the meaning of Section 1504(a)(2)) of the distributed
corporation immediately before the gain elimination transaction.
The proposed regulations under Section 732(f) further provide that gain elimination
transactions would include (without limitation) reorganizations under Section 368(a) in
which the corporate partner and the distributed corporation combine and a distribution
of the distributed stock by a corporate partner to which Sections 355(c)(1) or 361(c)(1)
apply. The proposed gain elimination rule does not apply if (1) in exchange for the
distributed stock, the transferor of the distributed stock receives stock or a partnership
interest that is exchanged-basis property with respect to the distributed stock, or (2) a
transferee corporation holds the distributed stock as transferred-basis property with
respect to the transferor corporation’s gain.
Aggregation of basis
The proposed Section 732(f) regulations add a second rule that effectively narrows the
application of Section 732(f) in certain circumstances by allowing distributee corporate
taxpayers that are part of the same consolidated group to aggregate their outside tax
bases in a partnership, rather than applying Section 732(f) on a partner-by-partner basis.
The proposed rule specifically provides that if (1) two or more partners receive a
distribution of stock in another corporation and (2) the distributed stock is stock of a
corporation that is or becomes a member of the distributee partners’ consolidated group
following the distribution, then Section 732(f) would apply only to the extent that the
partnership’s adjusted basis in the distributed stock immediately before the distribution
exceeds the aggregate basis of the distributed stock of the corporation in the hands of the
corporate partners that are members of the same consolidated group immediately after
the distribution.
The rule is limited to consolidated groups and thus does not apply to the distribution of
shares of a controlled foreign corporation (CFC). The preamble states that the
requirement that the distributed corporation be a member of a consolidated group is
meant to avoid "unintended consequences" that could result if that corporation was a
CFC. However, the IRS requests comments on whether this proposed aggregation rule
should apply more broadly.
Tiered partnerships
Similar to the Section 337(d) temporary regulations, the Section 732(f) proposed
regulations require taxpayers to apply the regulations to tiered partnerships in a manner
consistent with the purpose of the regulations.
For additional information, please contact Karen Lohnes, Elizabeth Amoni, Michael
Hauswirth, or Megan Stoner.
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Final Treasury Regulations
Final Section 7874 regulations on determining whether an EAG has
substantial business activities in a foreign country
In general
The IRS June 4 published final regulations under Section 7874 (TD 9720) intended to
clarify the factors used to determine whether a corporation is a ’surrogate foreign
corporation.’ Specifically, the regulations set forth a bright-line test for determining
whether an expanded affiliated group (EAG) will be considered to have substantial
business activities in a foreign country.
The final regulations, which modify temporary regulations published on June 12, 2012
(TD 9592), apply to acquisitions completed on or after June 3, 2015. For further
discussion of TD 9592, see the July 2012 edition of This Month in M&A.
Generally, a foreign corporation can avoid treatment as a surrogate foreign corporation—
and therefore the limitations placed on certain of its tax attributes—if the EAG has
substantial business activities in the relevant foreign country. The final regulations retain
the bright-line test introduced in the temporary regulations, requiring that at least 25
percent of the group employees, group assets, and group income are located or derived in
the relevant foreign country. The IRS did not accept comments arguing that there is
insufficient support in the legislative history to Section 7874 for the bright-line rule;
instead, noting that the test is consistent with Section 7874 and its underlying policies,
and additionally noting that it is also more administrable than the prior facts-andcircumstances test.
Final regulations
The final regulations adopt the definitions of ’group employees,’ ’group assets,’ and ‘group
income’ from the prior rules, with certain modifications.
Group employees: The final regulations specify that the determination of the
number of employees must account for all members of the EAG under either (1)
US federal income tax principles or (2) the relevant tax laws in the jurisdiction of
the foreign corporation, but not both. The IRS declined to include independent
contractors as employees in certain circumstances for purposes of this test.
Group assets: The final regulations add that mobile assets physically present in
the relevant foreign country for more time than in any other country during the
testing period are considered present in such foreign country for determining
whether the 25-percent threshold is satisfied.
Group income: The final regulations specify that group income must be
determined consistently for all members of the EAG using either US federal
income tax principles (e.g., GAAP) or relevant financial statements (e.g., IFRS).
The final regulations state that an entity that is not a member of the EAG on the
acquisition date is not a member of the EAG, even if it would have qualified as a member
at some earlier point during the testing period. Further, an entity’s disposition of all its
assets may or may not cause it to cease to be a member of the EAG depending on whether
the entity remains in existence on the acquisition date. Finally, consistent with the rule in
Notice 2014-52, the final regulations clarify that members of the EAG are determined by
taking into account all transactions related to the acquisition, even if they occur after the
acquisition date.
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The final regulations also add a look-through rule, whereby in determining which
corporations are members of the EAG, each partner in a partnership is treated as holding
its proportionate share of the stock held by the partnership.
In addition, the final regulations revise the ‘anti-abuse’ rule set forth in the temporary
regulations by excluding from the group employees, group assets, and group income tests
certain items associated with a transfer of property to an EAG that are disregarded under
Section 7874(c)(4).
Observations
The IRS retained the bright-line rule set forth in the temporary regulations, which
appears to have been designed so that the statutory exception will rarely apply. While it
can be questioned whether the approach is consistent with congressional intent, the IRS
rejected comments that there is insufficient support for the bright-line rule and
concluded that the rule is consistent with Section 7874 and its underlying policies. The
preamble to the regulations provides that the bright-line rule is more administrable than
a facts-and-circumstances test and has the benefit of providing certainty in applying
Section 7874 to particular transactions. At the same time, retaining the bright-line rule
may suggest that the IRS will continue to scrutinize US company moves aboard.
For more information, please contact Carl Dubert or Tim Lohnes.
Final Section 382 regulations relating to EESA
The IRS June 5 published final regulations under Section 382 (TD 9721) affecting loss
corporations whose stock is or was purchased by Treasury under the Emergency
Economic Stabilization Act of 2008 (EESA). The final regulations preclude such loss
corporations from experiencing a Section 382 ownership change when Treasury sells
stock purchased under EESA. The final regulations adopt without substantive change the
text of temporary and proposed regulations issued on July 31, 2014 (TD 9685 and REG105067-14) and remove the corresponding temporary regulations. For a discussion of the
temporary and proposed regulations, see the August 2014 edition of This Month in M&A.
Observations
In Notice 2010-2, the IRS provided that Treasury’s sale of stock acquired under the EESA
could not itself trigger an ownership change under Section 382. However, the IRS
became concerned that amendments to the Section 382 regulations in October 2013 (TD
9638) may have rendered Notice 2010-2 inoperative. The final regulations ensure that
the rule in Notice 2010-2 continues to apply.
For additional information, please contact Rich McManus, Olivia Ley, or Andrew
Gottlieb.
Proposed Regulations
Proposed Section 1502 regulations on ‘circular basis’
The IRS June 11 published proposed regulations (REG-101652-10) intended to provide
relief and certainty in cases in which the current regulations fail to prevent the so-called
circular basis problem within a US consolidated group. The regulations are largely
mechanical in nature and would provide an alternative four-step computation of
consolidated taxable income in certain situations. The regulations are proposed to apply
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to consolidated return years beginning on or after the date final regulations are published
as final.
The circular basis problem
To prevent the income, gain, deduction, or loss of a member from being reflected more
than once within a consolidated group, the consolidated return regulations require
adjustments to be made to a member’s basis in subsidiary stock to reflect those items
(investment adjustments). For example, if a consolidated group absorbs a subsidiary
member’s net operating losses (NOLs), the basis in the stock of the subsidiary member is
reduced by the absorbed losses.
In certain instances, the investment adjustments resulted in a situation where a
consolidated group would be required to make iterative investment adjustments that
ultimately utilized the member’s entire NOL without changing the consolidated group’s
net taxable income—the circular basis problem. For example, assume a member of a
consolidated group (M) recognized gain from selling the stock of a member (S) with
NOLs. S’s NOLs would be used to offset the gain, resulting in a reduction of M’s basis in
the S stock immediately before the sale, causing additional gain on the sale of the S stock
that could be offset by even more of S’s NOLs. This cycle would repeat itself until S’s
NOLs were fully utilized.
Current regulations
The current regulations circumvent the circular basis problem in certain situations. They
operate by determining a maximum amount of S’s deduction or loss that may be used to
offset income or gain recognized on the sale of the S stock (the absorbed amount) by M.
The absorbed amount is determined by tentatively computing taxable income (or loss) for
the year of the sale (and any prior years to which the deductions or losses may be carried)
without taking into account M’s income and gain from the sale.
Once the absorbed amount is determined, M’s basis in the S stock is then adjusted by an
amount equal to the absorbed amount, but only to the extent it is actually absorbed in
computing consolidated taxable income (CTI). After the adjustment is made, gain or loss
on the sale of the S stock is recognized and included in CTI, and the absorbed amount is
applied against CTI with no further adjustments required. The current regulations,
however, fail to resolve the circular basis problem in all cases.
Proposed regulations
The proposed regulations generally would apply an approach similar to the current
regulations if the entire absorbed amount is actually absorbed in computing CTI. If the
full amount of the absorbed amount is not used, the proposed regulations set forth an
alternative four-step approach. The steps of the alternative approach would be as follows:
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Step 1:
Compute CTI by excluding any income, gain, or loss on any share of
subsidiary stock and use the losses of each disposed of subsidiary equal
in both amount and character and from the same taxable years as those
used in the computation of its absorbed amount.
Step 2:
To the extent the disposing member has net income or gain on the
subsidiary stock and a loss of the same character (determined without
regard to the stock net income or gain), the disposing member’s loss is
used to offset the net income or gain on the subsidiary stock to the
extent of such income or gain. Any remaining net income or gain is
added to the consolidated group’s remaining income or gain
determined in Step 1.
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Step 3:
If, after Step 2, the consolidated group has remaining income or gain
and a disposing member has a net loss on subsidiary stock, that income
or gain is then offset by the loss on the disposition of subsidiary stock.
The amount of the offset is limited to the lesser of (1) the total
remaining ordinary income or capital gain of the consolidated group
(determined after the application of Step 2) or (2) the amount of the
disposing member’s ordinary income or capital gain (determined
without regard to the stock loss).
Step 4:
If the consolidated group has remaining income or gain, the unused
losses of all members are applied on a pro rata basis.
Observations
The proposed regulations appear to be a welcome refinement to the current circular basis
regulations. They seem to resolve a broader range of circular basis scenarios and do so in
a way that is both mechanical and administrable, replacing a variety of approaches
taxpayers currently are using in the absence of other guidance. While it is not certain that
the proposed regulations would resolve all circular basis problems, it appears they would
address a majority of the issues troubling taxpayers.
For more information, please contact David Friedel, Olivia Ley, or Viraj Patel.
Private Letter Rulings
PLR 201524005
The PLR addresses whether Distributing’s repayment of debt to unrelated creditors
before a D/355 transaction could be considered a payment to creditors pursuant to the
plan of reorganization within the meaning of Section 361(b)(3).
Facts
Distributing was the common parent of a US consolidated group that conducted Business
A and Business B. As part of an overall plan to spin off Business A to its public
shareholders, Distributing formed Controlled and repaid pre-existing debt to unrelated
creditors. Thereafter, Controlled borrowed from third-party lenders, and Distributing
transferred the Business A assets to Controlled in exchange for Controlled common stock,
the assumption of liabilities, and a portion of the money Controlled borrowed (the Special
Distribution) (collectively, the Contribution).
Distributing repaid additional pre-existing debt and then distributed the stock of
Controlled to its shareholders (the Distribution). Following the Distribution, Distributing
intended to (1) distribute the Special Distribution to its shareholders through quarterly
dividends, redemptions pursuant to existing stock repurchase plans, or otherwise, or (2)
transfer the Special Distribution to its creditors within an unspecified number of months
following the Distribution.
IRS analysis
The IRS ruled that Distributing’s repayment of existing debt before the Special
Distribution could be considered a payment to creditors within the meaning of Section
361(b)(3) provided that it otherwise qualified as a distribution in pursuance of the plan of
reorganization under Sections 361(b)(1)(A) and 361(b)(3). The PLR also concluded that
Distributing’s proposed use of the Special Distribution would be treated as a distribution
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in pursuance of the plan of reorganization within the meaning of Section 361(b) provided
that the Contribution and the Distribution together qualified as a reorganization within
the meaning of Sections 368(a)(1)(D) and 355.
Observations
The IRS appears to have granted the taxpayer in this PLR considerable flexibility in
structuring and executing its transaction. While some practitioners take the view that
funds used to pay creditors within the meaning of Section 361(b)(3) must be tied directly
to the funds transferred from Controlled to Distributing, the IRS in the PLR seemed
willing to provide some leeway to taxpayers in ordering the transactions—at least under
the facts involved—as long as the two steps are part of the same overall plan. This PLR
may indicate how the IRS might react to similarly situated taxpayers who face difficulty
structuring their D/355 transactions strictly in accordance with Section 361.
For more information, please contact Derek Cain or Rich McManus.
PLR 201524016
This PLR concluded that a holding company calculating its gross receipts for purposes of
the Section 165(g)(3) worthless securities rule includes all gross receipts received in
intercompany transactions and Section 381 transactions. Further, gross receipts received
in intercompany transactions are treated as ‘gross receipts from passive sources’ only to
the extent they are attributable to the other party’s gross receipts from passive sources
(the look-through approach).
Under simplified facts, Parent, the common parent of a consolidated group (the Parent
Group), owned all the stock of Holdco 1, which in turn owned all the stock of Holdco 2.
Holdco 2 owned Subsidiary, which in turn owned S1 and a number of other direct and
indirect subsidiaries. Holdco 2 and its subsidiaries disposed of most of their assets to a
third party for cash (the Asset Sale), retaining some to partially repay certain retained
liabilities. Prior to the Asset Sale, Fmr Sub A and Fmr Sub B, subsidiaries of S1, had
merged into Subsidiary in a Section 381 transaction.
In order to claim a worthless stock deduction as an ordinary loss, Section 165(g)(3)
requires in this situation that (1) Holdco 1 directly own at least 80 percent of the voting
power and 80 percent of the value of Holdco 2’s stock, and (2) more than 90 percent of
Holdco 2’s aggregate gross receipts for all taxable years have been from sources other
than royalties, rents, dividends, interest, annuities, and gains from sales or exchanges of
stock and securities. The IRS ruled in the PLR that Holdco 2’s gross receipts include all
amounts of gross receipts received in intercompany transactions and Section 381
transactions. The amount of gross receipts received in intercompany transactions that
constitute gross receipts from passive sources is determined using the look-through
approach.
Observation
This PLR is consistent with several prior letter rulings addressing a similar issue,
including PLRs 200932018 and 201011003 (see the September 2009 and April 2010
editions of This Month in M&A, respectively). Similarly, see PLR 200710004 (discussed
in the April 2007 edition of This Month in M&A) for one of the first rulings to include
gross receipts as a Section 381(c) carryover attribute even though it is not specifically
enumerated in Section 381. PLR 201524016 continues the IRS trend of rulings that apply
the look-through approach to determine whether a worthless subsidiary satisfies the
gross receipts test under Section 165(g)(3)(B).
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For additional information, please contact Tim Lohnes, Horacio Sobol, or Andrew
Gottlieb.
Other guidance
CCA 201525010
This Chief Counsel Advice Memorandum (CCA) concerns the definition of recourse and
nonrecourse indebtedness for purposes of Section 1001 in particular, with respect to
indebtedness of a special purpose entity (SPE) formed as a limited liability company
(LLC) under the relevant state law (which is taxed as a partnership for federal tax
purposes), and whose members have pledged their respective membership interests in
the entity and have provided personal guarantees in connection with the indebtedness,
which is also secured by the assets of the LLC.
Facts
The taxpayer LLC was an SPE organized to purchase real property and to construct,
market, and sell the homes that it built on such property. The taxpayer was prohibited
from engaging in any business unrelated to owning and developing the property and had
no assets other than those related to the property. The taxpayer received loans from a
third-party lender in order to develop the property. The notes underlying the loans were
secured by a deed on the property, pledges of membership interests in the taxpayer by its
members, and unconditional and irrevocable guarantees made by the members of the
LLC to the lender.
The taxpayer relinquished its last unsold parcel of real property to a lender in a nonjudicial foreclosure sale. The issue is whether the taxpayer, whose members were
insolvent at the time of the transaction, recognized (excludable) cancellation of
indebtedness (COD) income under Section 61(a)(12) as a result of the foreclosure sale
due to the recourse nature of the debt, or whether the taxpayer recognized gain from
dealing in property under Section 61(a)(3) as a result of the foreclosure sale due to the
nonrecourse nature of the debt. The resolution of the issue depends on whether the debt
is recourse or nonrecourse under Section 1001.
Section 1001 analysis
Under Section 1001, the amount realized on a sale or disposition of property securing a
recourse liability does not include amounts that are COD income under section 61(a)(12).
Therefore, when property encumbered by recourse indebtedness is transferred in
satisfaction of a debt, the transaction results in an amount realized on sale and an amount
of COD income. The regulations under Section 1001 provide that when property securing
a nonrecourse liability is transferred in satisfaction of a debt, the amount realized
includes the full amount of liabilities from which the transferor is discharged as a result of
the disposition. Therefore resolution of this issue depends on whether the indebtedness
of the LLC is recourse or nonrecourse under Section 1001.
Treas. Reg. sec. 1.1001-2(c) provides a brief definition of recourse and nonrecourse for
purposes of Section 1001, and provides that a loan is recourse if the borrower is
personally liable for the debt, and nonrecourse if the borrower is not personally liable for
the debt and the creditor’s recourse is limited to the secured assets. The taxpayer LLC
argued that the section 752 regulations determine if partnership debt is characterized as
recourse or nonrecourse to a partnership for purposes of Section 1001, and under Section
752, the taxpayer’s debt is recourse.
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The Office of Chief Counsel (Income Tax & Accounting) responded that Section 752 is not
applicable because the regulations thereunder are limited to determining the partners’
basis in the partnership, and the definition of recourse and nonrecourse under Section
752 is specifically limited to issues under Section 752 and is not intended to extend to
issues under Sections 61 and 1001. The IRS stated that the issue of whether the debt is
recourse or nonrecourse for Section 1001 purposes requires a factual analysis of the
operating and loan documents and the relevant state law. While no conclusion is drawn
in the CCA whether the debt of the SPE LLC taxpayer is recourse or nonrecourse under
Section 1001, the IRS provides a summary of its observations to aid the practice office in
its analysis.
The CCA cites to Great Plains Gasification Associates v. Comm’r (T.C. Memo 2006-276)
as an example of the relevant facts and circumstances analysis that must be performed in
determining whether debt is recourse or nonrecourse under Section 1001. The CCA
concludes that when dealing with an LLC formed as a SPE, “the combination of the
Members’ pledges, general assignment of rights, and guarantees, in addition to the loan
being secured by all assets of the taxpayer as a result of its status as an SPE, may be
sufficient for the loan to be recourse to the entity.” Under the stated facts, express
unconditional personal liability language in the note may not be necessary to make the
debt recourse to the entity under Section 1001.
Observation
While the CCA does not resolve the technical issue, it provides insight into the IRS’s view
of the significant factors to consider in determining whether indebtedness of a
partnership is recourse or nonrecourse for purposes of Section 1001, which is an issue
that has received little attention in published guidance.
For additional information, please contact Jeffrey Rosenberg, John Schmalz, or Megan
Stoner.
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Let’s talk
For a deeper discussion of how this issue might affect your business, please contact:
Tim Lohnes, Washington, DC
Karen Lohnes, Washington, DC
+1 (202) 414-1686
+1 (202) 414-1759
[email protected]
[email protected]
Horacio Sobol, Washington, DC
Elizabeth Amoni, Washington, DC
+1 (202) 312-7656
+1 (202) 346-5296
[email protected]
[email protected]
Derek Cain, Washington, DC
David Friedel, Washington, DC
+1 (202) 414-1016
+1 (202) 414-1606
[email protected]
[email protected]
Wade Sutton, Washington, DC
Carl Dubert, Washington, DC
+1 (202) 346-5188
+1 (202) 414-1873
[email protected]
[email protected]
Rich McManus, Washington, DC
Jeff Rosenberg, Washington, DC
+1 (202) 414-1447
+1 (202) 414-1765
[email protected]
[email protected]
Olivia Ley, Washington, DC
John Schmalz, Washington, DC
+1 (202) 312-7699
+1 (202) 414-1465
[email protected]
[email protected]
Matthew Lamorena, Washington, DC
Michael Hauswirth, Washington, DC
+1 (202) 312-7626
+1 (202) 346-5164
[email protected]
[email protected]
Viraj Patel, Washington, DC
Megan Stoner, Washington, DC
+1 (202) 312-7971
+1 (202) 414-4549
[email protected]
[email protected]
Andrew Gottlieb, Washington, DC
+1 (202) 346-5079
[email protected]
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