In this edition of Planned Giving Online, Jonathan D. Ackerman, Esq. reviews the history of IRC section 337, the effect of newly issued final regulations on transfers of corporate assets to charitable organizations, and why the new rules might not apply to certain transfers to charitable remainder trusts.
By: Jonathan D. Ackerman, Esquire
In general, a corporation and its shareholders are subject to two levels of income tax. If a corporation sells an appreciated asset, it will pay a tax on the gain. When the net proceeds from the sales transaction are distributed to the shareholders of the corporation, the shareholders will pay a tax on the receipt of the proceeds. Therefore, the corporation (other than an S corporation) is deemed to be a separate entity for tax purposes and two levels of tax are imposed.
Since a corporation is a separate taxpaying entity, Treasury had consistently contended that a distribution of appreciated property to its shareholders should cause a taxable event to the corporation. Treasury contended that the corporation should treat a distribution of the appreciated asset as a sale. Since the asset has appreciated in value over the corporation's tax basis in the asset (i.e., acquisition cost of the asset), the corporation should pay a tax on the excess. An asset that has appreciated in value over the asset's tax basis is, in tax terminology, referred to as an asset with "built-in-gain."
Treasury unsuccessfully attempted to impose this corporate level tax on a distribution of appreciated property to its shareholders, and in 1935, the Supreme Court held that such a distribution would not cause a taxable event to the corporation. That landmark decision was General Utilities & Operating Co. v. Helvering, 296 US 200 (1935), and the court's conclusion actually reached the level of a tax doctrine, the General Utilities doctrine - a distribution by a corporation of appreciated property to its shareholders would not cause a corporate level tax.
Based upon this doctrine, a common transaction to avoid the corporate level tax arose: the shareholders would first distribute the assets in liquidation of the corporation and then sell the assets to a buyer. Although such a transaction would not cause a corporate level tax, shareholders would have to pay a shareholder level tax on the distribution, based upon the excess of the fair market value of the assets as compared to the shareholders' tax basis in their stock.
A practical problem correspondingly arose: What happens if the shareholders can't find a suitable buyer for the assets? The shareholders have unnecessarily incurred a capital gains tax on the liquidation.
In order to solve this practical problem, the corporate officers would negotiate a sale of the corporate assets. Once an agreement was reached, the shareholders would arrange for a liquidation of the corporation just prior to closing, and the shareholders would then sell those assets to the buyer. In another landmark decision, C.I.R. v. Court Holding Co., 324 US 331 (1945), the Supreme Court held that the substance of the transaction (i.e., a sale contemplated, negotiated and virtually closed by the corporation's officers) would control, and the taxable gain on the sale by the shareholders of the assets would be imputed back to the corporation. However, the Supreme Court in United States v. Cumberland Public Service Co., 338 US 451 (1950), refused to tax the corporation in a transaction where the shareholders first attempted to sell their stock and then offered to liquidate the corporation and sell the assets to the buyer. Although reaching contrary results in similar structures, the Supreme Court distinguished these two cases based upon their particular facts.
The General Utilities doctrine was codified in the Internal Revenue Code of 1954. Pursuant to IRC Sections 311(a)(2) and 336, either a current or a liquidating distribution of appreciated property to its shareholders would not be subject to a corporate level tax. In addition, and in an attempt to resolve the lack of certainty created by the Court Holding and Cumberland Public Services cases, Congress enacted IRC Section 337, which statutorily eliminated the corporate level tax upon a sale by the corporation of its assets and subsequent liquidation of the net sales proceeds to its shareholders. Of course, the shareholders were still subject to tax on the liquidating distribution.
Treasury finally prevailed. Along with many other significant tax changes, the Tax Reform Act of 1986 repealed the effect of the General Utilities doctrine. IRC Sections 311(b) (relating to non-liquidating corporate distributions of appreciated assets to shareholders) and 336(a) (relating to liquidating corporate distributions to shareholders) cause a corporate-level tax. In addition, since the general nonrecognition rule of IRC Section 337 was inconsistent with the statutory repeal of the General Utilities doctrine and the changes made to IRC Sections 311 and 336, the nonrecognition rule under "new" IRC Section 337 was limited to the liquidation of a subsidiary into its parent. Thus, the only tax-free liquidating corporate distribution of appreciated property is the liquidation of a subsidiary into its parent.
However, IRC Section 337 went even further. IRC Section 337(b)(2)(A) provides that, if the parent is a tax-exempt entity (i.e., a charity), the liquidation of a taxable subsidiary into the tax-exempt parent will cause a corporate tax at the subsidiary level. In addition, IRC Section 337(d) provided the Secretary of the Treasury with the right to issue Regulations to carry out the purposes of the General Utilities repeal and to prohibit the use of tax-exempt entities to circumvent those purposes.
The Big Picture. As may be expected, the Treasury issued Proposed Regulations on January 15, 1997 and finalized those Regulations in Treasury Decision 8802 on December 28, 1998. The Regulations generally provide that under either of two scenarios, a taxable event will be incurred at the corporate level:
(a) a taxable corporation transfers all or substantially all of its assets to one or more tax-exempt entities (Asset Sale Rule), or
(b) a taxable corporation changes its status to a tax-exempt entity (Change in Status Rule).
More Detail. IRC Section 337(b)(2)(B) and the new Regulations provide several exceptions to the Asset Sale Rule and the Change in Status Rule. If the tax-exempt entity uses the assets in an activity that generates unrelated business taxable income (UBTI), the corporation will incur no tax on the sale. If, however, the tax-exempt entity later sells the assets, it must incur UBTI on the gain. In addition, if the tax-exempt entity ceases to use those assets in an unrelated business, it will be deemed to have sold the assets on the date of such cessation.
What happens if the tax-exempt entity only partially uses those assets in an unrelated activity? The Regulations provide quite a bit of detail in this regard, but the end result is that the taxable corporation will incur a tax on a pro rata basis, based upon the representation made by the tax-exempt entity as to the percentage of use in an unrelated activity. If the expected unrelated use by the tax-exempt entity decreases, the tax-exempt entity will recognize the deferred gain in an amount that is proportionate to the decrease in unrelated activity use.
The Final Regulations exclude transactions that qualify for nonrecognition under IRC Sections 1031 (like kind exchange) and 1033 (involuntary conversions). In addition, any transfer of assets, which would otherwise cause a taxable event to the taxable corporation under another IRC provision, is excepted from the application of these tax recognition rules.
The Regulations define a taxable corporation as any corporation that is not a tax-exempt entity. A tax-exempt entity is defined as any entity exempt from tax under IRC Section 501(a) and thus, includes all private and public charities, as well as the other types of tax-exempt entities. The Regulations also clarify that the United States, a state, or any political subdivision are treated as tax-exempt entities for these purposes. It is important for gift planners to note that a charitable remainder annuity trust or a charitable remainder unitrust as defined in IRC Section 664(d) is also treated as a tax-exempt entity for this purpose.
In determining the definition of "substantially all" for purposes of the Asset Sale Rule, the Regulations refer to the corporate reorganization rules under IRC Section 368(a)(1)(C). The definition of "substantially all" under those rules is not defined in the statute; rather, the definition is based upon all of the facts and circumstances. The courts have considered various factors in determining whether a corporation has transferred substantially all of its assets, including but not limited to, the percentage of assets transferred, the types of assets retained (operating or investment), the purpose for the retention of assets and the liabilities of the corporation prior to the transfer. It should also be noted that, for the purposes of issuing a private letter ruling, the IRS announced that the "substantially all" requirement will be satisfied if:
1) there is a transfer of assets representing at least 90% of the fair market value of the net assets, and
2) at least 70% of the fair market value of the gross assets held prior to the transfer.
Needless to say, the determination of whether "substantially all" of the assets are transferred as applied to the Asset Sale Rule is not clear cut and potentially provides some planning opportunities.
The Regulations also contain an anti-abuse provision, which makes the Regulations applicable to any series of related transactions having an effect similar to the Asset Sale Rule or the Change In Status Rule. The Regulations are effective (as commented in the December 29, 1998, PGDC News Alert) for transfers of assets occurring after January 28, 1999, unless the transfer is pursuant to a written agreement which is (subject to customary conditions) binding on or before January 28, 1999. There are many other exceptions and special rules that have limited applicability and interest to charitable gift planners and are therefore not mentioned in this article.
Some commentators to the Regulations suggested that a gift of assets to charity should be treated differently than a transfer of assets because a gift is made without consideration and the donor generally is not taxed on the "built-in-gain" of a contributed asset. Treasury clarifies that the Regulations are not intended to affect the tax consequences of a corporation's gift of a portion (i.e., less than substantially all) of its assets to charity. The Regulations also do not affect the tax consequences when shareholders donate some or all of their corporate stock to charity. If, however, shareholders donate all or substantially all of their corporate stock to a charity and the charity then liquidates the corporation, IRC Section 337(b)(2) will tax the liquidating corporation on the gain.
As stated above, these rules apply to a charitable remainder trust (CRT). Thus, a transfer of all or substantially all of the assets of a taxable corporation to a CRT will cause a taxable event to the corporation. This is a significant departure from some typical planning opportunities. For instance, it was well established that a taxable corporation could be a donor to a term of years CRT. The unitrust or annuity trust payments would be made to the corporation for the defined term (not to exceed 20 years). However, the effect of the new Regulations is to cause a taxable event to the corporation for a gift of all or substantially all of its assets to the CRT. Such a result would not be taxwise. Of course, there are always other complicated corporate tax issues to be considered in any such plan, but these Regulations essentially eliminate the planner's ability to even suggest such a course.
The above analysis of the historical background of the taxation of corporations should clarify many issues in gift planners' minds. For instance, if all of the stock of a corporation is contributed to a CRT and the corporation then sells the assets, many planners had wondered whether a taxable event has occurred. The answer is clear. Although the CRT will not pay a tax, the corporation itself (as a separate taxpaying entity) will pay the tax on the sale. Likewise, if the CRT simply liquidates the corporation and then attempts to sell the assets, the corporation will again incur the tax. Both of these results obviate the tax benefits of but creating the CRT in the first place. The historical background also lays some of the groundwork for the step transaction (or the prearranged sales) analysis raised in the Palmer/Blake line of cases.
Emanuel J. Kallina, II, Esq., another member of the PGDC Editorial Review Panel, analyzed the application of these Regulations to a charitable remainder trust. In considering the effect of the definition of "substantially all," he wondered whether Treasury had contemplated the fact that a CRT represents a split-interest gift in which the donor ordinarily retains a significant income interest in the CRT. In effect, the corporate donor is not transferring substantially all of its assets, because the only transfer of assets being made relates to the present value of the remainder interest in the CRT.
Based on this possible confusion, Mr. Kallina contacted the IRS staff member who prepared these Regulations and offered the following example and questions:
An S corporation transfers all of its assets (having a value of $1,000,000 with a zero basis) to a 20 year CRT with an 8% payout. The charitable deduction for the transfer (i.e., present value of the charitable remainder interest) is calculated to be $200,000. Therefore, in reality, the corporation has transferred only 20% of its assets to the CRT. The corporation retains an interest in the other 80% of the assets by virtue of its retained income interest in the CRT. Is this transaction subject to the tax under the 337(d) Regulations? That is, does it fulfill the "substantially all" requirement?
When presented with this example, the IRS staff member commented that this was an interesting scenario and intimated that this situation was not considered when the Regulations were drafted. As expected, the IRS Agent was unwilling to commit that such a construction was viable.
What if this construction of the Regulations, as specifically applied to CRTs, permits a taxable corporation to contribute its assets to a CRT without recognizing a taxable gain?
Jonathan D. Ackerman is a partner in the Baltimore law firm of Kallina & Ackerman, LLP and is a member of the PGDC Editorial Review Panel.