Jack Cummings (aka Jasper L. Cummings, Jr.) writes in the November 12, 2012 Tax Notes at 797-808 about "The Demise of the Liquidation-Incorporation Doctrine." This is a must-read not only for corporate-tax policy wonks, but also for those who want to understand at least one of the reasons for the decrease in corporate taxes over the last few decades.
In the major rewrite to the tax code achieved in 1986, Congress legislatively undid the result of General Utilities, a case that allowed appreciated assets to leave corporate solution without taxation. That is, Congress enacted provisions, particularly section 311(b), that purports to eliminate the ability of corporations to make distributions of appreciated property to shareholders without paying the tax toll on the appreciation while in corporate solution, except for certain situations covered by section 332 (i.e., complete liquidation into a corporate parent) and section 368 (i.e., bootless corporate reorganizations) that explicitly provide for non-recognition of gain in target corporate assets. The policy grounds for nonrecognition in those provisions is that a domestic corporate parent or acquirer receives the corporate assets in kind, allowing a deferral of the recognition until the assets' later sale or distribution out of corporate ownership.
But the best-laid plans of mice and men oft go astray. And General Utilities repeal has gone astray at least in part with the avid assistance of Treasury and IRS, which Jack Cummings ably explains in his article.
Since 2000 we have witnessed another response to General Utilities repeal, this time with the aid of Treasury and the IRS: the conversion of the C reorganization (and sometimes the A reorganization) into a tool to avoid General Utilities repeal as well as dividend taxation, through the upstream reorganization plus reincorporation.
Today a corporate tax director who wants to move Business A out of Subsidiary X, leaving it with Business B, can do so by (1) making sure that X is a "checkable entity"; (2) checking the box to liquidate X into a disregarded entity; (3) having X transfer Business A to Parent; and (4) checking the box to reincoporate X. After those easy steps, which can be entirely invisible to the outside world, X may be more bnubile, more easily spun, or sold with less tax cost, because any gain in Business A need not be recognized.
Several conscious acts by Treasury and the IRS have led to this new escape hatch from General Utilities repeal: the 1996 reg. section 301.7701-1,-2, and -3 check-the-box rules; the 2000 repeal of the Bausch & Lomb doctrine; the 2007 adoption of the 'no recharacterization' regulation [Reg. section 1.368-2(k)], which is the subject of this article; and IRS ruling practice that confirms all the beneficial results of those changes. Id. at 797.
Cummings assesses a likely logical path that the Treasury and IRS may have followed to become comfortable with the reg's statement that these transactions would not be subject to recharacterization, and then concludes:
[T]he principal practical consequence of the rule, when combined with chief counsel's lenient attitude toward complete liquidations, is to permit a subsidiary to make a distribution to its parent without recognizing gain under section 311 or 361(c), and without the parent receiving a section 301 or 356 distribution. ... Those consequences may provide clarity, but they provide a very taxpayer-friendly clarity that writes out of the tax law the step transaction doctrine in cases of incomplete liquidation, even though the doctrine remains stated in reg. section 1.331-1(c) and section 346. Id. at 801.
But the step transaction is one of those regulations that states a doctrine established by the Supreme Court in multiple reorganization decisions. The step transaction doctrine surely can reveal Controlled to be the reorganization successor of Subsidary, and Congress has not provided otherwise.
Reg. section 1.368-2(k) has [therefore] left the law in a confused state, or perhaps in a near perfect state for spinoff planners who want electivity by form. Id. at 802.
Cummings discusses a number of "basic principles" -- including Congressional intent that section 332 control the nonrecognition and basis results of liquidations; Congressional support for a "substantially all" criterion for reorgs; Congresional treatment of related corporation reorganizations as "special"; Congress's declining to provide that C reorgs cannot be recharacterized; and the reiteration of the liquidation-reincorporation rule in regulations -- and concludes that they "counsel strongly against writing a no-recharacterization rule." Id. at 806.
Whatever benefrits of certainty Treasury thought it would achieve by eliminating the cross-chain reorganization possibility have been swamped by the uncertainties it left or created ..., the closing agreements the IRS still has to seek, and the gutting of section 311 it has facilitated (not to mention further encouraging the notion that any consolidated group that pays tax on an excess loss account must have a stupid tax director). Id at 806.
Cummings concludes that the various "simplifications" discussed in the article are troubling:
[These simplifications] have led to the unexpected consequence that well-advised subsidiary corporations need never recognize section 311 gain. Perhaps that is good tax policy. . . . But usually when that type of tax policy is made it involves the action of Congress, not Treasury, particularly when Congress has indicated a contrary intention by repealing General Utilities. Id. at 808.
Tax practitioners and academics alike have thought that the open, communicative relationship among Treasury and IRS officials and the tax bar, demonstrable at any ABA tax section meeting, is generally good. It permits the bar to share with government officials real situations that may have escaped attention in a regulatory or legislative development, thus making officials aware of any potentially harmful impact of those proposed regulatory or legislative changes. At the same time, it allows the bar to comprehend the underlying rationales for proposals, thus providing a sound foundation for policy discussions.
But there are also real problems for tax administration if that relationship grows too cozy at the same time that there exists a continuing revolving door between service at the Treasury or IRS and significant positions as officers in the ABA or state bar associations and as commenters and panelists on regulatory or legislative proposals. Many of those officials remain in office, while many of their former teammates have resumed their careers and are frequent commenters on regulatory developments.
The taxpayer-friendly developments in the liquidation and reorganization areas under the Bush administration are a predictable result of that sometimes-too-cozy relationship and the corporatism inherent in much corporate tax lobbying. Regulatory developments -- in particular the regulations regarding recharacterization and gain and loss recognition in the reorg context and the many tax-saving opportunities opened by the check-the-box regs and the decision to recognize "upstream" reorganizations (like A reorg mergers of a subsidiary into a parent) --represent an overture to corporate taxpayers that is not merited by the current economic realities, the longstanding application of the step transaction doctrine in these contexts, nor even the actual language of the tax code.