United States

IRS issues guidance for prespin-off recapitalizations into control

Revenue procedure addresses whether recapitalization is respected

TAX ALERT  | 

In issuing Rev. Proc. 2016-40, the IRS has provided two safe harbors for taxpayers regarding recapitalizations that may occur prior to and after a section 355 distribution.

What is a recapitalization into control?

To qualify as a tax-free section 355 distribution, the distributing corporation (D) must distribute stock representing ‘control’ of the controlled corporation (C). Control for this purpose is defined as 80 percent of the voting power of C and 80 percent of each class of stock not eligible to vote. Value is generally not a factor in determining control for this purpose. As a result, D may look to distribute C stock to its shareholders in a tax-free section 355 distribution even if it owns less than 80 percent of the value of C. To accomplish this, C could recapitalize its equity structure and issue to D shares of C that represent control.

Example: D owns roughly 55 percent of C’s voting common stock that represents C’s only class of stock. Each share of common stock holds a single vote. For D to distribute C in a tax-free transaction, D must own and distribute control. To obtain requisite control, C restructures its equity by issuing D ‘high vote’ common stock with four votes per share. Following the equity restructuring, D owns approximately 83 percent of the voting power (220 votes of a total of 265) of C and with no nonvoting stock outstanding, D has control of C and is able to distribute C in a qualifying section 355 transaction assuming all other requirements are met.

IRS concerns

The IRS has become concerned with these recapitalizations due to the fact that C often would unwind the recapitalization following the distribution by D, making the equity restructuring appear transitory. The fact that the IRS no longer is willing to rule on such transactions has made restructuring into control difficult due to the uncertainty as to how future transactions could impact the tax-free nature of the distribution. To help alleviate this uncertainty, the IRS has issued two safe harbors for taxpayers that undergo a pretransaction recapitalization into control.

Rev Proc 2016-40 safe harbors

Safe Harbor 1 applies if there is no action taken (including a plan) for 24 months following the distribution of C by C’s management, board of directors or controlling shareholders that would unwind the previous recapitalization.

Safe Harbor 2 applies where unwind of the previous recapitalization occurs as a result of an unanticipated third party transaction such as a merger or acquisition transaction. The safe harbor looks to the rules of Reg. section 1.355-7 to establish that the transaction was unanticipated and further limits shareholder overlap between C and the other party to the unwind.

In the event unwind of the recapitalization of control does not fall within a safe harbor, the revenue procedure has no bearing on the treatment of the transaction and all facts and circumstances would control treatment of the distribution.

Summary

Rev. Proc. 2016-40 provides welcome guidance and certainty to taxpayers in certain limited circumstances. To the extent a recapitalization into control is being considered to achieve a tax-free section 355 distribution or have done so and are concerned about unwinding the recapitalization, this new revenue procedure may be helpful. Contact your tax advisor to fully understand the tax impact of any restructuring surrounding a section 355 distribution.

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