IRS memo could affect treatment of section 1202 and carried interests

The Internal Revenue Service (the IRS or the Service) has issued a generic legal advice memorandum (GLAM or memorandum) addressing the meaningless gesture doctrine and holding periods of the stock following certain stockless contributions of capital to a corporation. The GLAM concludes that based upon the facts and circumstances of the two potentially abusive transactions, 1) section 351 applies to a meaningless gesture transaction (i.e., the contribution to capital by the sole shareholder of a wholly-owned corporation for no consideration), and 2) a split holding period is created in a meaningless gesture section 351 transaction. In addressing the apparent need for the memorandum, the IRS states that they have become aware of certain transactions where taxpayers enter into meaningless gesture transactions that “result in holding periods for corporate stock that are longer than the period of economic investment.”

Background

Section 351 is a nonrecognition provision that applies when the property is transferred by one or more persons to a corporation solely in exchange for that corporation’s stock, and immediately after the exchange, such person or persons are in control of the corporation.¹ If the property transferred is a capital asset or an asset as defined in section 1231, then the transferor has a holding period in the stock received that includes the holding period of the property transferred (i.e., a tacked holding period).² Generally, gain recognized on the sale or exchange of a capital asset (e.g., stock of a corporation) is taxable as long-term capital gain if the asset was held for more than one year.³

Meaningless gesture doctrine and holding periods

In the memorandum, the Service points to case law and its prior rulings that support the conclusion that a contribution of capital to a corporation by its sole shareholder, without the issuance of stock, still qualifies as a section 351 exchange.⁴ In this context of a meaningless gesture transaction to which section 351 applies, it has been unclear as to whether a stock is deemed issued or not. The case law does not provide for a deemed issuance of stock, nor does it appear to address holding period concepts.⁵ Rather, the cases address the issue in the context of whether a property transfer falls within section 351.⁶ Further, in 2009, the Service issued proposed regulations that would have treated stock as being deemed issued in a section 351 exchange where the issuance of stock otherwise would have been a meaningless gesture.⁷ While the proposed regulations were focused on basis tracing rules and did not explicitly provide for split holding periods upon the deemed issuance of stock, it is reasonable to infer that split holding periods would have applied to the deemed issued stock in a section 351 transaction.⁸ However, the proposed regulations were never finalized, were ultimately withdrawn in 2019,^9, and neither the proposal nor withdrawal was addressed in the GLAM.

Based upon the law above, it is unclear how the shareholder’s holding period of the stock would be affected by a section 351 exchange where no stock is issued. In other words, in a meaningless gesture transaction, would the holding period remain the same or would stock be deemed issued, thereby creating a split holding period? Under Rev. Rul. 85-164,¹⁰ a section 351 exchange occurred in which there was an actual issuance of stock in exchange for the transfer of multiple properties, with both short- and long-term holding periods. The ruling held that the stock issued in the exchange had a split holding period. The Service now takes the position in the GLAM that a split holding period occurs in stockless section 351 exchanges as well, but stops short of stating that there is a deemed issuance of stock in such transactions.

However, as illustrated by the discussion below, it is reasonable to infer that a deemed issuance and deemed recapitalization would occur in such circumstances in order to create a split holding period and split basis in the stock. Further, if there were split holding periods, split basis, and deemed recapitalization upon each contribution to determine the portion of basis that would take the new holding period, an added burden would be placed on taxpayers to value the company’s stock at each contribution.

Application of the meaningless gesture doctrine and split holding periods in the GLAM

Under the facts of the memorandum, there is an initial and valid section 351 exchange (i.e., the transfer by an individual shareholder of property to a corporation in exchange for all of the corporation’s stock). Of note is that the property contributed in the initial transfer is of negligible value. In situation 1, after the initial transfer and in the same year, the shareholder contributes cash to the corporation for no consideration. The shareholder, in the following year, sells the stock of the corporation and claims that all of the stock has a holding period exceeding one year. Situation 2 is the same except that the shareholder contributes in appreciated property to the corporation for no consideration in the transfer subsequent to the initial transfer. The Service states that after the subsequent transfers in both situations 1 and 2, the shareholder’s stock in the corporation has a split basis and split holding period to reflect the initial transfer and subsequent transfer. In other words, “the portion of each share attributable to the money [or property] transferred in the subsequent transfer[s] … has a holding period dating from the subsequent transfer[s].” According to the Service, such interpretation is consistent with the underlying principles of section 1223(1) that the holding period of the property and the sources of such property’s basis track one another. As a result, the stock attributable to the subsequent transfers has a holding period of less than one year when sold in the subsequent year, resulting in short-term (instead of long-term) capital gain to the shareholder.

It is important to note the recommendation in the GLAM that “the Service challenge transactions in which a shareholder's purported holding period in stock of a wholly-owned corporation ignores the effect of meaningless gesture transactions.” Further, the GLAM states that “[d]epending on the facts and circumstances, the Service may challenge the transaction on other grounds as well, including that the transaction lacks economic substance; that the form of the transaction does not correspond to its substance; or that a purportedly tax-free transfer to a corporation lacks business purpose or constitutes an ineffective assignment of income or conduit transaction.”

Consideration of potential impact on other Code provisions

The above analysis, as it relates to the meaningless gesture doctrine, suggests that mere capital contributions represent section 351 exchanges. Whether a capital contribution is a section 351 transaction, and further, whether it requires the creation of a split holding period, can significantly affect determinations of qualification of the benefits of sections 1202 and 1061.

Section 1202 provides for noncorporate taxpayers an exclusion from gross income of the gain from the sale or exchange of qualified small business stock held for more than five years.¹¹ If the meaningless gesture transaction analysis in the GLAM applies to treat a capital contribution as a section 351 exchange and further creates a split holding period, application of the exclusion could affect taxpayers positively or negatively. It is unclear if this would be the position of the Service, as such an interpretation may result in an expanded application of the per-issuer limitation under section 1202(b)(1)(B).¹² The statute seems clear that subsequent contributions to capital should not affect the 10 times aggregate basis exclusion; however, if meaningless gesture applies to create a deemed issuance and split holding period, it would seem the 10 times basis exclusion should apply to both the originally issued and deemed issued shares. On the flip side, where the contribution is made within five years of the sale of stock, the deemed issued shares would not appear to qualify for the exclusion due to the split holding period. To interpret the GLAM to suggest creating a split holding period but not increasing the 10 times basis exclusion would appear unreasonably taxpayer unfavorable. Likewise, for the gain exclusion (which has increased to 100% from a low of 50%),¹³ would capital contributions made while the gain exclusion on originally issued shares is 100% qualify as new shares, or is the GLAM suggesting a whipsaw to taxpayers by creating a split holding period but not allowing the increased exclusion percentage? Note that in examples 1 and 2 below, no attempt to create a holding period longer than the period of economic investment appears to exist.

Example 1:

A (an individual) incorporates X (a C corporation) in 2011 and contributes $10 million cash in exchange for 100% of the stock of X. A makes a subsequent contribution of $10 million to X in 2017, in which X does not issue stock in exchange. Assume X was a qualified small business, and the stock was qualified small business stock as defined within section 1202 at the date of the issuance and subsequent contribution. A sells the X stock in 2020, resulting in gain to A. If no split holding period and deemed issuance occurs from the 2017 contribution, then A receives the 100% exclusion percentage on the gain realized in the sale, but the 10 times aggregate basis exclusion is limited to the 2011 basis amount. If instead, a split holding period and deemed issuance occurs from the 2017 contribution, then A would not get the 100% exclusion percentage for the gain as it relates to the portion of stock resulting from the 2017 contribution.

Example 2:

A (an individual) incorporates X (a C corporation) in 2006 and contributes $10 million cash in exchange for 100% of the stock of X. A makes a subsequent contribution of $10 million to X in 2014, in which X does not issue stock in exchange. Assume X was a qualified small business and the stock was qualified small business stock as defined within section 1202 at the date of the issuance and subsequent contribution. A then sells the X stock in 2020, resulting in gain to A. If no split holding period and deemed issuance occurs from the 2014 contribution, then A receives only a 50% exclusion percentage on the gain realized in the sale, and the 10 times aggregate basis exclusion is limited to the 2011 basis amount. If instead, a split holding period and deemed issuance occurs from the 2014 contribution, then A would receive the 100% exclusion percentage and a separate 10 times aggregate basis exclusion for the gain as it relates to the portion of stock resulting from the 2014 contribution.

These inconsistent results illustrate that no matter the conclusion reached, a reasonable argument exists that section 1202 does not envision the application of the meaningless gesture doctrine to capital contributions.

Under section 1061, “applicable partnership interests” are afforded long-term capital gain treatment only if held by the taxpayer for three or more years.¹⁴ As with section 1202, the creation of split holding periods upon subsequent contributions to capital (characterized as stockless section 351 exchanges) would potentially deny the benefit of long-term capital gain treatment under section 1061 to the stock attributable to such contributions. Section 1061 does not provide any specific guidance for determining the holding period of stock for these purposes, but proposed regulations were recently issued under section 1061 (see our alert titled "IRS releases proposed carried interest regulations" on the proposed regulations).¹⁵ The proposed regulations provide that the relevant holding period is generally that of the asset being sold. This is consistent with the legislative history of section 1061, which cites section 702 and provides “[t]he character of partnership items passes through to the partners as if the items were realized directly by the partners. Thus, for example, long-term capital gain of the partnership is treated as long-term capital gain in the hands of the partners.”¹⁶ In other words, unlike the sale of the carried interest itself, the holding period for section 1061 is generally determined by looking to the asset held by the partnership that gave rise to the capital gain, not to how long the taxpayer has held the carried interest.¹⁷ Just as with the section 1202 examples above, the concept of meaningless gestures on stockless contributions could have significant ramifications.

Example 3:

Private equity (PE) fund invests in a portfolio company (a C corporation) on Jan. 1 of year 1, with an initial investment of $200 million. Subsequently, due to increased capital needs, the PE fund contributes additional capital of $50 million on Jan. 1 of year 2 and year 3 and $20 million on Jan. 1 in year 4. No stock is issued to the PE fund upon the contributions in years 2, 3, and 4. On Dec. 31 of year 4, the PE fund sells the portfolio company for $820 million, resulting in a gain of $500 million. Would the Service suggest viewing the subsequent capital contributions in such a scenario as requiring the application of the meaningless gesture doctrine, thereby resulting in split holding periods in the stock for each contribution? What would the holding period be on the stock for purposes of the section 1061 extended holding period requirement? Unlike the situations in the GLAM, where the taxpayer has significant economic investment from the beginning. This fact would appear to alleviate the IRS’ concern around artificially extending holding periods of stock beyond the true economic investment.

Example 4:

PE fund invests in a portfolio company (a C corporation) on Jan. 1 of year 1, with an initial investment of $200 million. By the end of year 2, it is clear that the company will sell before the end of year 3. PE fund owns a shell corporation (SC) from a prior investment that has a holding period in excess of three years. In an effort to satisfy the section 1061 three-year holding period, the PE fund transfers the company into the SC as a stockless capital contribution and sells the SC during year 3. The facts in this example are quite different from the prior example, closely resemble an example in the GLAM, and perhaps, warrant a split holding period.

Conclusion

In conclusion, the GLAM provides insight into the Service’s meaningless gesture position of creating a split holding period in a stockless property contribution. Although the memorandum does not serve as a precedential authority, it does indicate the general position of the Service on this issue. While instructive, the situations in the GLAM appear to be abusive situations, as the taxpayer used shell companies to make subsequent contributions to capital that artificially extended the holding period of the stock beyond the taxpayer’s true investment. As illustrated by the examples above, applying the meaningless gesture doctrine in other situations may lead to inconsistent (both favorable and unfavorable) results for taxpayers. Therefore, it is unclear as to whether the Service would more broadly apply for this position. Further, if the Service did want this analysis to apply more broadly than just in the context of abusive situations, it is unclear as to why the proposed regulations discussed above were not finalized. In particular, the GLAM is a concern when considering the interplay with other Code sections such as section 1202 or section 1061, as described above.

_{^{1 Section 351(a). “Control” for purposes of section 351(a) is defined in section 368(c), which requires “ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.”}}

_{^{2 Section 1223(1). Section 1231(b) refers to property used in a trade or business.}}

_{^{3 Section 1222(3).}}

_{^{4 Rev. Rul. 64-155, 1964-1 C.B. 138; Lessinger v. Comm’r, 872 F.2d 519 (2nd Cir. 1989).}}

_{^{5 See e.g., Lessinger, supra note 2 at 522; Jackson v. Comm’r, 708 F.2d 1402, 1405 (9th Cir. 1983); Rosen v. Comm’r, 62 T.C. 11, 19 (1974).}}

_^6 Id.

_{^{7 See Prop. Reg. section 1.358-2(g)(3) proposed under Notice of Proposed Rulemaking (REG–143686–07) 74 F.R. 3509 (Jan. 21, 2009), as corrected by 74 F.R. 9575 (Mar. 5, 2009). Specifically, the proposed regulations provided for a deemed issuance of stock followed by a deemed recapitalization of such stock under section 368(a)(1)(E).}}

_{^{8 See Rev. Rul. 85-164, 1985-2 C.B. 117.}}

_{^{9 84 F.R. 11686 (March 28, 2019).}}

_{^{10 1985-2 C.B. 117.}}

_{^{11 Section 1202(a)(1). Qualified small business stock is defined in section 1202(c).}}

_{^{12 Section 1202(b)(1) provides for the taxpayer’s amount of eligible gain to be taken into account for the partial exclusion from gross income under subsection (a) to “not exceed the greater of (A) $10 million reduced by the aggregate amount of eligible gain taken into account by the taxpayer under subsection (a) for prior taxable years and attributable to dispositions of stock issued by such corporation, or (B) 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year. For purposes of subparagraph (B), the adjusted basis of any stock shall be determined without regard to any addition to basis after the date on which such stock was originally issued.”}}

_{^{13 Section 1202(a)(4).}}

_{^{14Section 1061(a). Applicable partnership interest refers to “any interest in a partnership which, directly or indirectly, is transferred to (or is held by) the taxpayer in connection with the performance of substantial services by the taxpayer, or any other related person, in any applicable trade or business.” Section 1061(c).}}

_{^{15 Notice of Proposed Rulemaking, REG-107213-18.}}

_{^{16 H.R. Report No. 115-409, 276 (Nov. 13, 2017).}}

_{^{17 See id.; REG-107213-18.}}