On March 28, the Treasury Department (Treasury) and the Internal Revenue Service (IRS) withdrew a broad set of 2009 proposed regulations governing the recovery of corporate shareholder stock basis. Prop. Regs. section 1.301-2(a), REG-143686-07 (Jan. 21, 2009). The proposed regulations were intended to comprehensively clarify the application of sections 301(c) and 302(a) and related sections to to corporate shareholders who hold several classes of stock with differing bases. In its withdrawal notice, however, the IRS said it will continue to apply a part of the regulations it believes was correct under prior law.
Section 301 provides that corporate distributions are treated (i) first as dividends to the extent of the corporation's E&P; (ii) then as a return of capital to the extent of the shareholder's basis in the shares; and (iii) finally as gain on the amount that exceeds the shareholder's basis in the shares. Where a shareholder owns a single block of shares the application of this provision is straightforward. Where, however, a shareholder owns several blocks of shares with differing tax bases, the application of this provision is more complex. May the shareholder reduce to zero the basis for all blocks of shares before recognizing any gain (the aggregate approach)? Or must the shareholder reduce the bases of the various blocks proportionately (share-by-share approach), which can lead to recognition of gain on one block and retention of basis in another?
To illustrate, suppose A owns 100% of the stock of ABC Inc. with a basis of $150. If in a single year ABC Inc. has $0 of E&P and makes a distribution of $140, A will reduce its basis to $10 and recognize no gain. If, however, A acquired the stock of ABC Inc. in two blocks, whose bases differ, the question arises as to how those bases should be reduced. If Block 1 consisted of 100 shares with a basis of $150, while Block 2 consisted of 100 shares with a basis of $0, does A still recognize no gain? Or must A attribute the $140 distribution to the two blocks proportionately—$70 to each—in which case A would reduce A’s basis in Block 1 to $80, but recognize gain of $70 on Block 2?
The proposed regulation adopted the share-by-share approach. This conclusion has support in a Fourth Circuit Court of Appeals decision that ruled similarly, Johnson v. United States, 435 F.2d 1257 (4th Cir. 1971).
The proposed regulations also addressed a related provision, the dividend equivalent redemption rule of section 302. Under section 302, a corporate redemption of shareholder stock is treated as a section 301 dividend distribution if, broadly, the shareholder’s interest relative to other shareholders remains the same. The proposed regulations provided that where a corporation has multiple classes of shares held by a shareholder, and shares belonging to only some of the classes are redeemed, the basis of all shares held by the shareholder in those redeemed classes are reduced, on a pro rata basis. The regulations included further detail on this scenario, as well as additional rules related to sections 304, 351, 354, 356, 358, 368, 861, 1001, and 1016, all of which follow the share-by-share approach.
In its withdrawal notice, the IRS mentioned a concern that the approach taken by the proposed regulations enabled, “minor changes to an overall business transaction [to] cause meaningful changes to the tax consequences, thereby elevating the form of the transaction over its substance.” Accordingly, the Treasury Department and the IRS are withdrawing the regulations and instead will further study these issues.
Notwithstanding its withdrawal, the IRS stated it continues to believe that under current law, some aspects of the regulations are correct. With regard to the initial section 301-related question of aggregate approach vs. share-by-share approach, the share-by-share approach as per Johnson v. United States should be followed. With regard to redemptions governed by section 302(d), unrecovered basis in the redeemed stock of a shareholder may be shifted to other stock only if that adjustment is proper under Reg. section 1.302-2(c). Finally, not all shifts of a redeemed shareholder’s unrecovered basis result in proper adjustments, and some basis adjustments can lead to inappropriate results.
Due to the complexities surrounding these issues, taxpayers are advised to consult with their tax advisors when performing section 301-related computations.