Acquiring the assets of another corporation, in a tax free transfer, and provided that the owner of the transferring corporation also owns the acquiring corporation is considered a “type D” reorganization. In this specific type of transaction, where it is acquisitive and not divisive, then the definition of control can be found in §304(c)(1), and is a simple ownership of at least 50% of the combined voting power, and 50% of the combined value of the outstanding stock. In addition to this, §304(c)(3) includes attribution rules that need to be considered when determining the control tests. This section relies mostly on the normal §318 rules, but does make some modification.
The following is a discussion of the control requirements that qualify a transaction for §368(a)(1)(D). An example of how the step transaction doctrine can disqualify a transaction via the control rules will first be examined. Then an examination of the attribution rules and how they can manifest in determining control requirements. Finally, an examination of the how the control requirement can work against the taxpayer, especially in the case of a corporation wholly owned by a single taxpayer.
Step Transaction Doctrine
In the case of YOC Heating Corp. v. Commissioner, Reliance wanted to purchase the assets of Nassau. Reliance had been experience as profitable period of growth but needed some key assets that Nassau currently had. However, Nassau’s operations were not considered profitable enough for Reliance to desire. Therefore, Reliance approached Nassau about buying the key assets. However, the minority shareholders blocked the deal forcing an alternative method to be arranged. The majority shareholders agreed to sell their portion of Nassau stock to Reliance, providing Reliance with 84.8% control of the company.
Reliance agreed to this, and purchased the shares. After an unsuccessful campaign to buy the outstanding stock, Reliance set forth an offer to purchase the assets of Nassau. Under the offer, a plan was established to change the name of Nassau, create a new company named Nassau, have the old company sell, assign, and transfer its assets to the new company. The outstanding shareholders would be eligible to receive one share of new Nassau’s stock for every three shares of old or $40 for each share of stock own in old Nassau. Only Reliance accepted the offer of stock, all other shareholders took the offer of money in exchange of their shares.
Once the transactions were fully complete, Reliance claimed a step up in basis of the assets, which the new Nassau had purchased from the old Nassau. Reliance would argue that both §334(b)(2) and the Kimbell-Diamond case supported that the final transaction should be treated as a liquidation, and the assets would receive a step up in basis. The Commissioner argued that the transaction was actually a reorganization, ether under §368(a)(1)(D) or §368(a)(1)(F), and since these would be tax-free transactions, there would be no step up in the basis of the assets.
While not the focus of this discussion, the argument for liquidation treatment is important to the YOC case. Before embarking on this deal, Reliant had consulted with both its attorney and accountant and had a clear course of action. However, Reliant claims that despite the form of the transaction, the substance is that old Nassau liquidated into new Nassau. The court found this argument to be lacking since new Nassau did not actually own old Nassau, and the taxpayer deliberately chose the form. The courts have always held that the requirements to reach a §334 liquidation are strict and in this case there was no compelling reason to ignore them.
In this case, the commissioner was arguing for an initial tax-free treatment of the transfer of assets. If the transaction was in reality a reorganization, and not a liquidation or sale, then the assets would have a carryover basis from the original owners. Without the step up in basis, the allowable depreciation would be considerably lower, and would result in a higher tax liability.
In order to qualify for a type D or F reorganization, there must be a continuation of control from before the transaction to after the transaction. The exact wording of §368(a)(1)(D) is:
A transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred.
On the surface, it appears that Reliance had control of both old Nassau and new Nassau before and after the transaction. Even with the small amount of stock purchased from the minority shareholders, Reliance still owned more than 84%. As seen, for the purposes of D reorganizations, only 50% is required.
The commissioner also argued for a type F reorganization. For this type of reorganization, §368(c) defines control as being “at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock.” Again, it appears that Reliance meets this requirement with its 84% ownership.
However, the courts looked at the entire series of transactions as one transaction. Using this “integrated transaction” doctrine, also known as the “step transaction” doctrine, the courts were able to treat the transactions as one transaction between the former owners of the Nassau and Reliance. Under this view, it becomes apparent that there was a significant change in ownership, and neither control requirement is met. Due to this the court rejected the commissioner’s argument that this should be a tax free reorganization. The court finally ruled that the transaction should be treated as a sale of assets from the former owners to Reliance, and all transactions accounted for in the new basis.