appear that the application of section 337 should not be objected to on the grounds that the liquidation provisions cannot apply if the reorganization rules apply. Possible Proposal Section 361 could be amended to prevent the recognition of gain by an acquired corporation that uses qualified consideration or boot to pay off debts. In addition, present law could be clarified to expressly provide nonrecognition treatment to a corporation that disposes of consideration received pursuant to a plan of reorganization; in such a case, the application of sections 336 and 337 would be proscribed. If this proposal were adopted, the taxation of corporations that are acquired in reorganizations would no longer turn on the form in which the corporation's debts are settled. 4. Treatment of Acquiring Corporations in Triangular Reorganizations Present Law and Background Section 1032 provides nonrecognition treatment for a corporation that acquires property in exchange for its stock. In a triangular reorganization, a principal part of the consideration used by the acquiring corporation consists of stock of its parent corporation. Although the Internal Revenue Service has ruled that nonrecognition treatment is available to a corporation that uses its parent's stock as consideration in a transaction that qualifies as a reorganization, 131 the statutory support for such treatment is unclear. Possible Proposal Section 1032 could be amended to provide explicitly that no gain or loss is recognized on the transfer of parent-corporation stock pursuant to a plan of reorganization. 5. Boot Derived from Reorganizations Involving Certain Foreign Corporations Present Law and Background Under section 1248, gain recognized on the sale or exchange of stock in a foreign corporation by a U.S. person owning ten percent or more of the voting stock could be treated as a dividend. This rule was designed to prevent U.S. taxpayers from accumulating earnings free of U.S. tax in a controlled foreign corporation, and then (rather than repatriating the earnings in the form of dividends that would not be eligible for the dividends received deduction) disposing of the stock at capital gains rates for a price that reflects the accumulated earnings. In general, section 1248(g) provides exceptions for cases in which realized gain is taxable as ordinary income under other provisions of the Code. In the case of gain realized in connection with a reor 131 Rev. Rul. 57-278, 1957-1 C.B. 124 (without discussion of the basis for this conclusion). See also Prop. Treas. Reg. sec. 1.1032.2 (which would interpret section 1032 as reaching the desired result). ganization, however, the statutory exception refers to "any gain realized on exchanges to which section 356 ... applies" (sec. 1248(g)(2)). Thus, under a literal interpretation of the statute, section 1248 is inapplicable to a shareholder who receives boot pursuant to a plan of reorganization, even if the boot is taxed as capital gain. Possible Proposal The scope of section 1248(g)(2) could be limited to that of the other exceptions contained in section 1248(g). That is, the general rule should not apply to the extent that section 356 operates to characterize a shareholder's gain as dividend income, but would apply if the gain is taxed as capital gain. 6. Transfer of Property to Controlled Corporations Present Law and Background No gain or loss is recognized by a taxpayer who transfers property to an 80-percent controlled corporation solely in exchange for stock or securities in the corporation (sec. 351). Gain, but not loss, is recognized to the extent that the consideration for the transfer consists of property other than qualified consideration. The transferee's basis in the property is the same as the basis in the hands of the transferor, increased by the amount of gain (if any) recognized by the transferor (sec. 362). The transferor's basis in the stock or securities received is equal to the basis in the property transferred, increased by the amount of gain recognized and decreased by the amount of boot received (sec. 358). Possible Proposals In its report proposing the Subchapter C Revision Act of 1985, 131a the staff of the Senate Finance Committee identified the following problem areas under section 351: (1) Although there is an overlap between section 351 and reorganization provisions, the limitations on the receipt of securities in a reorganization do not apply to a section 351 exchange; and (2) where the property transferred has a basis that exceeds its fair market value, taxpayers can duplicate corporate level losses. Under the Senate Finance Committee staff proposal, the same nonrecognition rule that applies to securities received in a reorganization would apply to securities received in a section 351 exchange. Thus, securities would not be received tax-free if no securities were surrendered. Further, if the basis of the property transferred exceeded fair market value at the time of the exchange, then the transferor's basis in the qualified consideration received would equal the fair market value of the transferred property (increased by the amount of recognized gain and decreased by the amount of boot). 131 Staff of the Senate Comm. on Finance, 99th Cong., 1st Sess., The Subchapter C Revision Act of 1985 (S. Prt. 99-47), May, 1985. C. Miscellaneous Provisions 1. Depreciation Recapture in Certain Tax-Free Exchanges Present Law and Background The recapture rules prevent the conversion of ordinary income to capital gains by requiring gain on the disposition of depreciable property to be taxed as ordinary income (rather than capital gains), to the extent of depreciation deductions taken with respect to the property. Under present law, a taxpayer can effectively assign ordinary recapture income to another taxpayer by transferring depreciable property in a tax-free exchange. For example, section 1245(b) provides an exception to the recapture rule for depreciable personal property where the property is transferred to a controlled corporation in a transaction accorded nonrecognition treatment under section 351. Similarly, an acquired corporation recognizes no recapture income if it transfers depreciable assets in a tax-free reorganization. If depreciable property is transferred to a corporation that has net operating losses, for example, no tax may be imposed on the recapture income. Possible Proposal Consideration could be given to applying the depreciation recapture rules whenever an asset is no longer accounted for on the return that benefitted from the previously-claimed deductions. Thus, there would be recapture in all otherwise tax-free acquisitive reorganizations, as well as when a subsidiary is no longer included in the consolidated return of the affiliated group that claimed the deductions. 132 Alternatively, some other mechanism could be devised to prevent the assignment of recapture income. For example, in a section 351 exchange, the shareholder's stock might be tainted so that ordinary income would result on disposition of the stock (or of the asset), to the extent of recapture income at the time of the section 351 transfer. In such a case, there would be a corresponding adjustment to the asset's basis in the hands of the corporation when the shareholder is taxed. 2. Conversion of a C Corporation to an S Corporation Present Law and Background In general, an S corporation is not subject to tax but is treated as a conduit, similar to the treatment of partnerships. Thus, shareholders who elect to treat their existing closely held corporation as an S corporation effect a material change in the tax character of their investment. Nevertheless, the conversion of a C corporation to an S corporation is not a taxable event. 132 Similarly, the Administration's proposal to impose a recapture tax on excess depreciation would prevent taxpayers from circumventing the proposed recapture rule by transferring property in nonrecognition transactions. This proposal is discussed in Joint Committee on Taxation, Tax Reform Proposals: Taxation of Capital Income (JCS-35-85), August 8, 1985. Possible Proposal An election to convert C corporations to S corporations, or certain acquisitions by S corporations of C corporations, could be treated as taxable events, at least with respect to recapture income. 3. Worthless Stock Deductions Present Law and Background Under section 165(g), taxpayers can deduct losses resulting from the worthlessness of corporate securities. Generally, such losses are capital losses. However, if a parent corporation owns at least 80 percent of each class of a subsidiary's stock and the subsidiary has derived more than 90 percent of its gross receipts from active business activities, the loss to the parent from worthlessness of the subsidiary's stock is an ordinary (rather than capital) loss. Whether stock is worthless is determined on the basis of facts and circumstances, some of which may be subject to the control of the parent.133 The provision may be intended to prevent certain disparities in treatment between a branch and a subsidiary. However, it has been suggested that in some circumstances the availability of ordinary loss treatment may encourage a parent corporation to claim and cause worthlessness of a subsidiary rather than continue operations when the subsidiary stock has declined in value. A separate issue may arise in the case of a non-consolidated subsidiary that is believed worthless in one year but is later revived by infusion of new assets. In Textron, Inc. v. United States, 561 F.2d 1023 (1st Cir. 1977) the court held that, even though the taxpayers had claimed an ordinary worthless stock deduction, the net operating losses of the subsidiary could still be used to shelter income from the new business. Possible Proposals Some argue that it would be desirable to eliminate the disparity between claiming worthlessness and otherwise disposing of subsidiary stock by requiring capital loss treatment in all cases. With respect to the Textron issue, some have suggested a rule that whenever a corporation's stock becomes worthless, (or at least when this has produced an ordinary loss deduction), its preexisting tax attributes (such as net operating losses and credit carryovers) should be extinguished. 4. Taxes of a Shareholder Paid by the Corporation Present Law and Background If a corporation pays a tax imposed on a shareholder on an interest as a shareholder, present law allows a deduction to the corporation rather than the shareholder whose tax is paid (sec. 164(e)). 133 Facts that may be considered relevant and that may be subject to the parent corporation's control include the following: when the subsidiary is liquidated, when it terminates operations, when the parent ceases to advance operating capital, and when its operating officers abandon any hope or expectation of realizing a profit. This rule is inconsistent with the general rule that taxes are deductible only by the person on whom they are imposed. The provision was originally adopted to provide a deduction to banks that voluntarily paid local taxes imposed on their shareholders, but operates to permit corporations to pay a deductible dividend. See Hillsboro National Bank v. Commissioner, 457 U.S. 1103 (1983). The extent to which the provision is in current use is unclear. Possible Proposal Section 164(e) could be repealed. If section 164(e) is repealed, a corporation's payment of a tax imposed on a shareholder would be treated as a taxable dividend to the shareholder. 5. Deferral by Solvent Taxpayers of Discharge of Indebtedness In general Income Present Law and Background Code section 61(a)(12) provides that gross income includes "income from discharge of indebtedness." While in general the statute does not further define that term, discharge of indebtedness is generally considered to occur when a taxpayer's debt is forgiven, cancelled, or otherwise discharged by a payment of less than the principal amount of the debt. For example, if a corporation has issued a $1,000 bond at par which it later repurchases for only $900 (thereby increasing its net worth by $100), the corporation realizes $100 of income in the year of repurchase. 134 Pursuant to certain statutory exceptions (sec. 108), income is not currently recognized from discharges arising in a title 11 (bankruptcy) case, or from discharges outside of bankruptcy to the extent the taxpayer is insolvent before the discharge.135 Although income is not recognized currently in these bankruptcy or insolvency cases, certain tax attributes of the debtor-including net operating loss carryovers, certain credit carryovers, and the basis of assets-must be reduced, in a specified order, by the amount of the discharged debt, unless the taxpayer elects first to reduce the basis of depreciable property by the debt discharge amount. If the debt discharge amount exceeds the amount of tax attributes that can be reduced, it has no tax consequence. In the case of a solvent debtor outside bankruptcy, the full amount of discharged debt generally is recognized as income in the year the discharge occurs. However, a solvent taxpayer may elect to adjust the basis in its depreciable assets (or realty held as inventory) in place of currently recognizing income (secs. 108(c) and 1017), thereby deferring recognition for tax purposes. This election is available for discharge of any indebtedness incurred by a corpo 134 United States v. Kirby Lumber Co., 284 U.S. 1 (1931); Helvering v. American Chicle Co., 291 U.S. 426 (1934); Comm'r v. Jacobson, 336 U.S. 28 (1949); Treas. Reg. sec. 1.61-12(a). 135 If a taxpayer is insolvent before the discharge occurs, the amount of the taxpayer's insolvency must be determined. If the amount of the discharge exceeds the amount of the taxpayer's insolvency, the excess must be currently recognized as income unless excepted under some other provision. |