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Morris Trust transactions are a popular means of divesting unwanted businesses on a tax-free basis. However, you must execute the transaction in a specified manner. If you don't, two levels of taxes will ensue.
Robert Willens, CFO.com | Europe
June 6, 2011
Does it make a difference, for taxes purposes, if the steps taken to complete a so-called reverse Morris Trust transaction are done out of sequence? A recent technical advice memorandum (TAM) from the Internal Revenue Service explains the potential problems, and why the order of the steps matters. In the example provided by the IRS, several companies are involved in a transaction that leads to a taxable event.
To set the stage, this is what we know about the companies:
• Delta Corp. owned all of the stock of two other companies, Tau Inc. and Center Inc.
• On or about October 28, 1981, Tau merged with SubOne Corp., a wholly-owned subsidiary of FirstCorp.
In the merger, FirstCorp issued 1,120,763 of its shares, with 1,011,084 issued directly to Delta's shareholders. (This was done because Delta's shareholders had responded to a tender offer in which the stock of FirstCorp was offered by Delta to its shareholders in exchange for their Delta stock.) In addition, the remainder of the FirstCorp stock — 109,679 shares — was issued to Delta, and was promptly redeemed by FirstCorp for cash.
The pieces of the transaction added up to a reverse Morris Trust deal; that is, the transaction encompassed all the steps of a reverse Morris Trust except that the steps occurred "out of sequence." Indeed, the merger preceded, rather than followed, the distribution of stock to the "distributing company's" shareholders. In this case, the distributing company was Delta.
The question posed to the IRS's national office was whether the transaction should be "recharacterized" as a non-pro-rata exchange by the tendering Delta shareholders. If the transaction can be recharacterized, neither the distribution of the Tau stock nor the second-step exchange of Tau stock for FirstCorp stock would be taxable when looked at through the lens of Sections 355 and 368 of the tax code.
However, the national office ruled that the transaction should not be recharacterized. Accordingly, both Delta and the tendering Delta shareholders were taxed with respect to the distribution by Delta of its FirstCorp stock to its shareholders in exchange for their Delta stock. (See LTR 8821001, October 20, 1987.) Here's why.
The parties structured the transaction as a merger of Tau into SubOne, specifically as an exchange for FirstCorp common stock followed by a non-pro-rata exchange of FirstCorp common stock to any tendering Delta shareholders. If the form is followed, the distribution of FirstCorp stock to the Delta shareholders fails to meet the requirements of Section 355, the rule that allows corporations to make tax-free distributions of stock to their shareholders.
The reason the transaction fails is because in a Section 355 transaction, the distributing corporation must dole out at least an amount of stock in the controlled corporation that constitutes "control." (For this purpose, control means the ownership of stock possessing at least 80% of the total combined voting power of all classes entitled to vote and at least 80% of the total number of shares of each class, if any, of the nonvoting stock.) In this case, Delta distributed only 15.07% of the FirstCorp voting stock.
As a result, the IRS observed that the recharacterization "is not supported by the evidence." Again, the basic question is whether the merger occurred with Delta as the sole Tau shareholder or with Delta tendering shareholders as the shareholders of Tau. (See Court Holding Company v. Commissioner, 324 U.S. 331 (1945).) In the end, the IRS found that the merger occurred with Delta as the sole shareholder of Tau.
The agency saw Delta as the sole shareholder of Tau, noting that Delta conducted all of the negotiations for the merger and exchange and, therefore, only Delta was "entitled to" receive the shares of FirstCorp stock pursuant to the amended reorganization agreement of March 15, 1981. Further, as set forth in the proxy statement description of the exchange offer, Delta retained the sole right — after expiration of the exchange offer — to distribute any remaining FirstCorp shares to the nontendering shareholders or to hold them itself. This, the IRS noted, is "clear evidence" that there was both in form and in substance a transaction in which Delta, as the sole shareholder of Tau, had the right to receive the shares of FirstCorp. Moreover, the fact that, at Delta's direction, FirstCorp shares were transferred directly to the tendering shareholders was not conclusive.
It is important to review a revenue ruling (Rev. Rul. 75-406, 1975-2 C.B. 125) that was cited by the taxpayers in this case. The ruling involved a spin-off in which the controlled corporation, not the distributing corporation, took part in a subsequent reorganization. In the ruling, X Corp. (XCorp) distributed pro-rata to its shareholders all of its stock in Y Corp. (YCorp). After the distribution, a plan of reorganization was submitted to, and voted on, by the YCorp shareholders under which YCorp would merge into Z Corp. (ZCorp), an unrelated company.
Subsequent to the distribution, the YCorp shareholders approved the merger at a shareholder meeting specifically called for the purpose. YCorp then merged into ZCorp and the YCorp stock was converted into ZCorp stock. In the ruling, the IRS stated that the distribution and merger did not violate the continuity of interest (COI) requirement and was not a device to distribute earnings and profits.
In fact, the IRS concluded that Rev. Rul. 75-406 was clearly distinguishable from the case involving the Delta distribution. Most notably, in the revenue ruling case, the shares of the controlled corporation were actually distributed to, and held by, the shareholders of the distributing corporation. In the Delta case, no shares of Tau were distributed to, nor held by, the tendering shareholders.
In addition, in Rev. Rul. 75-406, the XCorp shareholders were informed of, and voted upon, the plan of reorganization only after they had received the shares of YCorp. In the Delta case, there was no separate consideration of, or vote on, the subsequent merger. The reorganization and exchange offer were submitted together to all of the Delta shareholders. The favorable vote on the reorganization occurred prior to the termination of the exchange offer, and Delta shareholders who did not participate in the exchange offer voted in favor of the reorganization.
Even assuming that the tendering shareholders constructively received the shares of Tau in exchange for their Delta shares, their ownership of the Tau shares was not "real and meaningful" because of the prearranged approved merger.1 So, unlike Rev. Rul. 75-406, the exchange of Tau shares for shares of FirstCorp violated the COI requirement.
1 Under current law, the fact that the merger was prearranged and preapproved would not seem to be a disqualifying factor. In Rev. Rul. 98-27, 1998-1 C.B. 1159, the IRS apprised taxpayers that it will not apply any formulation of the step-transaction doctrine to determine whether the distributed corporation was a controlled corporation immediately before the distribution solely because of any postdistribution acquisition or restructuring of the distributed corporation, whether prearranged or not.
Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.