Letter Ruling 9827020, April 3, 1998
Uniform Issue List Information:
UIL No. 0351.00-00
Transfer to corporation controlled by transferor
UIL No. 1374.00-00
Tax imposed on built-in gains
Code Secs. 351 and 1374
This letter responds to your December 31, 1997 request for rulings on certain federal income tax consequences of a partially completed transaction.
Summary of Facts
Parent is the holding company parent of a consolidated group that, through direct and indirect subsidiaries, conducts Business A and Business B (the "Parent Group"). The stock of Parent is owned by members of a family, certain trusts, and the estate of the founder.
Parent wholly owns S1 , and S1 wholly owns S2 , S3 , and S4 . S3 wholly owns S5 , S6 , S7 , and S8 . S1 is primarily engaged in Business B. S2 is a foreign sales corporation. S3 , S4 , S5 , and S6 are engaged in Business A or operations related to Business A. S7 and S8 are inactive.
S1 uses the LIFO method of accounting for its inventory, the cost of which is attributable entirely to purchases in the ordinary course of business at market prices. S2 uses the administrative pricing rules under §925(a)(1) or (2) of the Internal Revenue Code.
Proposed Transaction
For what the taxpayer represents are valid business reasons, the Parent Group has proposed and partially completed the following transaction:
(i) On or before Date 1, S6 , S7 , and S8 liquidated in transactions intended to qualify under §§332 and 337 .
(ii) On Date 1, S1 transferred its Business B assets (including inventory) and the stock of S2 to Newco in exchange for the stock of Newco and Newco's assumption of liabilities associated with the Business B assets (the "Exchange").
(iii) On or before Date 2, Parent and its shareholders took such actions as were necessary to satisfy the S corporation eligibility requirements under §1361(b) .
(iv) On Date 2, Parent merged into S1 .
(v) S1 will (i) elect under §1362 to be treated as an S corporation, effective for its taxable year beginning on Date 3 (the "S Election") and (ii) elect under §1361(b)(3) to treat S3 , S4 , and S5 as qualified subchapter S subsidiaries (the "Qualified Subsidiaries") ((i) and (ii) together, the "Elections"). S2 and Newco will remain C corporations.
Exchange Representations
The taxpayer has made the following representations regarding the Exchange:
(a) No stock or securities were issued for services rendered for the benefit of Newco in connection with the Exchange, and no stock or securities were issued for indebtedness of Newco that was not evidenced by a security or for interest on indebtedness of Newco that accrued on or after the beginning of S1 's holding period for the debt.
(b) Any patents or patent applications transferred by S1 to Newco qualified as "property" under §351 . S1 transferred all substantial rights in such patents or patent applications within the meaning of §1235 .
(c) S1 did not retain any significant power, right, or continuing interest, within the meaning of §1253(b) , in the franchises, trademarks, or trade names transferred.
(d) The Exchange was not the result of the solicitation by a promoter, broker, or investment house.
(e) S1 did not retain any rights in the property transferred to Newco.
(f) The adjusted basis and the fair market value of the assets transferred by S1 to Newco, in each instance, equaled or exceeded the sum of the liabilities assumed by Newco plus any liabilities to which the transferred assets were subject.
(g) The liabilities of S1 assumed by Newco were incurred in the ordinary course of business and are associated with the assets transferred.
(h) There is no indebtedness between Newco and S1 , and no indebtedness was created in favor of S1 as a result of the Exchange.
(i) The transfers and exchanges occurred under a plan agreed upon before the Exchange in which the rights of the parties were defined.
(j) All exchanges occurred on approximately the same date.
(k) There is no plan or intention on the part of Newco to redeem or otherwise reacquire any stock or indebtedness issued in the Exchange.
(l) Taking into account any issuance of additional shares of Newco stock; any issuance of stock for services; the exercise of any Newco stock rights, warrants, or subscriptions; a public offering of Newco stock; and the sale, exchange, transfer by gift, or other disposition of any stock of Newco received in the Exchange, S1 is in "control" of Newco within the meaning of §368(c) .
(m) S1 received stock approximately equal to the fair market value of the property transferred to Newco.
(n) Newco will remain in existence and retain and use the property transferred to it in a trade or business.
(o) There is no plan or intention by Newco to dispose of the transferred property other than in the normal course of business operations.
(p) Each of the parties to the Exchange paid, or will pay, its, his, or her own expenses, if any, incurred in the Exchange.
(q) Newco will not be an investment company within the meaning of §351(e)(1) and §1.351-1(c)(1) (ii).
(r) S1 is not under the jurisdiction of a court in a title 11 or similar case (within the meaning of §368(a)(3)(A) ) and the stock or securities received in the Exchange were not used to satisfy the indebtedness of such debtor.
(s) Newco will not be a "personal service corporation" within the meaning of §269A .
Exchange Rulings
Based on the information submitted and the representations set forth above, we rule as follows on the Exchange:
(1) No gain or loss was recognized by S1 on the Exchange (§§351(a) and 357(a) ).
(2) The basis of the Newco stock received by S1 in the Exchange equals the basis of the property exchanged therefor (§358(a) and (d) ).
(3) The holding period of the Newco stock received by S1 in the Exchange includes the period during which S1 held the assets exchanged, provided the assets were capital assets under §1221 or property described in §1231 at the time of the Exchange (§1223(1) ).
(4) No gain or loss was recognized by Newco on its receipt of S1 assets in the Exchange (§1032(a) ).
(5) The basis of each S1 asset received by Newco in the Exchange equals the basis of that asset in the hands of S1 immediately before the transfer (§362(a) ).
(6) The holding period of each asset received by Newco in the Exchange includes the holding period of that asset in the hands of S1 immediately before the transfer (§1223(2) ).
(7) Under its LIFO method, Newco will not be required to treat the inventory received in the Exchange as separate from otherwise identical inventory subsequently acquired or produced.
(8) Section 1363(d) does not require S1 to include in its gross income any LIFO recapture amount for the inventory transferred to Newco in the Exchange.
(9) Section 1248 does not apply to either the S Election or the transfer of S2 stock to Newco in the Exchange (§1248(d)(6) ).
Section 1374 Discussion
On Date 3, S3 owned and held certain real property containing timber (the "Timber"). At the time the Timber is cut S3 will have held the Timber for the period required under §631(a) . S3 has the right to cut the Timber for sale on its own account or for use in its trade or business. S3 has made an election under §631(a) to treat the cutting of its Timber as a sale or exchange of the Timber. S3 has entered into one contract with an unrelated party and may enter into additional contracts with unrelated parties on or before Date 4 that will allow the parties to cut and remove Timber from S3 's timberlands (the "Contracts"). Each Contract will provide that the buyer purchase Timber at a set price per thousand board feet and that the total contract price be determined by the volume of Timber removed from a designated area. Each Contract will also provide that S3 retain the risk of loss on, and title to, the Timber until the buyer has severed and paid for it.
Taxpayer asks whether the income received during the recognition period from Timber dispositions will be subject to tax under §1374 .
Section 1374 imposes a corporate-level tax on an S corporation's net recognized built-in gain during the recognition period (generally 10 years) following (a) a C corporation's conversion to S corporation status (§1374(a) ), or (b) an S corporation's acquisition of C corporation assets in a carryover basis transaction (§1374(d)(8) ).
Section 1374(d)(2) provides that an S corporation's net recognized built-in gain for any taxable year is generally its taxable income for the year computed as if it were a C corporation, but taking into account only items treated as recognized built-in gain or recognized built-in loss.
Section 1374(d)(3) provides that recognized built-in gain includes any gain recognized on the disposition of an asset during the recognition period, except to the extent the S corporation shows that (a) it did not hold the asset as of the beginning of the first taxable year for which it was an S corporation (the "Conversion Date"), or (b) the gain recognized was greater than the excess of the asset's fair market value over its adjusted basis on the Conversion Date.
Section 1.1374-4(a) of the Federal Income Tax Regulations provides that §1374(d)(3) applies to any gain or loss recognized during the recognition period in a transaction treated as a sale or exchange for federal tax purposes.
Section 1374(d)(6) provides that if the adjusted basis of any asset is determined (in whole or in part) by reference to the adjusted basis of any other asset held by the S corporation on the Conversion Date, the asset is treated as held by the S corporation on the Conversion Date, and any determination under §1374(d)(3) with respect to that asset is made by reference to the fair market value and adjusted basis of the other asset on the Conversion Date.
In Example 1 of §1.1374-4(a)(3) , X is a C corporation that elects to become an S corporation effective January 1, 1996. On the Conversion Date, X owns a working interest in an oil and gas property on which production of oil has not yet begun, and the fair market value of the working interest exceeds X's adjusted basis in the working interest by $200,000. During the recognition period, X produces and sells oil from the working interest and includes $75,000 in income on the sale. X's $75,000 of income is not recognized built-in gain because on the Conversion Date X held only a working interest in the oil and gas property and not the oil it sold.
In Example 2 of §1.1374-4(a)(3) , Y is a C corporation that elects to become an S corporation effective January 1, 1996. On the Conversion Date, Y owns a royalty interest in an oil and gas property, and the fair market value of the royalty interest exceeds Y's adjusted basis in the royalty interest by $100,000. During the recognition period, Y sells the royalty interest and recognizes a gain of $75,000 on the sale. Y's $75,000 gain is recognized built-in gain because Y held the royalty interest on the Conversion Date.
Section 631(b) provides that if a taxpayer disposes of timber held for more than a requisite period under any form or type of contract in which the taxpayer retains an economic interest in the timber, the income from the disposal is considered gain or loss on a sale of timber. The date of disposal of the timber is deemed to be the date the timber is cut, but if payment is made to the owner under the contract before the timber is cut the owner may elect to treat the date of payment as the date of disposal. The taxpayer generally recognizes capital gain on the sale under §1231 in an amount equal to the difference between the amount realized for the timber and the timber's adjusted depletion basis. See §1231(b)(2) .
Under §1.631-2(d)(1) , payments received in advance of cutting pursuant to a §631(b) contract are treated as realized from the sale of timber if the contract of disposal provides that the amounts are to be applied as payment for timber subsequently cut.
Neither §631(b) nor the regulations thereunder give guidance on what constitutes a retained economic interest. Section 1.611-1(b)(1) , however, provides than an economic interest is possessed when a taxpayer has acquired by investment any interest in standing timber and secures, by any form of legal relationship, income derived from the severance of the timber, to which the taxpayer must look for a return of capital. In other words, an owner retains an economic interest under a timber cutting contract if the amount of the payment for the timber depends solely on the actual quantity of timber cut.
The Contract is a pay-as-cut contract, under which all proceeds paid to S3 are payments for Timber actually cut. S3 retains title and risk of loss until severance of the Timber, and all uncut Timber reverts to S3 at the close of the Contract period. S3 is the owner of the Timber, as the term "owner" is defined in §1.631-2(e)(2) , and has held the Timber for the requisite period under §631(b) . Consequently, S3 will retain an economic interest in the Timber disposed of under the Contract such that §631(b) will apply.
Section 1374 Rulings
Based solely on the information submitted and authority set forth above, we rule as follows:
(10) S1 's income from the sale of logs during the recognition period from Timber cut by S1 and the Qualified Subsidiaries on their timberlands during the recognition period will not be subject to tax under §1374 .
(11) S1 's income under §631(a) on cutting Timber during the recognition period will not be subject to tax under §1374 .
(12) S1 's income under the Contracts on dispositions of Timber during the recognition period will not be subject to tax under §1374 .
Caveats
The Internal Revenue Service expresses no opinion about the tax treatment of the proposed transactions under any other section of the Code or regulations or the tax treatment of any conditions existing at the time of, or effects resulting from, the proposed transaction that are not specifically covered by the above rulings. In particular, no rulings were requested, and no opinion is expressed, on the tax treatment of:
(i) The actual liquidations of S6 , S7 , and S8 described above in step (i) or the deemed liquidations of S3 , S4 , and S5 pursuant to elections described above in step (v), part (ii);
(ii) The transactions described above in step (iii);
(iii) The merger of Parent into S1 described above in step (iv);
(iv) The termination of the Parent Group pursuant to the S Election;
(v) The character of income derived from any Timber disposition or from any payment under a Contract;
(vi) Any Timber disposition occurring during the recognition period under any contract or arrangement other than a Contract or those described in rulings (10) through (12) above;
(vii) Any sales of Timber cut before, rather than during, the recognition period;
(viii) Income categories under §1374 other than those described in rulings (10) through (12) above; and
(ix) The validity of the Elections.
Procedural Statements
This ruling letter has no effect on any earlier documents and is directed only to the taxpayer who requested it. Section 6110(j)(3) provides that it may not be used or cited as precedent.
The taxpayers involved must attach a copy of this letter to their federal income tax returns for each recognition period year in which an above-described disposition occurs.
Pursuant to a power of attorney on file in our office, a copy of this letter is being sent to each of your authorized representatives.
Sincerely, Assistant Chief Counsel (Corporate), Wayne T. Murray, Senior Technician/Reviewer, Branch 4.