A Brief Look at the New 2000 Proposed Anti-Morris Trust Regulations

09/01/1999

Internal Revenue Code (“IRC”) § 355 generally provides that, if a corporation distributes to its shareholders stock of a corporation that it controls immediately before the distribution and certain other conditions are met, neither the distributing corporation (“Distributing”) nor its shareholders recognize gain or loss.  Several requirements for tax-free treatment operate to limit the circumstances under which Distributing or the controlled corporation (“Controlled”) can undergo an acquisition of their stock directly or indirectly of a fifty percent or greater interest in conjunction with a distribution that qualifies for corporate and shareholder-level nonrecognition per IRC §355.  The catalyst for change was the Commissioner v. Mary Archer W. Morris Trust case which allowed a change of control to occur while still qualifying the transaction for tax-free treatment.
 
Enactment of IRC §355(e).
 
In 1997, Congress added IRC §355(e) to the Code in order to prevent what it viewed as the abusive use of these so-called “Morris Trust” transactions, i.e., abusive spinoff transactions.  The law requires corporations to recognize gain on certain stock or securities distributed as “part of a plan or arrangement” in the course of acquisitions that otherwise would be tax-free under IRC § 355.  IRC § 355(e)applies to a distribution if stock representing a 50% or greater interest in Distributing or Controlled is acquired pursuant to a plan or series of related transactions.
 
Where either Distributing or Controlled have an acquisition of more than a fifty percent interest in their stock and if the distribution and the change in control are part of a “plan or series of related transactions,” then Distributing (but not its shareholders) will recognize gain on the distribution.  Any change in control of Distributing or Controlled during the four-year period beginning two years before the date of the distribution will be treated as pursuant to a plan unless it is established that the distribution and the change in control are not pursuant to a plan.  Both the distribution and acquisition are tested to determine whether or not they are part of a plan or series of transactions.
 
Issuance of 1999 Proposed Regulations.
 
On August 24, 1999, the IRS and Treasury issued proposed regulations that provided the exclusive means by which a taxpayer could show that a distribution and an acquisition were not part of a plan.  These rules were heavily criticized by practitioners who felt the rules made it too difficult to prove that taxpayers’ transactions were not part of a plan.  Taxpayers were required to establish the absence of a plan by clear and convincing evidence.  Practitioners felt it was unreasonable for taxpayers to have to prove a negative circumstance by such a heavy standard of proof.  In response to this criticism, the IRS and Treasury withdrew the 1999 proposed regulations and issued new proposed regulations in their place on December 29, 2000 (“the 2000 Proposed Regulations”).
 
Issuance of 2000 Proposed Regulations.
 
The 2000 Proposed Regulations adopt a broader view of rebutting the statutory presumption that a distribution of controlled stock followed by an acquisition within two years are part of the same plan.  Because practitioners felt that the previous “clear and convincing evidence” standard for rebutting the presumption was too high, the standard of proof normally used in civil cases, “preponderance of the evidence” is applied by the 2000 Proposed Regulations.
 
The 2000 Proposed Regulations take a facts and circumstances approach providing a much more flexible standard for taxpayers to show their transactions are not part of a plan or arrangement.  It should be noted that under the 2000 Proposed Regulations, the weight to be accorded many of the factors will vary, depending upon the context.  The 2000 Proposed Regulations provide further guidance in determining whether a plan or arrangement exists by examining timing and intent factors.  For example, the timing of discussions pertaining to related transactions and the intent of the various parties to the transactions, although the intent of third parties is not relevant.  Ultimately, the decision depends on the intentions and expectations of the relevant parties.
 
The following is a nonexclusive list of additional factors that, if present, will tend to add weight to an argument that a distribution and acquisition are part of a plan: 

  • Discussions with outside parties before the first transaction occurred;
  • Evidence that the distribution was motivated by a business purpose to facilitate the acquisition of Distributing or Controlled;
  • The fact that both transactions (i.e., the acquisition and the distribution) occurred within six months of each other or there was an agreement, understanding, arrangement; or substantial negotiations regarding the second transaction within six months after the first transaction;
  • Evidence that Distributing distributed Controlled stock with the intention of decreasing the likelihood of the acquisition of Distributing or Controlled by separating it from another corporation that is likely to be acquired.
  • Evidence that the debt allocation between Distributing and Controlled made it likely that an acquisition would occur in order to service the debt.

The 2000 Proposed Regulations also contain a nonexclusive list of factors indicating that a plan was not in place.  These include:

  • Absence of discussions with outside parties before the first transaction occurred;
  • Existence of a corporate business purpose (other than a purpose to facilitate the acquisition);
  • Identifiable, unexpected changes in market or business conditions after the first of the two transactions;
  • Evidence that the distribution would have occurred at the same time and in the same form regardless of the acquisition or a previously proposed similar transaction. 

The 2000 Proposed Regulations not only expand methods to rebut the presumption, but also include six safe harbor provisions under which a distribution and an acquisition will not be viewed as part of a plan.  The provisions of the safe harbors are more specifically set out below:
 
Safe Harbor I: An acquisition made more than six months after a distribution will receive safe harbor treatment if no agreement, understanding, arrangement or substantial negotiations concerning the acquisition occurred prior to six months after the distribution and the distribution was motivated by a substantial corporate business purpose to facilitate an acquisition.
 
Safe Harbor II: Certain acquisitions made more than six months after a distribution for which there was no agreement, understanding, arrangement, or substantial negotiations concerning the acquisition within six months after the distribution will receive safe harbor treatment.  In contrast to Safe Harbor I, Safe Harbor II applies to situations in which the distribution was motivated by a business purpose to facilitate an acquisition of no more than 33% of the stock of Distributing or Controlled.  In addition, less than 20% of the stock of the corporation whose stock was acquired in the acquisition or acquisitions was either acquired or the subject of an agreement, understanding, arrangement, or substantial negotiations prior to six months after the distribution.
 
Safe Harbor III: Acquisitions more than two years after a distribution receive safe harbor treatment so long as there was no agreement, understanding, arrangement, or substantial negotiations concerning the acquisition at the time of the distribution or within six months thereafter.
 
Safe Harbor IV: Acquisitions more than two years before a distribution receive safe harbor treatment if there was no agreement, understanding, arrangement or substantial negotiations concerning the distribution at the time of the acquisition or within six months thereafter.
 
Safe Harbor V: An acquisition of Distributing or Controlled stock that is listed on an established market will receive safe harbor treatment if the stock is transferred between shareholders of Distributing or Controlled who are less than five-percent shareholders.
 
Safe Harbor VI: An acquisition of stock in a IRC §83 transaction by an employee or director of Distributing or Controlled in connection with the performance of services will receive safe harbor.
 
The 2000 Proposed Regulations will apply to distributions made after they are published as final.  It is interesting to note that IRC §355(e) would not have affected the result in the Morris Trust case because in that case, the shareholders of Distributing held stock representing approximately 54% of the acquiring corporation subsequent to the combining transaction.  IRC §355(e) is not applicable if shareholders of Distributing, as a result of their ownership of shares of Distributing, own 50% or more of the Controlled and acquiring corporation subsequent to a merger.  In most recent Morris Trust transactions, the shareholders of Distributing ended up with a less than 50% interest in the combined entity.
 
While most tax practitioners will conclude that the safest approach to these types of transactions are to fall within one of the safe harbors, even with the most careful of planning, circumstances may occur that remove a taxpayer from within the safe harbor.  If this happens, practitioners should explain to the client that safe harbors are a nonexclusive route to tax-free treatment.  Moreover, when suggesting an arrangement that is outside the scope of a safe harbor, practitioners must also make it clear to the client that there is a significant risk that the Service may challenge the tax-free nature of the arrangement.

Endnotes.

  • See Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794 (4th Cir. 1966).
  • 1997 TRA, P.L. 105-34, §1012(a) and (b)(1), generally effective for transactions occurring after April 16, 1997.
  • A 50% or greater interest means stock possessing at least 50% of the total combined voting power of all classes of stock entitled to vote or at least 50% of the total value of shares of all classes of stock.
  • Email Disclaimer