[author: Clayton Garrett]
On August 30, 2013 the Treasury Department released final regulations regarding guidance on Section 362(e)(2),1 preventing the duplication of loss when property containing a net built-in loss is transferred to a corporation in a transaction covered by Section 351. A simple transaction, such as a taxpayer transferring assets with a basis exceeding value to a newly incorporated entity, may require the application of these rules. While the transaction may well be tax deferred under Section 351, the new regulations impose significant tax basis implications that must be considered. These regulations have the potential to impose compulsory inside basis reductions in situations that may not be otherwise apparent. Fortunately, this provision and the Regulations provide an election to avoid such treatment by shifting the loss reduction to the outside basis.
Under the general rule, Section 362(a) provides that a transferor takes a basis in the stock received equal to the adjusted basis of the property contributed. Similarly, a transferee takes a basis in the stock received equal to the adjusted basis of the contributed property in the hands of the transferor.2 Section 362(e) was enacted in two subsections to prevent the importation and duplication of losses in certain corporate nonrecognition transactions. Specifically, Section 362(e)(2) prevents duplication in the context of built-in loss transactions in which Section 351 applies and similar acquisitions of property, such as paid-in surplus or capital contributions.
When applicable, Section 362(e)(2) overrides the general basis rules of Section 362(a) and imposes a basis reduction on the acquiring corporation whereby the inside basis of the loss property is reduced by the property’s allocable portion of the transferor’s net built-in loss,3 essentially marking to market the built-in loss property contributed. Section 362(e)(2)(C) allows the parties to the transaction to make an irrevocable election to apply the basis reduction to the transferor’s stock basis received in the exchange rather than to the transferee’s basis in the assets. This election is potentially advantageous in that it allows the basis reduction to be transferred away from the assets, preventing the loss of tax depreciation and amortization.
Following the guidance issued in Notice 2005-70 and the 2006 proposed Section 362(e)(2) regulations, the final regulations adopt general operative rules to ease the identification of transactions subject to the basis reduction provisions. The operative rule in the regulations provides that whenever a person (Transferor) transfers property to a corporation (Acquiring) in a loss duplication transaction, Acquiring’s basis in each loss duplication property is reduced by the allocable portion of Transferor’s net built-in loss. Loss duplication property is defined as any property that is transferred in a Section 362(a)4 transfer, in which the transferee’s aggregate basis in the property transferred by the Transferor exceeds the value of the property immediately after the transfer. The Transferor must test each asset independently to determine whether Section 362(e)(2) applies.
As mentioned, to avoid such treatment, parties may elect to apply the basis reduction to the Transferor’s stock basis under Section 362(e)(2)(C) instead.5 To properly elect Section 362(e)(2)(C), the final regulations require a written, binding agreement to be executed between the Transferor and the acquiring entity agreeing to the irrevocable election, and an election statement must also be filed by the Transferor. Once jointly executed and filed, the election becomes irrevocable. The regulations now require the election statement to be filed in the first taxable year in which the property at issue is acquired by a person required to file a U.S. tax return.
Additionally, significant modifications have also been made in the context of contributions of partnership interests, with particular emphasis on partnership liabilities. To avoid the inconsistency of inside and outside basis resulting from the contribution of such interests, the new regulations specifically modify the definition of value to include liabilities in order to obtain equitable results. As a result, the value for determination of built-in loss existence will fluctuate in a manner similar to the partner’s basis, therefore avoiding the false appearance of a built-in loss. Lastly, the definition of "stock" has also been revised. Consequently, the stock received in exchange for contribution of built-in loss property will, in certain circumstances, include both stock and securities.6
While the final regulations provide clarity, there still appears to be some outstanding issues that remain uncertain. In particular, the receipt of nonqualified preferred stock in accordance with Section 351(g) remains unclear. Under this provision, nonqualified preferred stock may be treated as boot, and gain will be recognized to the extent of fair market value of the property received. The Transferor’s basis in the nonqualified preferred stock is treated as "other property" in accordance with Sections 351 and 358, and therefore receives a basis equal to its fair market value. The question that arises when built-in loss property is contributed in exchange for both common and nonqualified preferred stock and a Section 362(e)(2)(C) election is made, is whether the reduction in the contributor’s stock basis is allocated to both the common and nonqualified preferred stock. While it is arguable under the definition of "stock" that both should receive the basis adjustment, the intersection of these provisions is still uncertain. If the basis reduction does apply, the nonqualified preferred stock could create gain with the basis of the common stock increased above the amount of the built-in loss deduction that would have occurred but for nonqualified preferred stock.
As this provision can be easily overlooked, taxpayers may miss making a Section 362(e)(2)(C) election and lose valuable depreciation deductions. Taxpayers failing to make a timely election under these provisions may have relief under Treas. Reg. Section 301.9100. While the new regulations do not explicitly provide for such relief, it appears to still be available for taxpayers, provided the parties have entered into a written binding agreement satisfying the requirements in the Regulations before the relief request is submitted.
While the final regulations provide clarity, there still appears to be some outstanding issues that remain uncertain.
1 Unless otherwise stated, all references to "Section" are to the Internal Revenue Code of 1986, as amended, and all references to the "Regulations" or "Treas. Reg." are to the Treasury Regulations promulgated thereunder.
2 Section 358(a)(1).
3 Section 362(e)(2)(B).
4 Section 326(a) includes Section 351 transactions and other acquisitions of property as paid-in surplus or capital contributions.
5 Section 362(e)(2)(C).
6 Treas. Reg. Section 1.362-4(g)(11) defines stock as "both Acquiring stock and Acquiring securities received by Transferor in the transaction if gain or loss on the receipt of stock or securities is not recognized in whole or in part."