United States: Affiliation and Consolidation: Selected Group Membership Issues

Originally published October, 2003. To read this article in full, please go to the bottom of this page.

A. General: The term "affiliated group" means one or more chains of includible corporations connected through stock ownership with a common parent corporation which is an includible corporation, but only if--

1. the common parent ("P") owns directly stock meeting the requirements of Section 1504(a)(2) in at least one of the other includible corporations; and

2. stock meeting the requirements of Section 1504(a)(2) in each of the includible corporations (except the common parent, P) is owned directly by one or more of the other includible corporations.

B. Stock Ownership Requirements: Stock meets the requirements of Section 1504(a)(2) if it--

1. possesses at least 80% of the total voting power of the stock of the corporation; and 

2. has a value equal to at least 80% of the total value of the stock of the corporation. 

A. General: The direct ownership requirement looks to beneficial ownership rather than ownership of bare legal title. See Georgiou v. Commissioner, 70 T.C.M. 1341 (1995); INI Inc. v. Commissioner, 69 T.C.M. 2113 (1995); Miami Natl. Bank v. Commissioner, 67 T.C. 793 (1977); FSA 200013018 (Dec. 23, 1999).

B. Nominees: P is treated as the direct owner of stock of a subsidiary ("S") even after transferring title to that stock to a nominee where (i) the nominee is legally obligated to hold and deal with the S stock according to P's orders and direction and (ii) P may at any time obtain legal title to the stock by demand upon the nominee. See Rev. Rul. 70-469, 1970-2 C.B. 179.

C. "Nonvoting" Trusts: P is generally treated as the direct owner of S stock that P has contributed to a "nonvoting" trust (i.e., a voting trust where P may direct the trustee how to vote) of which P is the beneficiary. See Priv. Ltr. Rul. 87-40-010 (July 1, 1987); Priv. Ltr. Rul. 86-10-018 (Nov. 29, 1985). It does not matter whether the trust is a revocable trust (i.e., a trust that P can terminate at its discretion) or irrevocable.

D. Revocable Voting Trusts: P is generally treated as the direct owner of S stock that P has contributed to a revocable voting trust of which P is the beneficiary.

1. In Rev. Rul. 84-79, 1984-1 C.B. 190, the Service ruled that P was the direct owner of S stock transferred to a revocable voting trust. The Service analogized the revocable voting trust case to the nominee case of Rev. Rul. 70-469, where P was treated as the direct owner of stock even though the nominee had legal title because "the only thing lacking in P's complete and absolute ownership of th[e] share is the legal title, which P may at any time obtain by a demand upon [the nominee]."

2. In Gen. Couns. Mem. 39,166 (Mar. 5, 1984), the Service concluded that P continued to own directly S stock that P transferred to a revocable voting trust. The Service concluded that P's ownership of such stock was equivalent to P's ownership of stock transferred to the nominee in Rev. Rul. 70-469. Although the trustee was supposedly independent, the Service emphasized that P retained "legal control" of S when P transferred the S stock to the trust because P was able (i) to terminate the trust and (ii) to replace the trustee without cause at any time.

E. Irrevocable Voting Trusts

1. General rule: P is generally not treated as the direct owner of S stock that P has contributed to an irrevocable voting trust (i.e., a trust that P cannot terminate at its discretion) of which P is the beneficiary.

a. In Priv. Ltr. Rul. 80-40-054 (July 10, 1980), the Service ruled that P did not retain "the entire beneficial ownership" of S stock that P transferred to an irrevocable voting trust because P could not vote the stock. The Service further held that the beneficial ownership retained by P did not constitute "direct" ownership of the stock under Section 1504(a). The Service emphasized that, in the nominee case of Rev. Rul. 70-469, P retained both (i) the discretion regarding the nominee's vote and (ii) the right to obtain the stock back from the nominee upon demand.

b. In Priv. Ltr. Rul. 79-39-042 (June 26, 1979), the Service reached the same result.

2. Exceptions: However, in limited situations, the Service has treated P as the direct owner of stock held by voting trusts or subject to proxy agreements that appear to be irrevocable.

a. In Priv. Ltr. Rul. 91-40-013 (June 28, 1991), P indirectly owned all of the stock of S and sought to acquire Target. Target owned a subsidiary ("T-Sub") engaged in S's business, however, and the inclusion of T-Sub and S in the same group would have violated antitrust laws. To satisfy a governmental agency ("Agency"), P entered into a Voting Trust Agreement with a trustee selected by the Agency and approved by P. Under the Agreement, the trustee was to sell S and was vested with all voting powers prior to that sale (including the right to elect S's directors). The trust was initially to exist for a period of months, but could be extended. The trust was to terminate upon its sale of S or the P group's sale of Target or T-Sub (in which case the trust would return the S stock to the P group). The Service held that the transfer of the S stock to the voting trust did not disaffiliate S from the P group due to the following factors:

(i) The Agreement was of a relatively short duration;

(ii) The P group retained all economic interests in S; and

(iii) The P group could terminate the trust by selling Target or T-Sub.

b. In Priv. Ltr. Rul. 89-19-014 (Feb. 9, 1989), a foreign corporation indirectly owned all of P's stock. A P subsidiary acquired 80% of B corporation's stock. B owned all of the stock of C corporation and D corporation. The businesses of C and D required security clearances from a governmental agency ("Agency") that could be terminated if C and D came under foreign ownership, control or influence. To maintain those security clearances, C and D entered into Proxy Agreements. Under those Agreements, (i) B appointed proxy holders to vote the stock of C and D (even as to the election of directors), (ii) the proxy holders were required to exercise independent judgment, (iii) the proxy holders were to act in good faith to protect B's economic interests, and (iv) the proxy holders could not undertake certain actions without the approval of B (e.g., disposing of property valued at more than $100,000). B could terminate the Agreements whenever they were not necessary to maintain the security clearances; moreover, the Agreements terminated 30 days after those clearances were themselves terminated. The Service ruled that B's ownership of the stock of C and D satisfied the direct ownership requirement of Section 1504(a) in light of the following:

(i) B was entitled to offer business advice to the proxy holders and management of C and D;

(ii) The proxy holders' powers were limited as to certain activities;

(iii) B had the right to terminate the Agreements and reacquire the vote from the proxy holders at any time upon 30 day's notice and surrender of C and D's security clearances;

(iv) B entered into the Agreements solely to satisfy the Agency; and 

(v) B appointed the initial proxy holders.

c. Note the following with respect to Priv. Ltr. Ruls. 91-40-013 and 89-19-014:

(i) The Service seemed to emphasize in each case that its ruling was based on the unusual facts presented;

(ii) In both rulings, the trust or proxy arrangement was used to satisfy a governmental agency's requirement as to nontax matters; and

(iii) In both rulings, P or the P group could terminate the trust or proxy agreement by giving up security clearances or by selling other subsidiaries. Thus, it is possible that the Service viewed such agreements as the equivalent of revocable voting trusts.

3. Query: Does P’s "direct ownership" of stock depend on P’s ability to vote (or at least control the vote of) that stock?

a. Irrevocable nonvoting trusts vs. irrevocable voting trusts. If P is treated as the "direct owner" of voting stock held in an irrevocable nonvoting trust, why would P not be the "direct owner" of stock held by an irrevocable voting trust?

b. Ownership under the grantor trust rules. If P transfers S voting stock to an irrevocable voting trust in which P is the sole beneficiary, is the trust a grantor trust under Sections 671 (grantor trusts generally) and 673 (reversionary trusts)? If so, is P treated as the owner of the S stock held by the trust?

(i) See, e.g., Treas. Reg. § 1.673(a)-1(a) (providing that "[u]nder section 673(a), a grantor, in general, is treated as the owner of any portion of a trust in which he has a reversionary interest in either the corpus or income if, as of the inception of that portion of the trust, the grantor's interest will or may reasonably be expected to take effect in possession or enjoyment within 10 years commencing with the date of transfer of that portion of the trust").

(ii) As discussed above, the Service concluded in Gen. Couns. Mem. 39,166 (Mar. 5, 1984), that P's transfer of S stock to a revocable voting trust did not terminate their affiliation. However, the Service specifically noted in that General Counsel Memorandum: "We do not rely for our conclusion on the grantor trust provisions, sections 671-78, first because we need not do so, and second because we are doubtful whether the ownership at issue in those sections, i.e., whether the grantor owns the income stream from the assets transferred to the trust because of the grantor's control over the trust, is equivalent to the type of ownership required by section 1504(a)."

(iii) If P is treated as the owner of stock held by a grantor trust under the grantor trust rules, what is the basis for the Service's position that P should not be treated for Section 1504(a) purposes as the direct owner of stock held by an irrevocable voting trust that qualifies as a grantor trust?

(a) See Gen. Couns. Mem. 39,166 (Mar. 5, 1984) (discussed above, and suggesting that "legal control" over S is required). 

(b) See INI, Inc. v. Commissioner, 69 T.C.M. 2113 (1995) (addressing P’s transfer of an irrevocable proxy to vote S stock owned by P) (discussed below).

F. Irrevocable Proxies

1. In INI, Inc. v. Commissioner, 69 T.C.M. 2113 (1995), P owned all of S's stock, resulting in affiliation. P and a P shareholder ("X") then entered into a transaction in which, the court found, P transferred to X an irrevocable proxy to vote S's stock prior to P's actual sale of that stock to X.

2. Agreeing with the Service, the court ruled that P's transfer of the proxy terminated the P-S affiliation because the 80% voting power requirement was no longer satisfied -- even though (i) P continued to own the stock directly and (ii) the stock was 100% of S's voting stock.

3. The court stated: "[T]he control test contained in section 1504(a) requires that the parent beneficially own at least 80 percent of the voting power of all classes of stock issued by the subsidiary. [Parent] gave [an unrelated person] an irrevocable proxy to vote all of [the subsidiary's] issued stock; thus, once this proxy became effective [parent] could not satisfy section 1504(a)'s 80 percent voting power requirement. . . . Paramount to section 1504(a)'s definition of affiliation is that the parent possess at least 80 percent of total voting power of the subsidiary stock."

4. Note that the court was concerned not with P's ownership of stock possessing the requisite voting power, but rather with P possessing that voting power.

G. Single-Member Limited Liability Companies

1. A single-member limited liability company ("LLC") may be disregarded and treated as a division of its owner for federal tax purposes. See Treas. Reg. § 301.7701-3.

2. If P forms a single-member LLC that is disregarded and treated as a division, P should be treated for federal tax purposes -- including the affiliation provisions of Section 1504(a) -- as the direct owner of S stock actually owned by that LLC. See Priv. Ltr. Rul. 1999-26-017 (Mar. 30, 1999).

a. Treating a single-member LLC as a division of its owner effectively allows the LLC and the owner to consolidate for federal income tax purposes while avoiding the application of the consolidated return regulations.

b. Even if the single-member LLC elects to be treated as an association, S presumably would be a member of P’s affiliated group as long as P and the LLC together own the requisite amount of S stock. See Sections 1504(b) (defining "includible corporation") and 7701(a)(3) (defining "corporation").

3. However, if the LLC has a second member in addition to P and is treated as a partnership for federal tax purposes, S stock owned by the LLC will not be treated as owned by P for purposes of Section 1504(a). See Priv. Ltr. Rul. 96-40-010 (June 28, 1996) (where P owned a 99% interest in the LLC); Priv. Ltr. Rul. 96-26-031 (Mar. 29, 1996) (where P owned a 92.5% interest in the LLC).

H. Substantially Nonvested Stock Transferred to Employees: The Service has ruled that an employee will not be treated as owning "substantially nonvested" stock ¹ received from an employer or the employer’s shareholder for purposes of Section 1504(a).

1. In Priv. Ltr. Rul. 97-12-029 (Dec. 23, 1996), a corporation ("Company") had two classes of stock outstanding. P owned all of the Company’s Class B stock. The public and certain private investors owned all of the Company’s Class A stock. The ruling does not disclose the terms of the two classes of stock, but it appears that both classes of stock were voting stock and that P and the Company were affiliated. The Company then issued additional Class A stock to its own employees and those of its subsidiaries. The stock was substantially nonvested for a specified period (the "Restricted Period"). During the Restricted Period, the employees could direct the voting of their respective shares and receive dividends, but could not sell, transfer, pledge or assign the shares. In addition, the employees had no right to a liquidating distribution during the Restricted Period. The Service held that the employees would not be treated as owning the shares during the Restricted Period for purposes of Section 1504(a). The Service based its holding on Section 83 principles relating to the ownership of substantially nonvested property.

a. The Service relied on Treas. Reg. § 1.83-1(a)(1)(ii), which provides: "Until such property becomes substantially vested [i.e., either not subject to a substantial risk of forfeiture or transferable], the transferor shall be regarded as the owner of such property, and any income from such property received by the employee . . . constitutes additional compensation . . . ."

b. The Service then observed that, "[f]or purposes of section 1504(a), ownership of stock consists of the right to participate in the management of the company through voting (the election of directors), the right to receive dividends, and the right to receive assets upon liquidation."

c. The Service noted that the employees had no right to liquidating distributions and that dividends received on the stock during the Restricted Period were taxable as additional compensation and deductible as compensation by the transferor.

d. Accordingly, the Service held that the employees would not be treated as owning the shares during the Restricted Period for purposes of Section 1504(a).

2. In Priv. Ltr. Rul. 98-04-033 (Oct. 24, 1997), the Service addressed the same issue, although the ruling does not specify that the employees could direct the voting of the restricted shares while they were substantially nonvested.

a. As in Priv. Ltr. Rul. 97-12-029, the restricted shares were substantially nonvested for a specified period.

b. Applying the same Section 83 analysis as in the previous ruling, the Service held that the restricted stock "will not be treated as held by the employee during the period the restricted Sub stock is subject to a substantial risk of forfeiture within the meaning of §83(a)(1) for purposes of section 1504(a) of the Code."

c. In its holding, the Service referred to the period during which the stock was subject to a substantial risk of forfeiture, and ignored the issue of transferability. Under Section 83, however, an employee is treated as owning the stock as soon as the stock is either (i) not subject to a substantial risk of forfeiture or (ii) transferable. Presumably, the Service referred merely to the period during which the stock was subject to a substantial risk of forfeiture because, according to the facts of the ruling, the stock was also nontransferable throughout that period.

3. Issues

a. Priv. Ltr. Rul. 97-12-029 did not specify the respective voting power of the Class B stock held by P and the Class A stock held by the employees and other persons. Thus, it is possible that P would have satisfied the 80% voting power requirement even if the employees were treated as owning the substantially nonvested stock during the Restricted Period (and that only the 80% value test was at issue). The ruling, however, does not address this issue.

b. What if P owns 80 shares of S voting stock and S issues to its employees 30 shares of S stock that are substantially nonvested for a specified restricted period? Assume that, during the restricted period, the employees control the voting of the 30 shares and receive dividends (treated as additional compensation under Section 83). Assume further that an employee’s shares generally will vest at the end of the restricted period unless, within that period, the employee voluntarily terminates employment or is terminated by P for cause -- so that P cannot effectively control whether the shares ultimately vest (the apparent facts of Priv. Ltr. Rul. 97-12-029).

(i) Under the Service’s approach, it appears that S would be treated as owning the newly issued shares as treasury stock during the restricted period for purposes of Section 1504(a), so that P and S remain affiliated.

(ii) However, does the S stock owned by P still possess 80% voting power? Is P’s ownership of S stock sufficient if P does not possess 80% voting power?

(a) Are these facts similar to those presented where P transfers S stock to an irrevocable voting trust that also qualifies as a grantor trust? As discussed above, P apparently should be treated as owning the S stock held by such a trust under the grantor trust regulations. Nevertheless, as discussed above, the Service generally has concluded that P is not the direct owner of such stock for purposes of Section 1504(a) because P cannot control the vote.

(b) Are these facts similar to the facts presented by the irrevocable proxy at issue in INI (discussed above), where P’s ownership of S’s voting stock was not sufficient for purposes of Section 1504(a) because P transferred to another person an irrevocable proxy to vote that stock?

(iii) Note that the Service specified in Priv. Ltr. Rul. 97-12-029 that its treatment of substantially nonvested stock does not apply if an election is filed under Section 83(b). No such statement was included in Priv. Ltr. Rul. 98-04-033. Although an election under Section 83(b) affects the treatment of substantially nonvested stock for purposes of Section 83, does it affect P’s voting power? Should it affect affiliation?

c. What if, in the prior hypothetical, S issued 80 shares of substantially nonvested stock instead of only 30 shares, so that P controlled the vote of only 50% of S’s stock? Would the Service still treat the shares as owned by S under Section 83 principles and conclude that P and S continued to be affiliated, even though P lacked management control over S? See Tech. Adv. Mem. 94-52-002 (Aug. 26, 1994) and Alumax Inc. v. Commissioner, 109 T.C. 133 (1997), aff’d, 165 F.3d 822(11 th Cir. 1999) (discussed below).

d. Assume that P owns all of S’s voting stock, forms a single-member LLC that is treated as a division of P, and contributes 21% of the S stock to the LLC. As discussed above, P and S should be treated as affiliated. What if the LLC issues to its employees voting ownership interests that are substantially nonvested for purposes of Section 83 but that the employees can vote? Is the LLC a disregarded entity while the employees hold the substantially nonvested ownership interests? (If the LLC ceases to be a disregarded entity and is treated as a partnership, P and S presumably would be disaffiliated because P would own directly only 79% of S’s stock.)

I. The So-Called "Friendly Doctor Ruling" -- Priv. Ltr. Rul. 96-05-015 (Nov. 8, 1995), revoked in Priv. Ltr. Rul. 97-52-025 (Sept. 24, 1997)

1 Facts (simplified)

a. General: P, a health care insurance provider, sought to acquire a medical practice. To do so, a new professional corporation ("PC") was formed to acquire intangible assets of the targeted medical practice, employ the selling physicians, and provide medical care. Either P or S provided funds to PC for such acquisition.

b. Title Ownership and Operation: State law provided that only licensed physicians could own stock of a professional corporation. To satisfy that requirement, legal title to PC's stock was owned by an employee ("Employee"). S loaned to Employee the funds used to acquire the PC stock. The loans were evidenced by nonrecourse notes and secured by a pledge of the PC stock to S. S also held an option to acquire the PC stock from Employee at any time for an amount equal to Employee's initial purchase price. A subsidiary of S ("S-1") controlled PC's day-to-day operations by providing management services.

c. Voting Control: Under the pledge agreement, Employee was required (i) to give 10 day's notice before voting the PC stock, (ii) to consult with S regarding any such vote, and (iii) to give 5 day's notice of his voting intention. If Employee did not intend to comply with S's voting recommendation, S would exercise its option to purchase the PC stock through another physician employee who would vote as desired by S. If Employee misrepresented his voting intention, S would exercise its purchase option after Employee's vote and demand a revote.

d. Economic Interest: Employee could not receive dividends from PC. Employee could not profit from any increase in the value of PC because S could acquire the PC stock from Employee at any time under the option agreement for Employee's initial purchase price. Moreover, the nonrecourse nature of the note insured that Employee would not be liable if the PC stock declined in value.

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