Under the caption of "Title X -- Revenues," the Taxpayer Relief Act of 1997 (the "1997 Act"), signed by President Clinton on August 5, 1997, contains just five provisions in subtitle B, relating to "Corporate Organizations and Reorganizations." Do not be fooled. The 1997 Act is replete with provisions of relevance to businesses and their advisors, including some which, although not included in subtitle B of title X, are nevertheless relevant specifically to businesses organized in corporate form (as distinguished from partnerships and limited liability companies). In this column, we touch on a few of the provisions that are likely to be of general interest.1 Some of these, like the new limitations on the ability of corporations to implement tax-free spin-offs (the so-called "anti-Morris Trust" legislation) have already received significant notice in the financial press; others have for some reason so far attracted less attention.
Rollover of Gain from Sale of Qualified Stock
As almost everyone knows, the 1997 Act generally reduced the maximum Federal income tax rate on capital gains of noncorporate taxpayers to 20%, effective for sales after May 6, 1997.2 In order to prevent an inappropriate duplication of benefits, gain from the sale of small business stock held for more than five years that is eligible for the 50% exclusion is not eligible for the reduced 20% rate as well (since eligibility for both benefits would have resulted in a net tax rate of only 10%), but continues to be subject to the 28% rate of prior law (resulting in a continuation of the net tax rate of 14%).
However, the 1997 Act does add a new tax planning opportunity in the case of any qualified small business stock that has been held for more than six months. An individual who sells such stock after August 5, 1997, and, within 60 days after the sale, reinvests the proceeds in other qualified small business stock, is allowed to defer taxation of the gain by "rolling over" into the newly-purchased stock, thereby reducing its basis. To the extent that proceeds are not reinvested, the individual will continue to be subject to tax at the preferential 14% rate.
Exemption from Alternative Minimum Tax for Small Corporations and Repeal of Separate Depreciation Lives for Minimum Tax Purposes
Effective for taxable years beginning after December 31, 1997, the 1997 Act repeals the AMT entirely for any corporation that had average annual gross receipts of $5,000,000 or less for the three-year period beginning after December 31, 1994.3 If a corporation meets this $5,000,000 test as applied for the three-year period from 1995 through 1997, it will not lose its exemption from the AMT until its average annual gross receipts for a three-year period exceed $7,500,000 and, even then, the AMT will be applied in a somewhat less onerous manner. The special AMT rules for depreciation are also repealed for all taxpayers (large and small, corporate and noncorporate), with respect to property placed in service after December 31, 1998.
Election for 1987 Partnerships to Continue Exception from Treatment of Publicly Traded Partnerships as Corporations
The 1997 Act provides grandfathered publicly traded partnerships that do not meet the 90% passive-type gross income test with an election to continue to be treated as partnerships. The price for making the election is that the partnership will be subject to a tax of 3.5% of its gross income from the active conduct of a trade or business. A publicly traded partnership that makes this election will nevertheless be treated as a corporation commencing on any day on which it adds a substantial new line of business.
Limitation on Exception for Investment Companies Under Section 351
(i) The transfer results, directly or indirectly, in diversification of the transferors' interests, and
(ii) The transferee is (a) a regulated investment company, (b) a real estate investment trust, or (c) a corporation more than 80 percent of the value of whose assets (excluding cash and nonconvertible debt obligations from consideration) are held for investment and are readily marketable stocks or securities, or interests in regulated investment companies or real estate investment trusts.4
Similar rules apply in determining whether a transfer to a partnership is considered to be a transfer to an investment company, except that, since a business entity treated as a partnership for income tax purposes is not eligible to be a regulated investment company or a real estate investment trust, clause (ii)(a) and (ii)(b) are inapplicable. The Regulations contain rules relating to when "diversification" will be found to result from a transfer, the treatment of assets held by a subsidiary of a transferee corporation or partnership, and the time at which determination of "investment company" status is made.
As noted above, it is only the Regulations, and not the Code, that provide even an indirect definition of an "investment company" and that do so by reference to "readily marketable stocks or securities." Without changing this basic structure (i.e., without inserting a definition in the Code of an "investment company"), the 1997 Act does add a provision to the Code providing that a variety of other assets held for investment, in addition to readily marketable stocks or securities, are to be taken into account for purposes of the 80% test in the Regulations. These now include money, all stocks and other equity interests in a corporation (whether or not readily marketable),5 evidences of indebtedness,6 options, forward or futures contracts, notional principal contracts and derivatives, foreign currency, equity interests in noncorporate entities that are readily convertible into other assets on this list, and precious metals (unless, after the transfer, the metals are used or held by the transferee in the active conduct of a trade or business). Rules are provided to "look through" an entity an interest in which is transferred if the entity owns assets otherwise included on the list. Assets not held for investment will continue not be counted toward the 80% threshold. The new rules are generally applicable for transfers after June 8, 1997.
Certain Preferred Stock Treated as "Boot"
Effective generally for transactions after June 8, 1997, "nonqualified preferred stock" received by a taxpayer in a section 351 exchange or reorganization will not be considered to be "stock" for purposes of these provisions and the taxpayer will be forced to recognize gain to the extent of the value of such stock received. However, the receipt in a reorganization of nonqualified preferred stock in exchange for other nonqualified preferred stock, for debt securities, or, in the case of a recapitalization of a "family-owned corporation," for common stock, may still qualify for nonrecognition. "Nonqualified preferred stock" is defined as any stock which is limited and preferred as to dividends and does not participate in corporate growth to any significant extent, if (1) the holder has the right to have the issuing corporation redeem the stock, (2) the issuing corporation is required to redeem the stock, (3) the issuing corporation has the right to redeem the stock and, as of the date the stock is issued, it is more likely than not that such right will be exercised, or (4) the dividend rate on the stock varies with an index similar to interest rates or commodity prices.7
Denial of Interest Deductions on Certain Debt Instruments
Several recent tax acts have imposed limitations on the ability of issuers to deduct interest on "equity-flavored" debt instruments that would not otherwise have been recharacterized as equity. The 1997 Act continues this trend by denying any interest deduction for interest paid on a "disqualified debt instrument." A disqualified debt instrument is any indebtedness of a corporation if (a) the instrument is payable only in stock of the issuer or a related party, (b) the instrument is payable at the option of the issuer in (or convertible at the option of the issuer into) stock of the issuer or a related party, or (c) a substantial amount of the principal and interest is determined (or may at the issuer's option be determined) by reference to the value of stock of the issuer or a related party. The rules will also apply if (d) principal or interest is required, at the option of the holder, to be paid in (or determined by reference to) stock of the issuer or a related party, if there is a substantial certainty that the option will be exercised, or (e) the indebtedness is part of an arrangement which is "reasonably expected" to result in one of the transactions described in clauses (a) through (d). These rules are generally applicable to debt instruments issued after June 8, 1997.
Tax Treatment of Certain Extraordinary Dividends
In order to prevent abuse of these rules, the Code provides that a corporate recipient of an "extraordinary dividend" (which would generally include any stock redemption transaction) is required to reduce its basis in the stock with respect to which the extraordinary dividend is paid. Before the 1997 Act, if the amount of the required reduction exceeds the basis of the stock, the excess was taken into account as additional gain only at the time that the stock was sold.
In 1995, a much-publicized transaction involving Seagram's investment in DuPont -- in which Seagram received a large redemption distribution, which it treated as a "dividend" on the theory that it held sufficient options with respect to DuPont stock after the transaction that its interest in DuPont had not been reduced, even though its actual shareholdings went down substantially -- led Congress to take another look at these provisions. They have now been tightened materially, on a retroactive basis, with respect to distributions (including redemptions) occurring after May 3, 1995. First, in any case in which the basis reduction required in the case of an extraordinary dividend exceeds the basis of the stock, gain will be recognized immediately, rather than being deferred until the recipient corporation disposes of the stock. Second, if the reason that a redemption distribution that is received by a corporation is treated as a "dividend," rather than as a capital gain transaction, is that options that continue to be held by the recipient prevent there from being a "meaningful reduction" in the recipient's interest in the distributing corporation, the amount of the basis reduction is required to be recognized in income immediately, without regard to the recipient's remaining basis in its stock. In each of these cases, the benefit of the deduction for dividends received is effectively eliminated.
Modification of Holding Period Applicable to Dividends Received Deduction
Effective for dividends paid or accrued after September 4, 1997,8 the holding period will be determined on a dividend-by-dividend basis. The taxpayer will have to be "unhedged" for at least 46 days of the 90-day period beginning 45 days before each ex-dividend date (91 days of the 180-day period beginning 90 days before the ex-dividend date in the case of preferred stock subject to the 91-day rule). A "grandfather" rule is provided for certain stock which was held and hedged on June 8, 1997, and continuously thereafter.
Application of Section 355 to Distributions in Connection with Acquisitions and to Intragroup Transactions
The new rules presume such a plan exists where one or more persons acquire directly or indirectly stock representing a 50% or greater interest in either the distributing or controlled corporation during the four-year period beginning on the date two years before the date of the distribution; this presumption is, however, rebuttable. Broad regulatory authority is also granted to the Treasury Department to alter the normal tax rules in the case of spin-offs within an affiliated group. The legislative history reflects particular concern with basis-shifting and gain-elimination possibilities within such groups. The new rules are applicable generally with respect to distributions occurring after April 16, 1997, but only in the case of a plan (or series of related transactions) which involves an acquisition of stock of the distributing or controlled corporation that occurred after April 16, 1997.
Registration and Other Provisions Relating to Confidential Corporate Tax Shelters
The 1997 Act extends the registration requirement to certain "confidential corporate tax shelters." A confidential corporate tax shelter is a transaction (a) which has as a significant purpose the avoidance or evasion of tax by a corporation, (b) which is offered to potential participants under conditions of confidentiality, and (c) in which the promoters of the shelter may receive fees which exceed $100,000 in the aggregate. The information required to be registered includes a description of the shelter, the tax benefits it expects to generate, and a list of the people who have signed confidentiality agreements or who have been subjected to nondisclosure requirements. Failure to comply with these requirements may result in penalties equal to the greater of $10,000 or 50% of the total fees paid to the promoter prior to the date of registration. (If the failure to register was deemed to be caused by an intentional act, the penalty rises to the greater of $10,000 or 75% of all fees paid prior to the registration date.) This provision will become effective for tax shelters offered to potential participants after the date that the Treasury Department issues guidance on these filing requirements.
Modification of Taxable Years to Which Net Operating Losses May Be Carried
Modification of Taxable Years to Which Unused Credits May Be Carried
Expansion of Denial of Deduction for Certain Amounts Paid in Connection with Insurance
Prior to the 1997 Act, no deduction was permitted for premiums paid on life insurance policies covering the life of any employee or officer, or any person financially interested in a trade or business of the taxpayer, if the taxpayer was a direct or indirect beneficiary of the policy. The 1997 Act extends this rule to prohibit deductions for premiums paid on certain annuity and endowment contracts as well.
The 1997 Act also adds a provision disallowing deductions for a corporate taxpayer's interest expense allocable to unborrowed policy cash values, i.e., the excess of the cash surrender value of any insurance policies or contracts over the amount of any loan in respect of such policies or contracts. This allocation of interest expense on other, unrelated loans to unborrowed cash policy values is calculated by multiplying the aggregate amount allowable to the taxpayer as a deduction for interest by the ratio of the taxpayer's average unborrowed policy cash values of life insurance policies, and annuity and endowment contracts, issued after June 8, 1997, to the sum of these average unborrowed policy cash values plus the adjusted bases of the remainder of the taxpayer's assets.
Certain Notices Disregarded Under Provision Increasing Interest Rate on Large Corporate Underpayments
1. Among the more specialized areas in which the 1997 Act made significant changes that are beyond the scope of this article are taxation of certain financial products (including most noticeably elimination of "short against the box" transactions), the foreign-related provisions of the Internal Revenue Code, the rules governing real estate investment trusts, the rules governing pensions and employee benefits, and estate and gift taxes (including a special provision relating to "qualified family-owned business interests").
2. The tax rates applicable to capital gains realized by corporate taxpayers were generally not reduced by the 1997 Act.
3. In order to prevent easy evasion of the $5,000,000 requirement through the use of multiple corporations, the gross receipts of certain related entities are aggregated in order to determine if any of them satisfies that requirement.
Although it seems clear that the repeal of the AMT is intended to apply to "small corporations" that were not yet in existence during 1995 (or 1997), it is less clear how the mechanics of the $5,000,000 test would be applied to such corporations.
4. Treasury Regulation section 1.351-1(c)(1) (emphasis added).
5. The rule in the Regulations permitting a "look-through" in the case of a 50%-or-more-owned subsidiary ought to prevent this rule from creating investment company status in the case of a transferee corporation or partnership that does business through subsidiaries. However, venture capital funds that acquire minority interests in nonmarketable securities may now be treated as investment companies.
6. Presumably this means that the complete exclusion from consideration, for purposes of the 80% computation, of nonconvertible debt instruments, will no longer apply.
7. Clauses (1), (2), and (3) apply only if the right or obligation can be exercised within 20 years of the date of issuance and is not subject to a contingency at the issue date which makes the likelihood of redemption remote. Redemption of preferred stock by a person related to the issuer is generally treated like redemption by the issuer for purposes of this provision.
8. The 30th day after the date of enactment of the 1997 Act.
9. As well as the alcohol fuel credit, contributions to community development corporations credit, disabled access credit, employer social security credit, empowerment zone employment credit, enhanced oil recovery credit, incremental research credit, Indian employment credit, orphan drug credit, and work opportunity credit.
The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.