Attorney Says Regs Would Cause Acceleration of Shareholder Gain

Robert D. Burke of Hale and Dorr LLP, Boston, has criticized the proposed regs under section 453(h) for not addressing the type of corporation distributing the installment obligation. Burke says that if an S corporation distributes installment obligations in liquidation following the installment sale of its assets, there will be an acceleration of a disproportionate amount of gain into the year of sale. He suggests that in computing the gain on the deemed installment sale of the stock of the corporation, a portion of the shareholder's basis in his stock equal to the gain recognized by the corporation from the sales of assets after the adoption of the liquidation plan be applied against an equal amount of first "payments," whether distributions from the corporation or installment payments from the purchaser of the assets.

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Internal Revenue Service

Submitted by: Robert D. Burke, Esq.

Dated: June 20, 1997

[1] These comments are submitted in response to a notice of proposed rulemaking pursuant to Section 453(h) /1/ (REG-209332-80) issued by the Department of Treasury/Internal Revenue Service on January 21, 1997 (the "Proposed Regulations"). The comments generally relate to the application of the Proposed Regulations to distributions by S corporations of installment obligations qualifying under Section 453(h).

[2] The Proposed Regulations generally address the application of Section 453(h) without regard to the type of corporation distributing the installment obligation. Because of the operation of certain of the provisions of Subchapter S of the Code, such an approach produces a significant trap for the unwary which is both unfair and inconsistent with the Congressional intent underlying Section 453(h).

STATEMENT OF PROBLEM.

[3] The particular problem raised by the application of the Proposed Regulations to liquidating distributions of S corporations can perhaps best be demonstrated by means of an example.

Assume that X, an S corporation, is wholly owned by A. X

In the year of the sale, X recognizes $200 of gain which is

ANALYSIS.

[4] The result in the foregoing example is clearly inappropriate. The acceleration of a disproportionate amount of gain into the year of sale is inconsistent with the general intent of Section 453 of matching the timing of the recognition of gain from a sale with the receipt of payments. Moreover, it is inconsistent with the intent of Congress in enacting Section 453(h) as expressed in the report of the Senate Finance Committee accompanying the Installment Sale Act of 1980 which provides:

The committee believes that the treatment of a shareholder

S. Rep. No. 96-1000, 2d Sess., 1980-2 C.B. 494 at 505.

[5] As originally enacted, Section 453(h) would have achieved the stated Congressional intent when applied in conjunction with Section 337 of the Internal Revenue Code of 1954 as in effect prior to the Tax Reform Act of 1986 ("Old Section 337"). Under Old Section 337, no gain would be recognized by a corporation upon a sale of assets that met the requirements of Section 453(h). /2/ Thus, in the foregoing example, since no gain would be recognized by X, A would simply have been treated as if he had sold his zero-basis stock in X for $200 payable at closing and $200 per year for each of the next four years. Thus, A would have recognized $200 of gain in each year upon receipt of each payment.

[6] The repeal of Old Section 337 by the Tax Reform Act of 1986 eliminated the symmetry of the tax consequences of (i) an installment sale of stock and (ii) an installment sale of the corporation's assets followed by a liquidation meeting the criteria of Section 453(h) (hereinafter referred to as a "Section 453(h) Sale") by causing the corporation to recognize gain on the asset sale. Although such a lack of symmetry was appropriate for C corporations as a result of the general repeal of the General Utilities Doctrine, it was inappropriate in the context of S corporations. Accordingly, Congress enacted Section 453B(h) in the Technical and Miscellaneous Revenue Act of 1988. The report of the House Ways and Means Committee indicated its intent in enacting Section 453B(h) as a technical correction to the Tax Reform Act of 1986 as follows:

"This rule will allow the shareholder to report the gain

Id. at 64.

Thus, Congress generally intended to restore the symmetry between an

[7] Even if Congressional intent were unclear, modification of the Proposed Regulations to avoid the income-acceleration problem highlighted by the foregoing example would still be desirable. As currently drafted, the Proposed Regulations cause Section 453(h) together with Section 453B(h) to function as a trap for the uninitiated. Such sections on their face seemingly offer taxpayers a method for undertaking an installment sale of the assets of an S corporation with substantially the same tax consequences as a stock sale with no hint of the income-acceleration problem. Such a trap is obviously objectional from a tax-policy perspective.

[8] The income acceleration caused by the Proposed Regulations is also objectionable because taxpayers cognizant of the problem can avoid it by modifying their transactions. For example, shareholders of an S corporation could arrange to have the corporation sell its assets on the installment method but not liquidate. By keeping the S corporation in place simply to collect the deferred payments on the installment obligation, the acceleration problem would be avoided. Alternatively, the sale of assets could be structured so that the amount otherwise payable by the purchaser at closing would be payable several days after the closing. Provided that the corporation distributed the installment note to the shareholders pursuant to Section 453(h) prior to the receipt of any payment on the note, the acceleration problem would be avoided. Although either of these two approaches would eliminate the problem, they would do so at the cost of distorting the economic transactions of taxpayers for no apparent purpose. In many circumstances, the required economic distortion could be unacceptable to the taxpayers as a business matter or at least costly to implement. In any event, there does not seem to be any policy reason to force taxpayers to suffer these distortions or to punish those who do not (whether by choice or ignorance).

PROPOSED SOLUTION.

[9] As demonstrated in the above example, the Proposed Regulations do not result in the desired symmetry between a stock sale and a Section 453(h) Sale. In order to achieve such symmetry, the regulations should be modified to provide that in computing the gain on the deemed installment sale of the stock of the corporation, a portion of the shareholder's basis in his stock equal to the gain recognized by the corporation from sales of assets after the adoption of the plan of liquidation should be applied against an equal amount of the first "payments" (whether liquidating distributions from the corporation or payments received from the purchaser of the assets pursuant to the installment obligation) received by the shareholder. Remaining stock basis would then be allocated to any additional "payments" to be received pursuant to the general installment sale rules set forth in the Proposed Regulations. Such approach would not only restore the general symmetry between sales of stock and Section 453(h) Sales, but would be consistent with existing case law and rulings that provide that if a corporation makes a series of liquidating distributions, the distributions first offset the basis of the shareholders in their stock (so that only when aggregate distributions exceed the stock basis would gain be recognized). See, e.g., Revenue Ruling 85-48, 1985-1 C.B. 126; Ludorff v. Commissioner, 40 B.T.A. 32 (1939). /3/

ADDITIONAL COMMENTS.

[10] I also concur in the comments dated February 4, 1997 submitted by Kimberly S. Blanchard relating to the need for the Proposed Regulations to address the interaction between Sections 453(h) and 453B(h) on the one hand and Section 338(h)(10) on the other hand.

Respectfully submitted,

FOOTNOTES

/1/ Unless otherwise specified, all references herein to section numbers shall be to sections of the Internal Revenue Code of 1986, as amended.

/2/ Each of Section 453(h) and Old Section 337 generally applied in the case of a corporation that adopted a plan of liquidation, thereafter sold assets and liquidated within 12 months of the date of the adoption of the original plan of liquidation.

/3/ For an alternative "solution" see Ginsberg and Levin, Mergers, Acquisitions and buyouts, at Section 1108.4 (1997). Although the solution suggested by Ginsberg and Levin would generally eliminate the inappropriate acceleration of gain recognized by the shareholders of an S corporation pursuant to Section 453(h), in many circumstances it would not result in symmetry in treatment between the sale of stock of the corporation and the treatment under Section 453(h).

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