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Taking Stock of Voting Rights

Posted on Nov. 25, 2019
Benjamin M. Willis
Benjamin M. Willis

Benjamin M. Willis (@willisweighsin on Twitter; ben.willis@taxanalysts.org) is a contributing editor for Tax Notes Federal. He formerly worked in the mergers and acquisitions and international tax groups at PwC, and then with the Treasury Office of Tax Policy, the IRS, and the Senate Finance Committee. Before joining Tax Analysts, he was the corporate tax leader in the national office of BDO USA LLP.

In this article, Willis examines the voting rights of corporations. This article is part of a series on what the courts and the IRS recognize as stock.

Shares are portions of stock. Stock is the ownership rights in a corporation. Types of corporations vary incredibly, and thus so do their ownership rights.

The code’s various ownership thresholds for determining control of a corporation, often based on vote and value, that we’ll explore in a future article, was often based solely on voting rights historically. Remember passbook savings accounts? Stock. Voting rights there? Please. We’ll get there.

Shares, classes, and rights are a few of the countless ways stock can be divided, which is often required by law. That is why there are voting trusts, proxies, stock with no voting rights, and naked voting stock, or stock with only voting rights.

Stock Is a Bundle of Ownership Right(s)

Stock can include rights to vote and value, but not always. Value rights include earnings and liquidation proceeds as well as returns of capital, debt-like preferences, convertibility options, and much more. Nonstock can be treated as stock and vice versa and those determinations are generally based on the relevant code section, such as section 1504 or 382. Often times the so-called Himmel1 rights that many generally point to as representing stock, discussed more below, can’t even be owned or transferred. Good thing the check-the-box regulations did away with the free transferability-of-interests factor associated with corporations under the Kintner2 regulations, among other things.

While Himmel, a section 302 redemption case, is often misunderstood as defining the essential characteristics of stock, it does approximate most common stock rights. While many make much ado about nothing regarding Himmel, the court did indicate simplifications and generalizations were made in its attempt to define rights frequently found in common stock. Regarding the typical stock corporation, the court explained, “Ownership of stock can involve three important rights: (1) to vote, and thereby exercise control, (2) to participate in current earnings and accumulated surplus, and (3) to share in net assets on liquidation. Ownership of common stock generally involves all of these.” But the court also explained that “more difficult problems are raised when a corporation has more than one class of stock” or when those rights are separated and classes of stock or ownership rights may “not relate to voting power . . . rights to share in earnings [or] rights on liquidation” (emphasis added).

Many corporations determine if their owners — if any exist in the traditional sense — have rights that resemble the Himmel rights but should focus on what ownership rights are conferred upon a corporation’s owners. This is done in the section 368 creditor continuity regs, which often ignore a corporation’s stock rights based on case law. The Supreme Court in Helvering3 bases the meaning of stock on whatever ownership rights are truly available to the shareholders based on the facts of the relevant corporation. It relies on substance, not form, and transcends the narrow Himmel rights. Likewise, Congress has told us through section 385 that the determination of stock is generally based on substance not mere form. This is why debt can be treated as preferred stock during insolvency based on which owners get liquidating distributions.

Some code provisions focus solely on value, like the section 318 attribution of stock rules, while others focus on voting rights, like a section 368(a)(1)(B) reorganization in which an acquiring corporation must generally use solely “voting stock” as consideration, not to be confused with voting power.

The problem lies in the fact that corporations can be almost any type of legal entity and, importantly, most non-stock corporations don’t possess the traditional rights associated with stock. That is why defining stock is impossible. What rights can be owned for one corporation may not be recognized under the law governing another.

Many non-stock entities do not have traditional owners, or even members, and are not legally permitted to distribute earnings like typical corporations. The board may represent management or a manager, so there is no ability to transfer voting rights as generally occurs when a share of voting stock is issued and capable of being transferred. The equivalent of a shareholder might be a general member, a managing member, a beneficiary, a trustee, an account holder, an insured or a policyholder, or the holder of almost any number of rights or even a single right, such as UP-C structures for which pure voting rights are provided.

An association can provide its members with no true Himmel rights. But those entities are still subject to the provisions of the code. And while the redemption provisions, as was relevant in Himmel, may be incapable of being relevant because of an inability to make a distribution of earnings, that doesn’t mean ownership rights, or stock, do not exist. For example, while nonprofits or nonbusiness entities promoting social welfare are generally treated as corporations or associations under the code,4 they often have no stock. So analogies must be made to allow a right or rights to be treated as stock. That is done based on the intent behind the various code provisions that are designed to allow flexibility for corporations, including those without stock or typical ownership rights.

The equivalent of voting rights for nonprofits may be held by donors, founders, volunteers, program recipients, employees, and the benefiting public at large, all of whom may lack the ability to transfer the benefits and burdens of being associated with the entities.5 Nonprofits may or may not have members, and their trustees may appoint their own successors or make suggestions. These restrictions on control are often the result of protections against violating the private inurement doctrine that can result in loss of tax-exempt status.

LTR 8120165 illustrates how non-voting stock can be used to address concerns related to the private inurement doctrine applicable to section 501(c)(3) entities and other nonprofits. Nevertheless, the IRS has been known to revoke tax-exempt status for any private benefit or inurement to “insiders” including management, board members, high-profile employees, and those who can control access to the organization’s benefits. To dispense with the private inurement doctrine, the taxpayer in the letter ruling issued non-voting rights to new members representing no more than 10 percent of the total members. The organization’s historic voting membership consisted of nonprofit organizations and individuals employed by them already subject to their private inurement restrictions. The new non-voting stock was issued to new members that were employees of for-profit entities. Thus, insiders who could more easily obtain private benefits, such as non-arm’s-length agreements for services or products.6

Board-only nonprofits frequently have bylaws that prohibit the organization from having members to prevent control of major decisions — such as the election of the board — making standard ownership rights even more difficult to determine. In fact, volunteers, employees, or the voting public may be closest thing to shareholders, strangely enough, and they have no ability to vote or transfer voting rights of value.

If bylaws are slightly modified to change legal rights (for example, to expand the number of board seats based on updated state law requirements or decrease regulatory costs), does a slight change in rights and legal entitlements require entity (and possible owner) taxation upon realization because stock, as generally understood by many, does not exist? The answer often has been, and generally should be, no — even if the applicable nonrecognition provision requires the transfer of stock. This is generally because these ordinary business adjustments are in accordance with the congressional intent underlying the applicable nonrecognition provision and because stock represents a corporation’s available ownership rights, which cannot be defined for the countless types of entities created under state and foreign law that are treated as corporations.

But some believe that alteration of anything that could be deemed akin to control or voting rights represents modification of part of a corporation’s stock or a separate non-stock right that would be taxable to the holder or deemed owner. Unfortunately, the law in this area is nearly impossible to align with the incredibly diverse rights associated with different entities taxable as corporations (for example, who has section 368(c) control). The importance of the jurisdictional and legal limitations on these entities can’t be overstated in determining whether voting rights — or the closest thing possible — exist.

For entities with nonstandard ownership rights, including many foreign entities treated as corporations that we’ll discuss in another article, the authorities indicate that an entity’s ownership rights that are most akin to the more traditional rights described above will determine what will be treated as the “stock” for various purposes, such as determining control.7

Some Domestic Authorities

Ownership rights may be treated as stock even though they use a different label.8 In addition to non-profits, examples are prevalent in the context of mutual banks, life insurance companies, and savings and loan associations. Those entities generally do not issue stock. Instead, the equity — including the right to vote on matters affecting the entity, the right to share in current earnings, and the right to share in the assets on liquidation, commonly referred to as the Himmel rights — is conferred in something other than stock, if these rights exist at all.

For example, non-stock interests have been treated as stock in the context of maintaining “continuity” under reg. section 1.368-1(d) and (e). The IRS has ruled that when a mutual bank is converted to a stock bank as part of a holding company formation in which the stock bank becomes a second-tier subsidiary of a newly formed mutual holding company, the continuity of interest requirement is satisfied by the receipt of the membership interests in the new holding company in exchange for membership interests in the mutual bank when the mutual holding company acquires the mutual bank in the transaction.9

Likewise, when a mutual life insurance company converts into a stock life insurance company as part of a transaction in which the mutual life insurance company became a second-tier subsidiary of a mutual holding company, the continuity of interest requirement is satisfied by the receipt of the membership interests in the newly formed mutual holding company in exchange for membership interests in the mutual life insurance company when the mutual holding company acquires the life insurance company.10

When a mutual savings and loan association merges into another by having the merged association’s share account holders exchange their passbooks for passbooks with identical cash balances in the surviving association, the continuity of interest test is satisfied because in the exchange the share account holders of the transferor (merged association) obtain proprietary interests in the acquirer equal to their proprietary interest in the transferor.11 The IRS has ruled that mutual ownership interests in a mutual entity will be treated as stock within the meaning of section 351(a) when the mutual ownership interests represent the ownership rights of the mutual entity.12

Substance Usually Governs

A circular share structure can result from several common transactions. For example, many corporations have circular shares from a synthetic spinoff or split-off.

Instead of a parent distributing shares of its newly formed subsidiary in a section 355 distribution, parent gives its shareholders rights to exchange its stock for sub stock. Because shareholders can elect to exchange parent stock only for sub stock that is of equal value, there is no value to the distributed exchange rights other than the relatively nominal option value.

If shareholders exchange their rights, it’s a tax-free section 351 incorporation as part of the plan to form sub. Because the contractual rights were issued by sub to parent in exchange for a business of parent, parent’s formation of sub provided parent’s shareholders with the rights to sub stock. Depending on whether some or all of parent’s shareholders redeem the rights, many corporations concluded that the effect of this transaction was a synthetic tax-free split-off or spinoff, respectively.

Alternatively, direct tracking stock has been used to reach a similar result as opposed to exchange rights. As the stock entitles its owner to more economic rights than those associated with just one subsidiary or its assets the comfort level that it will not be treated as stock of that subsidiary increases. Even in-the-money options can be stock.

Whether form or substance applies in determining if a right or bundle of rights should be treated as stock depends on the applicable statute and its underlying congressional intent. Many provisions are intended to allow entities to engage in ordinary business transactions in a tax-efficient manner, and that intent should be respected. Of course, the determination of voting stock13 and voting power14 is generally made based on all the facts and circumstances.

FOOTNOTES

1 Himmel v. Commissioner, 338 F.2d 815 (2d Cir. 1964).

2 Kintner v. United States, 107 F. Supp. 976 (D. Mont. 1952), aff’d, 216 F.2d 418 (9th Cir. 1954).

4 See, e.g., Benjamin M. Willis, “Corporations Are Carried Away From the Carried Interest Rules,” Tax Analysts blog, Oct. 18, 2019; and Charleston Area Medical Center Inc. v. United States, No. 2018-2226 (Fed. Cir. 2019), aff’g 138 Fed. Cl. 626 (2018).

5 Reg. section 301.7701-3(c)(v)(A) provides, “An eligible entity that has been determined to be, or claims to be, exempt from taxation under section 501(a) is treated as having made an election under this section to be classified as an association.”

6 See also LTR 201028042, regarding the amorphous interpretation of “insiders,” which stems from federal securities laws.

7 Stuart Lazar, “The Definition of Voting Stock and the Computation of Voting Power Under IRC Sections 368(c) and 1504(a): Recent Developments and Tax Lore,” 17 Va. Tax L. Rev. 103 (1997).

8 See, e.g., section 7701(a)(7), providing that stock includes shares in an association, joint stock company, or insurance company; and Rev. Rul. 68-22, 1968-1 C.B. 142 (certificates of interest in a farmers’ cooperative association held to be stock because they were transferable, had a preference upon liquidation, and were redeemable in the discretion of the cooperative).

9 Rev. Rul. 2003-48, 2003-1 C.B. 863.

10 Rev. Rul. 2003-19, 2003-1 C.B. 468.

11 Rev. Rul. 69-3, 1969-1 C.B. 103; see also Paulsen v. Commissioner, 469 U.S. 131 (1985) (respecting bifurcated stock rights).

12 See LTR 9512013 (Ruling 4: “The mutual ownership interests in the MHC will be treated as stock within the meaning of section 351(a). See Rev. Rul. 69-3, 1969-1 C.B. 103.”).

13 Rev. Rul. 73-28, 1973-1 C.B. 187 (parent acquires all the stock of a second-tier subsidiary from a first-tier subsidiary in exchange for parent’s voting stock in a valid section 368(a)(1)(B) reorganization); see also Rudolph Wurlitzer Co. v. Commissioner, 29 B.T.A. 443 (B.T.A. 1933), aff’d, 81 F.2d 971 (6th Cir. 1936), cert. denied, 298 U.S. 676 (1936) (a corporation’s preferred stock owned by its subsidiary can be treated as voting stock for purposes of determining affiliation for consolidated tax returns).

14 E.g., Alumax Inc. v. Commissioner, 109 T.C. 133 (1997), aff’d, 165 F.3d 822 (5th Cir. 1999) (a board’s ability to manage the company was sufficiently limited by the voting restrictions in separate agreements that were held to lower the voting power below the 80 percent threshold in section 1504). See also Framatome Connectors USA Inc. v. Commissioner, 118 T.C. 32 (2002) (50 percent U.S. owner lacked the control, in substance, necessary to cause a foreign joint venture to be a controlled foreign corporation); Textron Inc. v. Commissioner, 117 T.C. 67 (2001) (beneficial interest in voting trust sufficient to create CFC); and reg. section 1.957-1(c), Example 7 (treating a U.S. owner of 45 percent of a foreign corporation’s stock as owning 90 percent of the corporation’s voting power for CFC classification purposes based on an oral agreement authorizing the U.S. owner to direct the votes attributable to the stock held by a 45 percent foreign owner).

END FOOTNOTES

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