IRS Withdraws Draft “Net Worth” Regulation


The IRS announced in July that it had withdrawn proposed regulations (the net worth regulations) that provided guidance regarding company incorporation, reorganizations and liquidations of insolvent companies. These regulations, which were proposed in 2005, required the exchange (or, in the case of the liquidation of a subsidiary in its parent company, the distribution) of “equity” in order for the transaction to benefit from a treatment of non-recognition under Internal Revenue. Code (the Code).

The Net Worth Settlement

Net worth in 332 liquidations

When it released the net worth regulations, the IRS said authorities interpreting the requirements for a tax-free liquidation of a subsidiary in its parent company (a liquidation of 332) consistently concluded that ‘a distribution of “equity” is required, and that the parent company should receive payment in its capacity as a shareholder of the liquidating subsidiary, and not only in its capacity as creditor.

Regulations in effect prior to the publication of the Net Worth Regulations implemented the net worth requirement for potential 332 liquidations by requiring the parent company to receive at least a partial payment for the shares it owns in the subsidiary. in liquidation. Such a payment could only take place if there was a distribution of equity. The only change in the net worth regulations made to this rule was to require the parent company to receive at least one partial payment for each class of shares it owns, if it owns shares of more than one class of equity. shares in the branch in liquidation. The IRS took this approach – which it saw as a “clarification” of the existing requirements – because it considered it appropriate that a taxpayer recognize a loss when it does not receive a distribution on a class of shares in a liquidation 332.

Net worth of 351 transactions and reorganizations

The IRS considers that the equity principles applicable to 332 liquidations also apply to “351 transactions” and potential tax-free reorganizations. However, the IRS ‘position that an equity swap is required is inconsistent with some existing authorities. The IRS has recognized the uncertainties that exist in this area and has sought to resolve them by adopting a net worth requirement for transactions under net worth regulations.

A 351 transaction – that is, a transfer of ownership to a company in exchange for shares in the company – is a non-recognition transaction under section 351 of the Code if certain conditions are met. The equity regulations required that there be a transfer of equity to the company and a receipt of equity from the company. The equity settlement added a similar equity swap requirement for certain potential tax-free reorganizations. The net worth requirement did not apply to reorganizations that were recapitalizations or simple changes of identity, form or place of incorporation, nor to certain acquisitive “D” reorganizations.

The IRS has said it believes the equity requirement is the appropriate unifying standard for non-recognition treatment because transactions that do not meet this requirement – that is, transfers of ownership in exchange for assuming liabilities or settling liabilities – look like sales and should not receive non-recognition treatment.

Notice of withdrawal

The IRS removed those parts of the equity regulations that required, as a condition of non-recognition, that (i) equity be transferred to a corporation in a 351 transaction, (ii) the corporation receiving the transfer from ownership in a 351 transaction is solvent, (iii) there is an exchange of equity in applicable reorganizations and (iv) in a 332 liquidation, the parent company receives at least one partial payment for each class of shares it holds in the subsidiary in liquidation.

In announcing the withdrawal, the IRS said it is of the view that, with respect to 332 liquidations, existing case law and published IRS rulings reflect the IRS’s position.

The IRS has also stated that it is of the view that the current law is sufficient to ensure that the reorganization provisions and section 351 of the Code are used to accomplish ongoing readjustments of interest in property held in the form of modified company; such “adjustments” are the touchstone of tax-free transactions, as opposed to taxable sales transactions.

However, the removal of net worth regulations leaves in place the uncertainty that previously existed in this area over 351 transactions and reorganizations involving insolvent companies. While the withdrawal can be seen as allowing taxpayers to rely on existing authorities that are inconsistent with the IRS ‘position, that position has not changed and the IRS can challenge a transaction that does not meet its requirements. the net worth requirement.

Creditor Continuity of interest

The equity regulations have also provided guidance on when (and to what extent) a company’s creditors are treated as “owners” of the company to determine whether continuity of interest is preserved in a potential reorganization. . In the absence of the preservation of the required continuity of interest, a reorganization will not be eligible for the non-recognition treatment. The portion of the equity regulations dealing with the continuity of interests of creditors was finalized in 2008 and is not affected by the removal of the rest of the equity regulations.

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