A recent Tax Court case has highlighted the issues involved when a corporate parent causes a subsidiary destined to be sold to make a pre- sale dividend to the parent in a non-consolidated return context. A corporate seller is concerned in such a case with preserving the 70% dividends received deduction "DRD"), as opposed to capital gain treatment. Currently, capital gains generally result in a 34% tax rate if the distribution is recharacterized as part of the selling price. The buyer is also concerned with the presale dividend issue since the "dividend" may be taxed to him or her rather than to the seller. This would leave him or her with a higher basis for the stock held in a company with a lower fair market value (i.e., a built-in capital loss).

In Litton Industries, Inc., 89 T.C. 75 (12/3/87), the corporate parent had acquired 100% ownership of a subsidiary, Stouffer, in October 1967. In early 1972, senior executives of both Litton and Stouffer discussed privately a possible sale of Stouffer, but no formal action or announcement occurred. In August 1972, Stouffer declared a $30 million dividend which it paid to Litton in the form of a negotiable promissory note. At that date, Stouffer had accumulated earnings and profits ("E & P") in excess of the face amount of the dividend. However, two weeks later, Litton publicly announced that a disposition of Stouffer was contemplated. Litton then received inquiries from various potential buyers, investment bankers and business brokers. During the next few months Litton contemplated a public offering of Stouffer stock. The registration statement declared that $30 million of the proceeds would be used to pay off the promissory note. As it turned out, Litton instead sold all of its Stouffer stock in March 1973 to Nestle, a Swiss corporation, in a cash sale. Nestle paid almost $75 million for the Stouffer stock and $30 million for the promissory note. On its separate tax return, Litton treated the $30 million dividend as an intercorporate dividend which qualified, at that time, for an 85% DRD. IRS Cites Waterman

The IRS argued in Litton that the dividend was, in substance, part of the sale proceeds which results in increased capital gains to the unconsolidated seller Litton. The Litton court distinguished an earlier case cited by the IRS, Waterman Steamship Corp., 70- 2 USTC para. 9514 (5th cir. 1970), rev'g 50 T.C. 650 (1968). In Waterman, a corporate parent responded to an offer to buy two subsidiaries for $3.5 million cash with a counteroffer to sell the subsidiaries for $700,000 after the subsidiaries declared and paid dividends of $2.8 minion to the seller. The parties agreed and the entire transaction was completed in a series of meetings within 90 minutes, including the total funding of the dividend payment by the purchaser. The Fifth Circuit, finding no business purpose, collapsed the two steps (i.e., a dividend followed by a sale) and reversed the Tax Court ruling that a dividend to the seller had occurred. The appellate court viewed the target subsidiary as a mere "conduit" for passing payment of the purchase price from the buyer through to the seller. In distinguishing Waterman, the Litton court found: 1) that the two steps were not interdependent (i.e., no dividend declaration in the absence of a consummated sale); and 2) the presence of a business purpose other than minimizing tax.

The Tax Court in Litton put considerable weight on its finding that, unlike Waterman, there was no prearranged sale agreement at the time the dividend was declared in August 1972. The separation in time between dividend declaration and ultimate sale supported the Court's finding of the lack of interdependency, as well as the possibility that a dividend liability in the form of a promissory note would not reduce the fair market value of Stouffer by a full $30 million under the multiple of earnings" valuation method that was popular at that time. Additionally, the evidence showed that the note could be satisfied short of a sale of Stouffer stock, in the full amount of the note, such as a borrowing or part borrowing, part public offering. The Court stated that while the tax law does not require a dividend to have a business purpose, the existence of one is a factor weighing against sham transaction" treatment. However, obtaining favorable tax consequences is not sufficient to show business purpose.

The IRS has recently acquiesced in result only in Litton, meaning acceptance of the result, but disagreement with some or all of the reasoning of the Tax Court, I.R.B. 1988-43. Thus, while Litton is a useful planning tool, it is likely the IRS will continue to pursue these cases, particularly where the facts of the case are less favorable in terms of the time sequence and the presence of a business purpose. Since Waterman has continued vitality, tax advisors must be prepared to rebut the IRS's assertion of "conduit transaction" while affirmatively trying to establish the independent significance of the purported dividend. Later Developments

Tax practitioners should be aware of Code Sec. 1059, enacted subsequent to the tax periods involved in Litton. Sec. 1059 provides, generally, that if a corporate shareholder receives an "extraordinary dividend" on stock and disposes of the stock without having held it for more than two years, the basis of the stock must be reduced by the untaxed portion of the dividend. Generally, a dividend is "extraordinary" if it equals or exceeds a "threshold percentage" of basis-5% on preferred stock, 10% on all other stock, subject to aggregation rules.

In a consolidated return context, the affiliated group members are subject to the investment basis adjustment "IBA") rules. Payment of a presale dividend results in a tax-free dividend with a corresponding reduction in basis under Reg. Secs. 1.1502- 14(a)(1) and 1.1502- 32(b)(2)(iii). Unless increased capital gain is desired to shelter a capital loss elsewhere, no particular tax advantage results.

One planning technique to take affirmative advantage of the IBA rules involved the declaration of a cash dividend by a consolidated subsidiary payable to its parent at a future date. Prior to dividend payment date, the future payee disposed of all of the subsidiary's stock at a price which had been reduced to reflect the dividend obligation. Under the IBA regulations prior to amendment, no basis reduction occurred, since the dividend was paid after disaffiliation. This post- disaffiliation dividend receipt was apparently sheltered by the 70% DRD, so long as the two-year Sec. 1059 holding period was satisfied. Recent amendments to the IBA rules which apply to dividends declared in 1988 and thereafter provide that the distribution is deemed to be made immediately before the disposition of all the subsidiary's shares.

Thus, while the dividend distribution is fully eliminated from the seller's income, the seller's basis in the disposed subsidiary is adjusted downward by the full dividend as of the date of sale. However, the new rules are not intended to alter existing case law in a nonconsolidated return context, such as Waterman and Litton. Tax practitioners must consider a host of other issues that arise in the pre-sale distribution cases, which are briefly mentioned. The presence of a specific buyer need not be fatal to dividend treatment where unwanted business assets exist (see TSN Liquidating Corp., 80-2 USTC para. 9640 (5th Cir. 1980)). The immediate disposition of the property it received as a dividend may be fatal to dividend treatment compare Basic, Inc., 77-1 USTC para. 9161 (Ct. Cl. 1977) with Dynamics Corp. of America, 71-1 USTC para. 9000 (Ct. Cl. 1971)). Additionally, the IRS has found dividend treatment rather than capital gain treatment where individual shareholders are involved (see Rev. Rul. 75-493, 1975-2 C.B. 109). As long as there is any distinction in the tax law between dividend and capital gain treatment, this area will remain active.

Paul F. Bulzacchelli

Passive Activity Loss Provisions Revised

This past spring, the IRS issued the second set of proposed and temporary regulations under Sec. 469, The Passive Activity Loss (PAL) Provisions. These new regulations define activity" and modify the first set of PAL regulations.

These provisions characterize the income derived from the rental and sale of property which is rented during the year in which it is sold in the ordinary course of the taxpayer's trade or business. Under the original rules, the rental of property was treated as incidental to the activity of dealing in such property if, in the year of sale, the property was primarily held for sale in the ordinary course of business. The effect was that the property was not treated as used in a rental activity in the year of the sale and, therefore, the character of the income derived from the rental and sale of the property would not automatically be passive. In general, passive income is more desirable than active because it can be offset by both passive and active losses. The inequitable consequences of this rule are best illustrated by the following example.

Assume Bob rented apartments in a building which he has owned for six years. Bob's activity is clearly passive since rental activities are inherently passive. Assume further that in 1989, Bob wishes to cash in on his investment. He converts the building into condominium units and attempts to sell them. Bob is now holding these units primarily for sale to customers in the ordinary course of his business of selling condominium units. The rental of a condominium unit that is sold would be treated as incidental to Bob's dealing activity, and, therefore, the income from the rental and sale of the condominium unit would not necessarily be treated as passive. Such income would be characterized according to the level of Bob's participation in the activity. The above result would not change even if the apartment building generated passive losses in prior years. This inequitable rule would cause the character of the income to vary depending upon the month of the year in which the units were sold. Fairness Prevails

The new rule creates a fairer and more sensible result. If the property had been used in rental activity for more than 80% of the period in which the taxpayer owned the property and was not acquired for the principal purpose of selling to customers in the ordinary course of business, the income will be treated as passive activity income. There is, however, a rebuttable presumption that property was acquired for the principal purpose of sale to customers in the ordinary course of the taxpayer's trade or business, if the rental period does not exceed the lesser of 24 months or 20% of the recovery period" (within the meaning of Sec. 168). The rebuttable presumption is also met if the property was simultaneously offered for sale to customers and used in the rental activity for more than 25% of the period during which the property was used in the rental activity. To illustrate, Bob, in the prior example, owned the apartment building for six years. At the beginning of the seventh year he converted the building into condominium units and commenced his selling activities. For all sales through the eighth year, he will be presumed to be involved in the rental activity. After the eighth year, however, there will be a rebuttable presumption that the principal purpose for the acquisition of the building was for sale to customers in the ordinary course of business.

At that point he will have held the property for the dual purpose of selling and renting for more than 25% of the holding period. Even if it is presumed that the principal purpose of the acquisition of the property was to sell it, the taxpayer can rebut that presumption by establishing the appropriate facts and circumstances. Obviously, the longer the period that the property was held prior to the start of the selling activity, the easier it will be to rebut the presumption.

Scott Tannenbaum text, such as Waterman and Litton. Tax practitioners must consider a host of other issues that arise in the pre-sale distribution cases, which are briefly mentioned. The presence of a specific buyer need not be fatal to dividend treatment where unwanted business assets exist (see TSN Liquidating Corp., 80-2 USTC para. 9640 (5th Cir. 1980)). The immediate disposition of the property it received as a dividend may be fatal to dividend treatment compare Basic, Inc., 77-1 USTC para. 9161 (Ct. Cl. 1977) with Dynamics Corp. of America, 71-1 USTC para. 9000 (Ct. Cl. 1971)). Additionally, the IRS has found dividend treatment rather than capital gain treatment where individual shareholders are involved (see Rev. Rul. 75-493, 1975-2 C.B. 109). As long as there is any distinction in the tax law between dividend and capital gain treatment, this area will remain active.

Paul F. Bulzacchelli

Passive Activity Loss Provisions Revised

This past spring, the IRS issued the second set of proposed and temporary regulations under Sec. 469, The Passive Activity Loss (PAL) Provisions. These new regulations define activity" and modify the first set of PAL regulations.

These provisions characterize the income derived from the rental and sale of property which is rented during the year in which it is sold in the ordinary course of the taxpayer's trade or business. Under the original rules, the rental of property was treated as incidental to the activity of dealing in such property if, in the year of sale, the property was primarily held for sale in the ordinary course of business. The effect was that the property was not treated as used in a rental activity in the year of the sale and, therefore, the character of the income derived from the rental and sale of the property would not automatically be passive. In general, passive income is more desirable than active because it can be offset by both passive and active losses. The inequitable consequences of this rule are best illustrated by the following example.

Assume Bob rented apartments in a building which he has owned for six years. Bob's activity is clearly passive since rental activities are inherently passive. Assume further that in 1989, Bob wishes to cash in on his investment. He converts the building into condominium units and attempts to sell them. Bob is now holding these units primarily for sale to customers in the ordinary course of his business of selling condominium units. The rental of a condominium unit that is sold would be treated as incidental to Bob's dealing activity, and, therefore, the income from the rental and sale of the condominium unit would not necessarily be treated as passive. Such income would be characterized according to the level of Bob's participation in the activity. The above result would not change even if the apartment building generated passive losses in prior years. This inequitable rule would cause the character of the income to vary depending upon the month of the year in which the units were sold. Fairness Prevails

The new rule creates a fairer and more sensible result. If the property had been used in rental activity for more than 80% of the period in which the taxpayer owned the property and was not acquired for the principal purpose of selling to customers in the ordinary course of business, the income will be treated as passive activity income. There is, however, a rebuttable presumption that property was acquired for the principal purpose of sale to customers in the ordinary course of the taxpayer's trade or business, if the rental period does not exceed the lesser of 24 months or 20% of the recovery period" (within the meaning of Sec. 168). The rebuttable presumption is also met if the property was simultaneously offered for sale to customers and used in the rental activity for more than 25% of the period during which the property was used in the rental activity. To illustrate, Bob, in the prior example, owned the apartment building for six years. At the beginning of the seventh year he converted the building into condominium units and commenced his selling activities. For all sales through the eighth year, he will be presumed to be involved in the rental activity. After the eighth year, however, there will be a rebuttable presumption that the principal purpose for the acquisition of the building was for sale to customers in the ordinary course of business.

At that point he will have held the property for the dual purpose of selling and renting for more than 25% of the holding period. Even if it is presumed that the principal purpose of the acquisition of the property was to sell it, the taxpayer can rebut that presumption by establishing the appropriate facts and circumstances. Obviously, the longer the period that the property was held prior to the start of the selling activity, the easier it will be to rebut the presumption.

Scott Tannenbaum