IRS Lays Mine Field for Some Stock Transactions

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February 01, 2008

Several years ago promoters devised a strategy to help corporations avoid large potential tax bills that would otherwise be due upon a sale of their business. The strategy was a so-called intermediary transaction. An intermediary corporation with unused tax benefits, such as net operating loss carryforwards, would acquire the stock of the corporation with the potential tax bill and then immediately sell off its appreciated assets to the real purchaser, using the intermediary's tax benefits to shelter the tax that would otherwise be due.

Not surprisingly, the IRS took a dim view of this loss of tax revenue and in 2001 (in IRS Notice 2001-16) included intermediary transactions among its listed transactions, meaning that they are subject to penalties for non-disclosure by their promoters and participants. However, it was unclear what degree of knowledge was necessary for a taxpayer to be a participant. Could a seller of corporate stock become an unwitting participant in a listed transaction shelter if its buyer happened to resell the assets of the acquired entity in a transaction that was sheltered by the buyer's pre-existing tax benefits?

Last Thursday, the IRS issued a notice (IRS Notice 2008-20, effective January 17, 2008) that supplies a more precise definition of an intermediary transaction tax shelter. The good news is that fewer taxpayers now have to worry about becoming unwitting participants. The bad news is that there are now virtually no excuses for stock transactions that happen to satisfy the four basic requirements of an intermediary transaction tax shelter, namely:

  1. A corporation (T) has a potential taxable gain, the tax liability for which cannot be eliminated with its current tax benefits.
  2. 50 percent or more of the stock of T is disposed of in related transactions within a 12-month period.
  3. During the 24-month period beginning 12 months before and ending 12 months after the date that at least 50 percent of the stock of T has been sold, all or most of T's assets are disposed of in taxable transactions.
  4. All or most of the tax liability arising from the disposition of T's assets during the period described in three is offset or avoided.

However, the IRS notice adds that a less than 5 percent shareholder of publicly traded T stock will not be treated as a participant for selling such publicly traded shares.

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THE EFFECT OF THE IRS NOTICE IS THAT ANY STOCK ACQUISITION THAT DOES NOT INVOLVE A SECTION 338 ELECTION TO PAY IMMEDIATE TAX ON BUILT-IN GAIN ASSETS COULD BECOME A LISTED TRANSACTION THROUGH ACTIONS OF THE BUYER TAKEN AFTER CLOSING TO DISPOSE OF THE ACQUIRED CORPORATION'S ASSETS. FURTHERMORE, A NONTAXABLE STOCK ACQUISITION ,SUCH AS A REVERSE TRIANGULAR MERGER, WOULD ALSO CARRY THIS POTENTIAL RISK.

IN MANY CASES INVOLVING A STOCK ACQUISITION, IT WILL THEREFORE NOW BE NECESSARY TO ADD A POST-CLOSING COVENANT UNDER WHICH THE BUYER AGREES NOT TO DISPOSE OF ALL, OR MOST, OF THE TARGET'S ASSETS FOR AT LEAST 12 MONTHS FOLLOWING CLOSING AND TO PROVIDE FOR INDEMNIFICATION OF THE SELLER IN THE EVENT OF ITS BREACH.

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