IRS Withdraws Proposed Regulations On Corporate Stock Basis Recovery
The IRS has withdrawn 2009 proposed regulations[1] that were intended to provide guidance on the recovery of stock basis. The purpose of the 2009 proposed regulations was to establish (i) a single model for stock basis recovery and identification by a shareholder receiving a distribution to which Internal Revenue Code Section 301 applies, and (ii) a single model for a sale or exchange transaction to which Section 302(a) applies (including certain aspects of reorganization exchanges), in each case, whether the provision applies directly or by reason of, e.g., Section 302(d), Section 304, or Section 356. The withdrawal was published in the Federal Register on March 28, 2019.
Introduction to Basis Recovery
Determining a shareholder’s stock basis recovery amount is a critical issue, as it governs the amount of gain that the shareholder may recognize when selling stock in a corporation or receiving a corporate distribution.
While a shareholder who sells or exchanges all of his/her shares computes gain or loss by using the entire basis in the stock, a shareholder that sells less than all of his/her shares of stock must identify the shares of stock sold and the basis associated with those shares to calculate gain or loss for tax purposes. Regulations under Section 1012[2] provide two methods for identifying stock sold: (i) the first-in, first-out (FIFO) method and (ii) the specific identification method. Under the FIFO method, the shares are deemed sold in the order in which they were purchased. If, however, the taxpayer can adequately identify the shares sold (by keeping records of which shares were bought when and how much was paid to acquire the shares), then the taxpayer may use his/her cost basis for purposes of calculating the gain or loss on the sale of those shares.[3] Any realized gain or loss is usually recognized.[4] However, where a shareholder receives proceeds from the corporation (rather than from a third party), the rules for recovery of tax basis are complex and, in some instances, uncertain.
Distributions by a corporation are generally governed by Section 301, which establishes a three-tier hierarchy under Section 301(c)(1)-(3) for determining the tax consequences of a distribution at the shareholder level:
- The distribution is treated as a dividend to the extent of the corporation’s current or accumulated earnings and profits (E&P).
- Distributions in excess of E&P are “applied against and reduce the adjusted basis of the stock.”
- Distributions in excess of the shareholder’s recovered basis result in capital gain.
Certain redemptions may also result in distribution treatment. Section 302 treats a redemption as a sale or exchange or as a distribution, based on the outcome of a series of fact-specific tests under Section 302(b). A redemption that does not satisfy any of the tests is a “dividend-equivalent redemption” pursuant to Section 302(d), which is treated as a distribution under the three-tier hierarchy outlined above.
Ambiguity on Basis Recovery for Certain Redemptions
Section 301 does not outline how to identify the shares upon which a distribution is made, specifically, whether a shareholder recovers its stock basis in the aggregate or on a share-by-share basis. Nor does the tax law specifically provide that transactions treated as distributions—i.e., Section 302(d) redemptions, certain Section 304 transactions, and certain reorganizations—should be subject to the same rules as an actual Section 301 distribution. For reorganizations, the Internal Revenue Code provides consequences resulting from different types of exchanges, but doesn’t specify whether the exchange is based on a shareholder’s aggregate stockholdings or on particular elements of the overall exchange.
The following example illustrates the ambiguity in a distribution scenario:
Corporation X has E&P of $100 and makes a distribution of $2 on each share of its outstanding stock to Individual A, who owns all 100 shares of Corporation X (i.e., a total distribution of $200). On Date 1, A had acquired 50 shares for $25 (“Block 1 Shares”). On Date 2, A had acquired 50 shares for $75 (“Block 2 Shares”).
Share-by-share approach: In a share-by-share tax basis recovery, Individual A tracks the specific share blocks. Each block would receive a dividend in the amount of its ratable share of E&P, or $50. The basis in Block 1 Shares would be reduced from $25 to zero, with the excess $25 being treated as capital gain. Block 2 Shares would be reduced from $75 to $25 of remaining basis, with no resulting capital gain. In total, A receives a $100 dividend, and recognizes a $25 capital gain.
Aggregate approach: Under an aggregate approach, A receives the same $100 dividend, but with respect to the remaining $100 of distributed property, A would aggregate the $25 of basis in Block 1 Shares and $75 of basis in Block 2 Shares, and thus recover the entire $100 with zero basis remaining. In total, A receives a $100 dividend as in the share-by-share approach, but recognizes no capital gain.
In the context of a Section 302(d) distribution, the same issue regarding basis recovery is present, with an added issue of how to account for remaining basis once shares are legally tendered to the corporation. The current regulations under Section 302 merely state, “In any case in which an amount received in redemption of stock is treated as a distribution of a dividend, proper adjustment of the basis of the remaining stock will be made with respect to the stock redeemed.”[5] The regulations under Section 302 provide three examples to illustrate the nature of a “proper adjustment.”[6]
In Examples 1 and 3, the redeemed shareholder continues to own stock of the corporation after the dividend-equivalent redemption. In those cases, the unrecovered basis in the redeemed shares is added to the basis of the shares of the redeeming corporation owned by the shareholder after the redemption. In Example 2, all of the shareholder’s stock is redeemed in a dividend-equivalent redemption, but the shareholder still indirectly owns stock of the redeeming corporation by reason of his wife’s continuing ownership of stock in the redeeming corporation; this example concludes that the redeemed shareholder’s basis in the redeemed shares shifts to his wife’s basis in her shares of stock of the redeeming corporation.
2009 Proposed Regulations and Withdrawal
The now-withdrawn 2009 proposed regulations provided that a shareholder should recover basis in a distribution using a pro rata, share-by-share approach. In support of this approach, the Preamble to the proposed regulations cited the landmark case Johnson v. United States.[7] In Johnson, a corporation made a distribution to its sole shareholder who held two different blocks of stock. The Fourth Circuit held that the taxpayer was required to recover basis under Section 301(c)(2) share-by-share, instead of on an aggregate basis, before gain was recognized under Section 301(c)(3). This approach has been adopted by the Tax Court on similar facts.[8]
The 2009 proposed regulations also applied the share-by-share approach to dividend-equivalent redemptions under Section 302(d). To prevent basis shifting, the regulations outlined, after share-by-share basis recovery, a recapitalization of the redeemed and any retained shares into the retained shares. For redemptions in which the taxpayer surrenders all shares actually (but not constructively) owned, as in Example 2 above, the 2009 proposed regulations treated unrecovered basis as a deferred loss, recoverable by the redeemed shareholder when the shareholder’s cumulative ownership changes met one of the applicable sale or exchange tests under Section 302(b) or when all shares of the issuing corporation (or successor) became worthless.
The 2009 proposed regulations were withdrawn as part of the current administration’s effort to withdraw or revise regulations that increase complexity and financial burdens on taxpayers, or that exceed the IRS’s statutory authority. Pursuant to the withdrawal notice, after considering criticism by practitioners and taxpayer advocacy groups, the Treasury Department and the IRS “determined that it is unlikely that the approach of the 2009 Proposed Regulations can be implemented in comprehensive final regulations without significant modifications.”
The withdrawal notice highlights that Treasury and the IRS are continuing to study the issues addressed in the 2009 proposed regulations, including issues surrounding basis reduction under Section 301(c)(2). However, the withdrawal notice reaffirmed the following positions of Treasury and the IRS:
- The results of a Section 301 distribution should derive from the consideration received by a shareholder in respect of each share of stock, pursuant to the share-by-share basis recovery approach of Johnson v. United States.
- In dividend-equivalent redemptions under Section 302(d), any unrecovered basis in the redeemed stock of a shareholder may be shifted to other stock only if such an adjustment is a “proper adjustment” within the meaning of Reg. Sec. 1.302-2(c). As an example for an improper adjustment, the withdrawal notice cites Notice 2001-45,[9] which addresses a basis shifting tax shelter that was classified as a “listed transaction.”
Observations
The withdrawal of the 2009 proposed regulations is viewed as problematic by some commentators. While the regulations left certain questions unanswered, they were a useful guidepost for practitioners looking for clarity on how to recover basis in certain corporate transactions. Taxpayers are now returned to the pre-regulation landscape of uncertainty. However, as noted in the withdrawal notice, Treasury and the IRS reaffirmed concurrence with Johnson and the approach to basis shifting under Reg. Sec. 1.302-2(c). Moreover, the removal of the 2009 proposed regulations does not rule out the possibility of future guidance on basis recovery.
Please contact the experienced federal tax specialists of BDO USA, LLP’s Corporate Tax Practice for guidance in navigating the uncertainty in this area of the tax law.
[3] Adequate identification is, however, not limited to the methods and evidentiary requirements provided in the Treasury Regulations; see, for example, Hall v. Commissioner, 92 T.C. 1027, 1036 (1989).
[4] Sec. 1001(c).
[5] Reg. Sec. 1.302-2(c).
[6] Reg. Sec. 1.302-2(c), Examples (1), (2), (3).
[7] 435 F.2d 1257 (4th Cir. 1971).
[8] Robert 0. Anderson v. Comm’r, 92 T.C. 138 (T.C. 1989).
[9] 2001-33 I.R.B. 129.
SHARE