Corporation's Drop Down of Assets Affects the Tax-Free Status

The plan of reorganization provides first that P will transfer substantially all the F1 stock to S in order to "decontrol" F1 for purposes of section 368(a)(1)(D). There is no plan or intention to take any act that would result in P's regaining control of F1.

As a second step, F2 will drop into a general partnership its land and buildings, the bulk of which are used in its business and represent less than one-third of the fair market value of the total gross assets of F2. F2 will receive in exchange a ninety-nine percent general partnership interest and F3, upon simultaneously contributing cash, will receive the remaining one percent interest. The reason for the drop down is to avoid imposition of a large tax that Country W would otherwise impose if those assets were transferred directly from F2 to F1.

The third step in the transaction will be the transfer of F2's assets, including the partnership interest, to F1 in exchange for F1's voting common stock and F1's assumption of F2's liabilities, which do not exceed either F2's basis in the transferred assets or the fair market value of those assets. F2 will then distribute to P the stock it received and dissolve. The F1 stock P receives will not be sufficient for P to regain control of F1.

The final step will be F1's organization of Newco, a Country W corporation, and F1's transfer to Newco of all the assets of a division in F2 which manufactures and sells * * * products. Following the transaction, the partnership will lease the land and buildings to F1 or Newco or both, and F2's businesses will be continued by F1 and Newco.

a. Continuity of business enterprise

An acquiring corporation can satisfy the continuity of business enterprise requirement, as described in Treas. Reg. section 1.368- 1(d), either by continuing the acquired corporation's historic business ("historic business requirement") or by using a significant portion of the acquired corporation's historic business assets in a business ("historic assets requirement"). Treas. Reg. section 1.368- 1(d)(3)(ii) provides that if the transferor corporation has more than one line of business, the transferee's continuance of a significant line of business will suffice. Example (1) of the business enterprise regulations illustrates the historic business requirement:

You also concluded, however, that F1 satisfied the business enterprise requirement by the alternate means of using a significant portion of F2's historic business assets. We have considered this conclusion in connection with our discussion of the continuity of interest requirement, below.

b. Continuity of proprietary interest

Treas. Reg. section 1.368-1(b) provides that requisite to a reorganization is a continuity of interest in the modified corporate form on the part of those persons who, directly or indirectly, were the owners of the enterprise prior to the reorganization.

In * * * G.C.M. 35117, I-4763 (Nov. 15, 1972), this office considered a transaction in which, as part of the plan, a merger was followed by a drop-down of all the assets of the acquired corporation into a partnership, of which the acquiring corporation was the sole general partner with a capital interest of 63.75 percent. We found no reorganization under the rule of Groman v. Commissioner, 302 U.S. 82 (1937), and Helvering v. Bashford, 302 U.S. 454 (1938), because continuity of interest was "remote" rather than direct. Under those cases, the transferor corporation's shareholders have no proprietary interest in the corporation that holds none of the transferred assets directly because it dropped the assets down to another entity.

In Groman, a newly organized corporation (Ohio) acquired the stock of another corporation (Indiana) in exchange for its own stock, stock of its parent corporation (Glidden), and cash. Indiana then transferred its assets to Ohio and was dissolved. The Supreme Court held that Glidden was not "a party to the reorganization" within the meaning of that term as used in the predecessor of section 368(b), and that the receipt of its stock by the former shareholders of Indiana was not tax-free, because its stock did not represent a sufficiently direct continuing interest in the assets of Indiana. The court reached this result even though Indiana's assets, after the reorganization, were owned by a corporation (Ohio) that was wholly owned by Glidden.

In Bashford, the shareholders of one corporation (Peerless) transferred their stock to another corporation (Atlas) in exchange for stock of Atlas, stock of a new subsidiary of Atlas, and cash. As part of the same plan, Atlas then transferred the Peerless stock to the new subsidiary. The Supreme Court refused to distinguish Groman on the basis that Atlas momentarily acquired the Peerless stock and held, under Groman, that Atlas was not a "party to the reorganization" since the interest that its stock represented in the acquired corporation was too remote to satisfy the continuity of interest requirement.

Here, section 368(a)(2)(C) overrules in part the "remote continuity" problem of Groman and Bashford by explicitly providing that F1 can drop F2's assets into Newco. There is, however, no statutory provision sanctioning the drop down of assets into the partnership./2/ This raises the question whether the continuity of interest requirement is satisfied when some but not all the transferred assets are transferred in turn outside the provisions of section 368(a)(2)(C).

Taxpayer asserted in G.C.M. 35117 that because partnerships are treated as conduits under Subchapter K, a drop down into a partnership should not raise a remote continuity problem. We continue to disagree. A partnership's nature as a conduit is irrelevant; to discover whether continuity of interest is remote requires examining how the transferred assets are held. In this respect, a partnership differs fundamentally from a corporation. For example, a stockholder's control of a corporation is directly proportional to the amount of stock owned. No such proportionate relationship exists for partners and their partnerships, as the Uniform Partnership Act provides in section 9(1):

The continuity of business enterprise regulations support this separate analysis. Thus, Example (1) of Treas. Reg. section 1.368- 1(d)(5), quoted above, states that "[t]he continuity of business enterprise requirement is met," not that the transaction is a reorganization. Treas. Reg. section 1.368-1(b) provides: "requisite to a reorganization . . . are a continuity of the business enterprise under the modified corporate form, and . . . a continuity of interest . . ." (emphasis added). Moreover, in the discussion of the business enterprise regulations in T.D. 7745, 1981-1 C.B. 134, it is stated that "[t]he courts have long recognized" the continuity of proprietary interest requirement, citing Groman and Bashford, and that the business enterprise requirement is a "necessary corollary" to that requirement.

However, we agree with your conclusion that G.C.M. 35117 is distinguishable, and conclude that the continuity of interest requirement is met here. The focus here and in G.C.M. 35117 is on the remoteness portion of the qualitative aspect of continuity of interest. That is, did each share of stock represent a sufficiently direct continuing interest in the former assets of the transferor corporation? We are aware of no precedent in which the issue was the amount of the acquired assets that must be retained, as compared with those dropped down to remote entities, in order to satisfy the continuity of interest requirement. We believe that issue is best resolved by analogy to the continuity of business enterprise requirement and, to some extent, the quantitative aspect of the continuity of interest requirement.

We agree with your implicit conclusion that remoteness is one aspect of continuity of interest that can be compared with continuity of business enterprise when continuity of business enterprise is analyzed based on historic assets. Accordingly, we believe it is appropriate to look to whether F1 and Newco retained "a significant portion" of F2's assets within the meaning of Treas. Reg. section 1.368-1(d)(4).

You concluded that the historic assets test was met because in Example (1) of Treas. Reg. section 1.368-1(d)(5), quoted above, continuity of business enterprise was found even though T sold two- thirds of its assets. We disagree. Example (1) explicitly refers to the historic business requirements; Example (2), however, refers explicitly to the historic assets requirement. It follows that Example (1) should not be used to illustrate the alternate test explicitly illustrated in Example (2).

The historic assets test of Treas. Reg. section 1.368-1(d)(4) is a facts and circumstances determination that considers the relative importance of the assets to the business and the net fair market value of the assets. Compare Laure v. Commissioner, 653 F.2d 253 (6th Cir. 1981) (continuity of business enterprise satisfied because assets retained in business were "very valuable" and of "crucial importance.") Thus, using an historic assets type of analysis, given the nature of the assets retained, inventory, machinery, patents, receivables, etc., as opposed to investment assets, and given the fact these assets represent two-thirds of the value of F2,/3/ we believe that the continuity of interest requirement is satisfied.

Regarding the quantitative aspect of the continuity of interest requirement, the Service, for rulings purposes, states in section 3.02 of Rev. Proc. 77-37, 1977-2 C.B. 566:

² Taxpayer makes a pro forma argument that the assets were dropped down into the partnership before the transfer to F1 and therefore the remote continuity problem is not present. If this were so, Groman and Bashford would long since have become irrelevant and no statutory amendments limiting the rule would have been necessary. But the Supreme Court realized how easily its Groman and Bashford requirement could be avoided (by forming the subsidiary before the reorganization), and thus stated that "the difference in the method or means by which [the parent's] control was secured [is] not material." Bashford, at 458.

³ We assume there is no substantial discrepancy between the percentage of gross and net fair market values attributable to the real estate.

⁴ The allowance for controlling corporation reflects the fact that section 368(a)(2)(C) allows drop downs into controlled subsidiaries.

⁵ We recognize that our analysis has implications on the drop down of some of the transferred assets to a partnership in a purported "D" reorganization. It is our understanding that you will consider this issue in a revenue ruling project.