Reorganizing A Passive Activity

 

I am looking at a case that stacks a couple of different tax rules atop another and then asks: are we there yet?

Let’s talk about it.

The first is something called the continuity of business doctrine. Here we wade into the waters of corporate taxation and - more specifically - corporate reorganizations. Let’s take an easy example:

Corporation A wants to split into two corporations: corporation B and corporation C.

Why? It can be any number of things. Maybe management has decided that one of the business activities is not keeping up with the other, bringing down the stock price as a result. Maybe two families own corporation A, and the two families now have very strong and differing feelings about where to go and how to get there. Corporate reorganizations are relatively common.

The IRS wants to see an active trade or business in corporations A, B and C before allowing the reorganization. Why? Because reorganizations can be (and generally are) tax-free, and the IRS wants to be sure that there is a business reason for the reorganization – and avoiding tax does not count as a business reason.

Let me give you an example.

Corporation A is an exterminating company. Years ago it bought Tesla stock for pennies on the dollar, and those shares are now worth big bucks. It wants to reorganize into corporation B – which will continue the exterminating activity – and corporation C – which will hold Tesla stock.

Will this fly?

Probably not.

The continuity of business doctrine wants to see five years of a trade or business in all parties involved. Corporation A and B will not have a problem with this, but corporation C probably will. Why? Well, C is going to have to argue that holding Tesla stock rises to the level of a trade or business. But does it? I point out that Yahoo had a similar fact pattern when it wanted to unload $32 billion of Alibaba stock a few years ago. The IRS refused to go along, and the Yahoo attorneys had to redesign the deal.

Now let’s stack tax rules.

You have a business.

To make the stack work, the business will be a passthrough: a partnership or an S corporation. The magic to the passthrough is that the entity itself does not pay tax. Rather its tax numbers are sliced and diced and allocated among its owners, each of whom includes his/her slice on his/her individual return.

Let’s say that the passthrough has a loss.

Can you show that loss on your individual return?

We have shifted (smooth, eh?) to the tax issue of “materially participating” and “passively nonparticipating” in a business.

Yep, we are talking passive loss rules.

The concept here is that one should not be allowed to use “passively nonparticipating” losses to offset “materially participating” income. Those passive losses instead accumulate until there is passive income to sponge them up or until one finally disposes of the passive activity altogether. Think tax shelters and you go a long way as to what Congress was trying to do here.

Back to our continuity of business doctrine.

Corporation A has two activities. One is a winner and the other is a loser. Historically A has netted the two, reporting the net number as “materially participating” on the shareholder K-1 and carried on.

Corporation A reorganizes into B and C.

B takes the winner.

C takes the loser.

The shareholder has passive losses elsewhere on his/her return. He/she REALLY wants to treat B as “passively nonparticipating.” Why? Because it would give him/her passive income to offset those passive losses loitering on his/her return.

But can you do this?

Enter another rule:

A taxpayer is considered to material participate in an activity if the taxpayer materially participated in the activity for any five years during the immediately preceding ten taxable years.

On first blush, the rule is confusing, but there is a reason why it exists.

Say that someone has a profitable “materially participating” activity. Meanwhile he/she is accumulating substantial “passively nonparticipating” losses. He/she approaches me as a tax advisor and says: help.

Can I do anything?

Maybe.

What would that something be?

I would have him/her pull back (if possible) his/her involvement in the profitable activity. In fact, I would have him/her pull back so dramatically that the activity is no longer “materially participating.” We have transmuted the activity to “passively nonparticipating.”

I just created passive income. Tax advisors gotta advise.

Can’t do this, though. Congress thought of this loophole and shut it down with that five-of-the-last-ten-years rule.

This gets us to the Rogerson case.

Rogerson owned and was very involved with an aerospace company for 40 years. Somewhere in there he decided to reorganize the company along product lines.

He now had three companies where he previously had one.

He reported two as materially participating. The third he treated as passively nonparticipating.

Nickels to dollars that third one was profitable. He wanted the rush of passive income. He wanted that passive like one wants Hawaiian ice on a scorching hot day.

And the IRS said: No.

Off to Tax Court they went.

Rogerson’s argument was straightforward: the winner was a new activity. It was fresh-born, all a-gleaming under an ascendent morning sun.

The Court pointed out the continuity of business doctrine: five years before and five after. The activity might be a-gleaming, but it was not fresh-born.

Rogerson tried a long shot: he had not materially participated in that winner prior to the reorganization. The winner had just been caught up in the tide by his tax preparers. How they shrouded their inscrutable dark arts from prying eyes! Oh, if he could do it over again ….

The Court made short work of that argument: by your hand, sir, not mine. If Rogerson wanted a different result, he should have done - and reported - things differently.

Our case this time was Rogerson v Commissioner, TC Memo 2022-49.

Buffett's Berkshire Hathaway Is Buying Duracell From Procter & Gamble

You may have read that Warren Buffett (through Berkshire Hathaway) is acquiring the Duracell battery line of business from Procter & Gamble in a deal worth approximately $4.7 billion. The transaction will be stock-for-stock, although P&G is stuffing approximately $1.7 billion of cash into Duracell before Berkshire takes over. Berkshire will exchange all its P&G stock in the deal. Even better, there should be minimal or no income tax, either to P&G or to Berkshire Hathaway.

Do you wonder how?

The tax technique being used is called a “cash rich split off.” Believe it or not, it is fairly well-trod ground, which may seem amazing given the dollars at play.

Let’s talk about it.

To start off, there is virtually no way for a corporation to distribute money to an individual shareholder and yet keep it from being taxable. This deal is between corporations, not individuals, albeit the corporations contain cash. Lots of cash.

How is Buffett going to get the money out? 

·        Buffet has no intention of “getting the money out.” The money will stay inside a corporation. Of course, it helps to be as wealthy as Warren Buffett, as he truly does not need the money.

·        What Buffett will do is use the money to operate and fund ongoing corporate activities. This likely means eventually buying another business.

Therefore we can restrict ourselves to corporate taxation when reviewing the tax consequences to P&G and Berkshire Hathaway.

How would P&G have a tax consequence?

P&G is distributing assets (the Duracell division) to a shareholder (Berkshire owns 1.9% of P&G stock). Duracell is worth a lot of money, much more money than P&G has invested in it. Another way of saying this is that Duracell has “appreciated,” the same way you would buy a stock and watch it go up (“appreciate”) in value.

And there is the trip wire. Since the repeal of General Utilities in 1986, a corporation recognizes gain when it distributes appreciated assets to a shareholder. P&G would have tax on its appreciation when it distributes Duracell. There are extremely few ways left to avoid this result.

But one way remaining is a corporate reorganization.

And the reorganization that P&G is using is a “split-off.” The idea is that a corporation distributes assets to a shareholder, who in turn returns corporate stock owned by that shareholder. After the deed, the shareholder owns no more stock in the corporation, hence the “split.” You go your way and I go mine.

Berkshire owns 1.9% of P&G. P&G is distributing Duracell, and Berkshire will in turn return all its stock in P&G. P&G has one less shareholder, and Berkshire walks away with Duracell under its arm.

When structured this way, P&G has no taxable gain on the transaction, although it transferred an appreciated asset – Duracell. The reason is that the Code sections addressing the corporate reorganization (Sections 368 and 355) trump the Code section (Section 311) that would otherwise force P&G to recognize gain.

P&G gets to buy back its stock (via the split-off) and divest itself of an asset/line of business that does not interest it anymore - without paying any tax.

What about Berkshire Hathaway?

The tax Code generally wants the shareholder to pay tax when it receives a redemption distribution from a corporation (Code section 302).  The shareholder will have gain to the extent that the distribution received exceeds his/her “basis” in the stock.

Berkshire receives Duracell, estimated to have a value of approximately $4.7 billion. Berkshire’s tax basis in P&G stock is approximately $336 million. Now, $336 million is a big number, but $4.7 billion is much bigger.  Can you imagine what the tax would be on that gain?

Which Berkshire has no intention of paying.

As long as the spin-off meets the necessary tax requirements, IRC Section 355 will override Section 302, shielding Berkshire from recognizing any gain.

Berkshire gets a successful business stuffed with cash – without paying any tax.

Buffett likes this type of deals. I believe he has made three of them over the last two or so years. I cannot blame him. I would too. Except I would take the cash. I would pay that tax with a smile.

There are limits to a cash-rich split off, by the way.

There can be only so much cash stuffed into a corporation and still get the tax magic to happen. How much? The cash and securities cannot equal or exceed two-thirds of the value of the company being distributed. In a $4.7 billion deal, that means a threshold of $3.1 billion. P&G and Berkshire are well within that limit.

Why two-thirds?

As happens with so much of tax law, somebody somewhere pushed the envelope too far, and Congress pushed back. That somebody is a well-known mutual fund company from Denver. You may even own some of their funds in your 401(k). They brought us IRC Section 355(g), also known as the two-thirds rule. We will talk about them in another blog.

The Sysco Merger and the Double Dummy

Recently a financial advisor called me to discuss investments and, more specifically, Sysco’s acquisition of U.S. Foods.  I had to read up on what he was talking about.

The Sysco deal is a reverse triangular merger. It is not hard to understand, although the terms the tax attorneys and CPAs throw around can be intimidating. Let’s use an example with an acquiring company (let’s call it Big) and a target company (let’s call it Small).

·        Big creates a subsidiary (Less Big).

·        Less Big merges into Small.

·        Less Big ceases to exist after the merger.

·        Small survives.

·        Big now owns Small.

Voila!

This merger is addressed in the tax Code under Section 368, and the reverse triangular is technically a Section 368(a)(2)(E) merger. Publicly traded companies use Section 368 mergers extensively to mitigate the tax consequences to the companies and to both shareholder groups.

In an all-stock deal, for example, the shareholders of Small receive stock in Big. Granted, they do not receive cash, but then again they do not have tax to pay. They control the tax consequence by deciding whether or not to receive cash (up to a point).

Sysco used $3 billion of its stock to acquire U.S. Foods. It also used $500 million in cash.

And therein is the problem with the Section 368 mergers.

It has to do with the cash. Accountants and lawyers call it the “basis” issue. Let’s say that Sysco had acquired U.S. Foods solely for stock. Sysco would acquire U.S. Foods' “basis” in its depreciable assets (think equipment), amortizable assets (think patents) and so on. In short, Sysco would take over the tax deductions that U.S. Foods would have had if Sysco had left it alone.

Now add half a billion dollars.

Sysco still has the tax deductions that U.S. Foods would have had.

To phrase it differently, Sysco has no more tax deductions than it would have had had it not spent the $500 million.

Then why spend the money? Well… to close the deal, of course. Someone in the deal wanted to cash-out, and Sysco provided the means for them to do so. Without that means, there may have been no deal.

Still, spending $500 million and getting no tax-bang-for-the-buck bothers many, if not most, tax advisors.

Let’s say you and I were considering a similar deal. We would likely talk about a double dummy transaction.

The double dummy takes place away from Section 368. We instead are travelling to Section 351, normally considered the Code section for incorporations.  

 

Let’s go back to Big and Small. 

·        Big and Small together create a new holding company.

·        The holding company will in turn create two new subsidiaries.

·        Big will merge into one of the subsidiaries.

·        Small will merge into the other subsidiary.

In the end, the holding company will own both Big and Small.

How did Small shareholders get their money? When Big and Small created the new holding company, Small shareholders exchanged their shares for new holding company shares as well as cash. Was the cash taxable to them? You bet, but it would have been taxable under a Section 368 merger anyway. The difference is that – under Section 362 – the holding company increases its basis by any gain recognized by the Small shareholders.

And that is how we solve our basis problem.

The double dummy solves other problems. In a publicly traded environment, for example, a Section 368 merger has to include at least 40% stock in order to meet the continuity-of-interest requirement. That 40% could potentially dilute earnings per share beyond an acceptable level, thereby scuttling the deal. Since a double dummy operates under Section 351 rather than Section 368, the advisor can ignore the 40% requirement.

The double dummy creates a permanent holding company, though. There are tax advisors who simply do not like holding companies.

Sysco included $500 million cash in a Section 368 deal. Assuming a combined federal and state tax rate of 40%, that mix cost Sysco $200 million in taxes. We cannot speak for the financial “synergies” of the deal, but we now know a little more about its tax implications.