Tax Court Rules S Corporation and Its Subsidiary Were Related Persons for Purposes of Section 1239 Despite Outside Investors

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By David I. Kempler, Esq. and Elizabeth Carrott
Minnigh, Esq.
 

Buchanan Ingersoll & Rooney PC, Washington, DC

In Fish v. Commissioner, T.C. Memo 2013-270, the Tax
Court held that cash received by an S corporation in a transaction
under §351 with its subsidiary should be reclassified as ordinary
income under §1239. In reaching its decision, the Tax Court
concluded that restrictive covenants on majority shareholder's
voting rights and management actions did not reduce voting power
below 50% and that, under the valuation control test of
§1563(a)(1), the taxpayer owned more than 50% of the
subsidiary.

Section 351 provides that "[n]o gain or loss shall be recognized
if property is transferred to a corporation by one or more persons
solely in exchange for stock in such corporation and immediately
after the exchange such person or persons are in control (as
defined in section 368(c)) of the corporation." However, §351(b)
provides that if other property or money, commonly referred to as
boot, is received by a transferor in an otherwise tax-free §351
transaction, the transferor must recognize gain to the extent of
the boot received. Section 1239 provides that a sale or exchange of
property to a related party, directly or indirectly, will generate
ordinary income instead of capital gains to the transferor if the
property will be, in the hands of the transferee, depreciable
property. Under §1239(b)(1), related persons include a person and
all entities that are controlled entities with respect to that
person. Under §1239(c)(1)(A), a corporation will be deemed to be a
controlled entity with respect to a person if more than 50% of the
value of the outstanding stock of the corporation is owned
(directly or indirectly) by or for that person.

In late 2004, Taxpayer entered into an arrangement with the
private equity firm, Edgewater, to obtain financial resources to
expand his successful computer security business, FishNet
Consulting, an S corporation. Taxpayer then formed Fish Holdings,
also an S corporation, and transferred all of FishNet Consulting's
common stock to Fish Holdings in a §351 transaction. Fish Holdings
elected to have FishNet Consulting treated as a qualified
subchapter S subsidiary ("QSub").  The election was treated as
a deemed tax-free liquidation of FishNet Consulting into Fish
Holdings under §332.

In January 2005, the Edgewater investors purchased $10.5 million
of newly-created series A preferred stock in FishNet Consulting
from Fish Holdings and agreed to purchase an additional $1.5
million of the series A preferred stock in three years. After
FishNet Consulting issued the series A preferred stock to the
Edgewater investors, it was no longer solely owned by Fish Holdings
and, therefore, its QSub status was terminated. Under
§1361(b)(3)(C)(ii), FishNet Consulting was treated as a new
corporation acquiring all of its assets and assuming all of its
liabilities from Fish Holdings, its S corporation parent,
immediately before its QSub status was terminated in exchange for
stock. The exchange was treated as if the Edgewater investors and
Fish Holdings made concurrent contributions to FishNet Consulting
in a §351 transaction.

FishNet Consulting made a one-time dividend to Fish Holdings
that included a January 2005 payment of $9.46 million from the
proceeds of the stock sale to the Edgewater investors plus an
additional valuation adjustment of $224,000 in December 2005. 
The IRS and Taxpayer agreed that the cash dividend distribution to
Fish Holdings was taxable boot but disagreed as to whether it was
taxable as ordinary income under §1239, as asserted by the IRS, or
long-term capital gain, as asserted by Taxpayer.

Section 1239(b)(1) defines "related persons" as "a person and
all entities which are controlled entities with respect to such
person." For purposes of determining whether an entity is a
controlled entity, §1239(c) applies the attribution rules set forth
in §267(c). The Tax Court concluded that in order to apply §1239 to
the distribution of sale proceeds from FishNet Consulting to Fish
Holdings, it must determine whether Fish Holdings and FishNet
Consulting were related persons for purposes of §1239.
Specifically, the Tax Court stated that it must determine whether
Fish Holdings owned either more than 50% of the total combined
voting power of all classes of FishNet Consulting's stock entitled
to vote or more than 50% of the total value of shares of all
classes of FishNet Consulting's stock.

After the January 2005 preferred stock purchase, Fish Holdings
owned 14,034,375 shares of FishNet Consulting's common stock, or
about two-thirds of the issued and outstanding shares of stock
entitled to vote, and the investors collectively owned 8,465,625
shares of FishNet Consulting's series A preferred stock, or
one-third of the issued and outstanding shares of stock entitled to
vote. Each share of common stock and preferred stock was entitled
to one vote. Therefore, on the sole basis of record ownership, the
Tax Court concluded that Fish Holdings owned more than 50% of
FishNet Consulting's voting stock.

Relying in part on Hermes Consol., Inc. v. United
States
, 14 Cl. Ct. 398, 405 (1988), wherein the court held
that a common stockholder that had less than 50% of the voting
power to elect members to the board of directors had voting power
below 50%, Taxpayer argued that even though on the basis of record
ownership Fish Holdings owned more than 50% of FishNet Consulting's
voting stock, Fish Holdings' voting power was less than 50%.

According to FishNet Consulting's amended articles of
incorporation, the common stockholder elected two out of the five
directors and the preferred stockholders elected another two. The
common stockholder also elected the fifth director, who must be
"independent," as defined in the amended articles of incorporation,
and must be approved by the preferred stockholders, which approval
cannot be unreasonably withheld. Although Fish Holdings elected
three out of five board members, or 60% of the board, Taxpayer
contended that the independence requirement for the fifth director,
in addition to the necessary approval by the preferred
stockholders, reduced Fish Holdings' voting power to less than 50%.
The Tax Court, however, concluded that the limitations on Fish
Holdings' ability to elect the fifth director are not the type that
would reduce its voting power to below 50%. Firstly, the Tax Court
noted that the independence requirement did not prevent Fish
Holdings from exercising its voting power to elect the fifth
director but merely reduced the pool of potential candidates
somewhat.  Secondly, the Tax Court concluded that the
requirement that the investors approve of the independent director
did not reduce Fish Holdings' voting power for that director.

Taxpayer then argued that even if Fish Holdings could elect
three out of the five directors, the negative covenants reduced its
overall voting power below 50%. In a shareholders agreement, the
shareholders agreed that until the Edgewater investors no longer
owned shares of FishNet Consulting, the company could not engage in
certain actions without the prior written consent of a majority of
the series A preferred stockholders, which effectively gave the
Edgewater investors veto powers over many FishNet Consulting
management matters.  However, the Tax Court concluded that
Fish Holdings had significantly more managerial control of the
company, irrespective of the negative covenants, by virtue of
Taxpayer's role in management. The Tax Court noted that Taxpayer,
Fish Holdings' sole stockholder, was "essentially FishNet
Consulting, and it was his expertise and management of the company
that was being purchased" as evidenced by the fact that FishNet
Consulting's valuation for purposes of the stock purchase agreement
was comprised of $9,462,700 in goodwill and $715,355 for other
assets. In reaching its decision, the Tax Court also distinguished
the decisions in Alumax, Inc. v. Commissioner, 109 T.C.
133 (1997), aff'd, 165 F.3d 822 (11th Cir. 1999), and Framatome
Connectors USA, Inc. v. Commissioner
, 118 T.C. 32 (2002),
aff'd, 108 Fed. Appx. 683 (2d Cir. 2004), where the entity
taxpayers were large corporations with domestic and international
affiliates that also had a high net worth and significant assets.
Accordingly, the Tax Court concluded that the negative covenants
reduced Fish Holdings' voting power, but, because of its ability to
elect three out of five directors, its overall voting power with
respect to FishNet Consulting did not fall to 50% or below as of
January 3, 2005.

The Tax Court further concluded that, under the valuation test
of §1563(a)(1), Taxpayer also owned more than 50% of FishNet
Consulting. Taxpayer's expert calculated share value assuming an
immediate liquidation after closing on the stock purchase
agreement, and concluded that the value of the FishNet Consulting
common stock held by Fish Holdings was $9,073,400 and the value of
the preferred stock held by the Edgewater investors was
$15,426,600. Conversely, the IRS expert's valuation assumed that
FishNet Consulting remained a going concern, and used the
redemption value of stock set forth in FishNet Consulting's amended
articles of incorporation, thereby concluding that the value of the
common stock was $14,520,000 and the value of the preferred stock
was $11,260,201. The Tax Court found that the redemption price
valuation offered by the IRS's expert was more reliable than the
hypothetical liquidation presented by Taxpayer's expert.
Accordingly, the Tax Court held that Fish Holdings owned more than
50% of the total value of shares of all classes of FishNet
Consulting's stock as of the January 2005 purchase, and as a
result, Fish Holdings and FishNet Consulting were related persons
for purposes of §1239.

Accordingly, the Tax Court concluded that as of the January 2005
purchase, Fish Holdings owned more than 50% of the total combined
voting power of all classes of FishNet Consulting's stock entitled
to vote and more than 50% of the total value of the shares of all
classes of FishNet Consulting's stock. Therefore, the Tax Court
held that Fish Holdings and FishNet Consulting were related persons
for purposes of §1239, and the $9,462,700 gain Fish Holdings
received from the transaction should have been reported by
Taxpayers on a flow-through basis as ordinary income. Here, where
the goodwill associated with Taxpayer was essentially the sole
asset of value for the subsidiary conclusion of the Tax Court seems
to be in line with the realities of ownership.

For more information, in the Tax Management Portfolios, see
Koutouras, Tizabgar, and Carreon, 564 T.M.
, Related Party
Transactions,  and in Tax Practice Series, see ¶2930,
Transactions Between Related Taxpayers.