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Corporations Converting to 501(c)(3) Face Potential Income Tax Trap

You can find the original article published on Bloomberg Tax on June 15, 2022 here. 

The shareholders of a taxable corporation may determine that it is better suited to be operated as a Section 501(c)(3) tax-exempt organization, in which case the corporation would convert to such status or contribute its assets to an organization already classified under Section 501(c)(3). Recently, in the face of diminishing readership and financial struggles, several taxable for-profit newspapers have converted to Section 501(c)(3) tax-exempt status.

Even where a transfer to charity is motivated wholly by charitable intent, and a charitable income tax deduction is otherwise available, a potential income tax trap exists in this context. This is because the corporation is deemed to have sold its assets at their fair market value, thereby potentially subjecting the corporation or S corporation shareholders to significant income tax liability on gain recognition attributable to appreciated assets.

This can produce a harsh result that is in direct contrast to the tax treatment generally accorded contributions of appreciated property to charity where there is no gain recognition for income tax purposes.

Section 337(d) Regs Aim to Prevent Efforts to Avoid Gain Recognition

Section 337(d) directed the Secretary of the Treasury to prescribe regulations “as may be necessary or appropriate to carry out the purposes” of general utilities doctrine repeal, “including regulations to ensure that such purposes may not be circumvented … through the use of a … tax-exempt entity.” These regulations, set forth under Reg. 1.337(d)-4, intend to reach transactions that are “economically similar to those liquidations but take different forms, so as to apply where a taxable corporation transfers ‘all or substantially all’ of its assets to a tax-exempt entity or a taxable corporation changes it status to become a tax-exempt entity.” The regulations apply regardless of whether the tax-exempt organization is described in Section 501(c)(3), which include charitable organizations that provide a broad array of benefits and services for public purposes.

Conversion of Taxable Corporation to Tax-Exempt Entity

Under a “change in status” rule of Reg. 1.337(d)-4(a)(2), a taxable corporation’s conversion to a tax-exempt entity is treated as if it transferred all its assets to a tax-exempt entity immediately before the change in status became effective. In this situation, the taxable corporation must recognize gain or loss as if the assets that are treated as transferred to the tax-exempt entity were sold at their fair market value.

Transfer by Taxable Corporation of All or Substantially All of Assets

Under an “asset sale rule” of Reg. 1.337(d)-4(a)(1), if a taxable corporation transfers “all or substantially all” of its assets to one or more tax-exempt entities, the taxable corporation must recognize gain or loss immediately before the transfer as if the assets transferred were sold at their fair market values. Reg. 1.337(d)-4(c)(3) does not in itself provide its own definition of the term “substantially all.” It instead states that “substantially all has the same meaning as under section 368(a)(1)(C),” a tax-free reorganization provision otherwise known as an C reorganization, whereby “substantially all” of the assets of one corporation is acquired solely in exchange for all or part of the voting stock of another corporation.

Meaning of Substantially All Under Section 368(a)(1)(C)

Because of the dearth of authority addressing the application of the “asset sale rule” under Reg. 1.337(d)-4(a)(1) and the meaning of “substantially all” in that context being based on the definition under Section 368(a)(1)(C), authority in the context Section 368(a)(1)(C) must be used. Section 368(a)(1)(C) was originally enacted to accommodate acquisitive reorganizations where a statutory merger form under state law was not available, or the parties otherwise did not want to engage in a merger transaction. Its legislative history referred to this provision as a “practical merger” designed to permit transactions that are “equivalent to a merger.”

Notwithstanding the legislative history, rather than an inquiry as to whether a transaction resembles a merger, the courts and the IRS have looked to the facts and circumstances to determine whether “substantially all” of the assets of a corporation have been transferred and not to any particular percentage of assets transferred. The focus in this context is on the nature of the properties retained by the transferor corporation, the purpose of the retention, and the amount thereof.

The leading case in this area Milton Smith v. Commisioner, involving a transfer of assets by Smith Co., a water transportation company, of assets worth $133,374.07, representing approximately 71% of the total assets, and retained the remaining $52,082.59 only to satisfy its liabilities. The IRS asserted that 71% of the gross assets transferred was not “substantially all.” In response, the court that “[w]hether the properties transferred constitute ‘substantially all’ is a matter to be determined from the facts and circumstances in each case rather than by the application of any particular percentage.” Because Smith Co. retained no assets for the purpose of engaging in any business, and the retained assets were only used to satisfy its remaining liabilities, the court concluded that in these circumstances, the corporation transferred substantially all of its assets.

Subsequent cases have similarly held that the only assets to be considered in making the “substantially all” determination are those necessary to operate the corporation’s business. Indeed, in Commissioner v. First National Bank, the court stated that assets retained by a corporation that “were merely investments held by it” and not essential to the operation of its business were not assets to be considered in determining whether substantially all of the assets of the corporation had been transferred.

Application of Substantially All Test Under Asset Sale Rule Reg. 1.337(d)-4(a)(1)

Based on the authority interpreting the meaning of “substantially all” in the context of Section 368(a)(1)(C), there will be a transfer of substantially all of a corporation’s assets for purposes of Reg. 1.337(d)-4(a)(1) where the only assets transferred are essential to the operation of the historic business operations of the corporation.

Query what the result should be when a corporation has previously ceased its business operations and only has assets that are held for investment or other nonbusiness purposes. In that case, under a strict reading of the case law and IRS authority, the transfer of such assets to charity, even if constituting all of the assets of the transferring corporation, should not trigger gain or loss recognition under Reg. 1.337(d)-4(a)(1). Prudence would dictate that even if a corporation’s only assets are investments and other nonbusiness assets, less than all, and perhaps substantially less, of such assets should be transferred to avoid the potential tax trap of Reg. 1.337(d)-4(a)(1).