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Temporary, proposed regs tighten rules for C corporation transfers to RICs and REITs

T.D. 9770, 06/07/2016; Reg. § 1.337(d)-7, Reg. § 1.337(d)-7T; Preamble to Prop Reg06/07/2016 ; Prop Reg § 1.337(d)-7

IRS has issued temporary and proposed regs that tighten the rules that tax certain transfers of property from a C corporation to a regulated investment company (RIC) or a real estate investment trust (REIT). The bulk of the new rules address situations in which a taxpayer effects a tax-free separation of REIT-qualifying assets from nonqualifying assets in a Code Sec. 355 distribution and the REIT-qualifying assets become the assets of a REIT.

Background. A corporation recognizes gain but not loss on nonliquidating distributions of property to its shareholders with respect to stock or in redemption of stock. (Code Sec. 311(a)) Except for liquidating distributions by 80% subsidiaries (Code Sec. 337(a)), gain or loss is recognized to a corporation on distributions of property in complete liquidation. The gain or loss is recognized as if the property had been sold to the distributee at its fair market value (FMV). (Code Sec. 336(a))

Code Sec. 337(d)(1) directs IRS to issue regs as may be necessary to ensure that gain recognition may not be circumvented through the use of a RIC, REIT, or tax-exempt entity.

Reg. § 1.337(d)-7 generally provides that if property of a C corporation (the C corporation transferor) becomes the property of a RIC or REIT by the qualification of that C corporation as a RIC or REIT or by the transfer of assets of that C corporation to a RIC or REIT (a conversion transaction), then the RIC or REIT will be subject to tax on the net built-in gain in the converted property under the rules of Code Sec. 1374 (tax on built-in gains of S corporations) and the underlying regs. However, this treatment doesn’t apply if the C corporation transferor elects to recognize gain and/or loss as if it sold the converted property to an unrelated party at FMV (deemed sale treatment). (Reg. § 1.337(d)-7(a)(1))

Code Sec. 355 generally provides that, if certain requirements are satisfied, a corporation may distribute stock (or stock and securities) of one or more controlled corporations to its shareholders and security holders without the distributing corporation, its shareholders, or its security holders recognizing income, gain, or loss on the distribution (a Code Sec. 355 distribution).

Sec. 311 of the 2015 Protecting Americans From Tax Hikes (PATH) Act added some new provisions.Code Sec. 355(h)(1) provides that Code Sec. 355 does not apply to a distribution if either the distributing corporation or the controlled corporation is a REIT. Code Sec. 355(h)(2) provides exceptions permitting a REIT to distribute the stock of another REIT or of a taxable REIT subsidiary under certain conditions. Code Sec. 856(c)(8) provides that a corporation may not elect REIT status during the 10-year period following a Code Sec. 355 distribution if such corporation was the distributing corporation or the controlled corporation in that distribution.

Temporary regs tighten rules where corporation spins off REIT. IRS was concerned that the existing rules don’t fully reflect the intent of Congress where a taxpayer effects a tax-free separation of REIT-qualifying assets from nonqualifying assets in a Code Sec. 355 spin-off and the REIT-qualifying assets become the assets of a REIT. (T.D. 9770, 06/07/2016)

IRS cited the following problems with the existing rules:

…After such transactions, gain on the assets held by the REIT may not be taxed at the corporate level because such gain is unlikely to be recognized within the recognition period during which the REIT is subject to Code Sec. 1374 treatment.
…The REIT and its shareholders may realize the benefit of appreciation on converted property without a transaction being subject to Code Sec. 1374 treatment or otherwise taxable at the corporate level. For example, a REIT that distributes rental income on appreciated converted property to its shareholders may be entitled to a dividends paid deduction under Code Sec. 562 and, therefore, effectively does not pay income tax at the REIT-level on that income, which in many cases will reflect the appreciation in the value of the property.
…Corporations affiliated with the distributing corporation or the controlled corporation could be used to circumvent the Congressional policy implemented through Sec. 311 of the PATH Act. (T.D. 9770, 06/07/2016)

To combat these problems, under the temporary regs:

  • A C corporation engaging in a conversion transaction involving a REIT within the 10-year period following a related Code Sec. 355 distribution is treated as making an election to recognize gain and loss as if it had sold all of the converted property to an unrelated party at FMV on the deemed sale date. (Reg. § 1.337(d)-7T(c)(6)) Code Sec. 1374 treatment is accordingly not available in these cases as an alternative to recognizing any gain with respect to the converted property on the deemed sale date. (T.D. 9770, 06/07/2016)
  • A party to a Code Sec. 355 distribution occurring within the 10-year period following a conversion transaction for which a deemed sale election has not been made recognizes any remaining unrecognized built-in gains and losses resulting from the conversion transaction (after taking into account the impact of Code Sec. 1374 in the interim period, as described in the next bullet). (Reg. § 1.337(d)-7T(b)(4)(i))
  • For the tax year in which the related Code Sec. 355 distribution occurs, the REIT’s net recognized built-in gain is the amount of its net unrealized built-in gain limitation (as defined in Reg. § 1.1374-2(a)(3)) for such tax year. For this purpose, the limitations in Reg. § 1.1374-2(a)(1) and Reg. § 1.1374-2(a)(2) do not apply because the net unrealized built-in gain limitation generally achieves the effect of a deemed sale election, adjusted for prior recognized built-in gains and recognized built-in losses. (Reg. § 1.337(d)-7T(b)(4)(i)) The regs also contain an adjustment to the aggregate basis of the converted property held by the REIT that reflects this recognition of gain. (Reg. § 1.337(d)-7T(b)(4)(ii))
  • The above rules apply to predecessors and successors of the distributing corporation or the controlled corporation and to all members of the separate affiliated group, within the meaning of Code Sec. 355(b)(3)(B), of which the distributing corporation or the controlled corporation are members. Predecessors and successors include corporations that succeed to and take into account items described in Code Sec. 381(c) of the distributing corporation or the controlled corporation, and corporations having such items to which the distributing corporation or the controlled corporation succeed and take into account. (Reg. § 1.337(d)-7T(f)(2))
  • Consistent with Sec. 311 of the PATH Act, there are two exceptions to the above rules. First, the temporary regs do not apply if both the distributing corporation and the controlled corporation are REITs immediately after the date of the Code Sec. 355 distribution and at all times during the two years thereafter. Second, the temporary regs do not apply to certain Code Sec. 355 distributions in which the distributing corporation is a REIT and the controlled corporation is a taxable REIT subsidiary. (Reg. § 1.337(d)-7T(f)(3)) In addition, and consistent with the effective date in Sec. 311(c) of the PATH Act, the temporary regs do not apply to distributions pursuant to a transaction described in a ruling request initially submitted to IRS on or before Dec. 7, 2015, which request has not been withdrawn and with respect to which a ruling had not been issued or denied in its entirety as of Dec. 7, 2015. (Reg. § 1.337(d)-7T(f)(3); T.D. 9770, 06/07/2016)

Temporary regs also clarify definition of “recognition period.” Under the Code Sec. 1374 rules, S corporations that were formerly C corporations must pay tax on the amount of net recognized built-in gain for any tax year beginning in the “recognition period.” (Code Sec. 1374(a)(1)) The PATH Act made permanent a temporary change in the definition of “recognition period” under these rules, from the 10-year period beginning with the first day of the first tax year for which the corporation was an S corporation, to the 5-year period beginning on that date. (Code Sec. 1374(d)(7), as amended by Sec. 127(a) of the PATH Act)

Reg. § 1.337(d)-7(b)(2)(iii) provides that, for purposes of the C-corporation-transfer-to-RIC-or-REIT rules, the recognition period—i.e., the period during which the Code Sec. 1374 rules apply—is: a) where the conversion transaction is a qualification of a C corporation as a RIC or REIT, the 10-year period described in Code Sec. 1374(d)(7) that begins on the first day of the first tax year of the RIC or REIT; or b) in the case of other conversion transactions, the 10-year period that begins on the day the property is acquired by the RIC or REIT.

The temporary regs drop the reference to Code Sec. 1374(d)(7) but otherwise do not change the Reg. § 1.337(d)-7(b)(2)(iii) definition of “recognition period.” (Reg. § 1.337(d)-7T(b)(2)(iii))

RIA observation: Thus, the temporary regs remove what has become a misleading reference to Code Sec. 1374(d)(7) but do not make any substantive change to the definition of recognition period.

Proposed regs expand the definition of “converted property.” The existing final regs (Reg. § 1.337(d)-7(a)(1)) and the temporary regs (Reg. § 1.337(d)-7T(a)(2)(vii)) define “converted property” as property owned by a C corporation that becomes property of a RIC or REIT. The proposed regs would expand that definition to also include any property the basis of which is determined, directly or indirectly, in whole or in part, by reference to the basis of property owned by a C corporation that becomes the property of a RIC or a REIT. (Prop Reg § 1.337(d)-7(a)(2)(vii))

Effective date of temporary regs. All of the above rules, other than the revised definition of “recognition period” in Reg. § 1.337(d)-7T(b)(2)(iii), apply to conversion transactions occurring on or after June 7, 2016 and to conversion transactions and related Code Sec. 355 distributions for which the conversion transaction occurs before, and the related Code Sec. 355 distribution occurs on or after, June 7, 2016. (Reg. § 1.337(d)-7T(g)(2)(ii))

The revised definition of “recognition period” in Reg. § 1.337(d)-7T(b)(2)(iii) is effective after Aug. 7, 2016. (T.D. 9770, 06/07/2016)

Effective date of proposed regs. The proposed regs will apply to conversion transactions that occur on or after the date the proposed regs are published in the Federal Register as final regs. (Prop Reg § 1.337(d)-7(g)(2)(iv))

References: For corporate assets transferred to RIC or REIT, see FTC 2d/FIN ¶  E-6850; United States Tax Reporter ¶  3374.03; TG ¶  20561.

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