With the enactment of IRC Code Section 269, Congress sought to combat certain tax evading strategies involved with the acquisition of a corporation (or its assets). Prior to the enactment of Section 269, the IRS was finding that taxpayers were acquiring corporations or a corporation’s assets for the principal reason of avoiding or evading income tax. Consequently, Section 269 gives the IRS power to forbid a deduction of a net operating loss (NOL) that was carried over from a prior year if it finds the taxpayer’s principal purpose for the acquisition was to utilize the NOL.
Generally speaking, a corporation’s “tax attributes” are preserved during the life of the entity. “Tax attributes” refer to things like the corporation’s capital loss carryovers, net operating loss carryovers, its method of accounting and tax year, and the basis it has in the assets. However, what happens if the corporation undergoes an ownership change? Sometimes the tax attributes are preserved; sometimes not. The ability of the new owner of a corporation to utilize the tax attributes, specifically any carryover losses, is dictated by a few provisions of the tax Code.
Section 269 allows the IRS to disallow all of the tax benefits associated with an acquisition if the principal purpose for the acquisition was tax avoidance. There are two required elements for this Section to apply: (1) the acquisition in question is one of the three types that is covered by Section 269, and (2) the taxpayer had a tax avoidance motive.
a. What types of acquisitions are covered by Section 269?
When the parties to a transaction have as their principal purpose the avoidance of income tax, Section 269 will apply in any one of three types of transactions. First, it is a transaction where a person acquires—directly or indirectly—the control of a corporation. Section 269(a)(1). “Control” (in this context) is defined as owning 50% of voting power of stock and 50% of its value. Section 269(a). “Person” (in this context) refers to an individual, a trust or estate, a partnership, association, or corporation. Treas. Regs. §1.269-1(d).
Second, Section 269 also applies to transactions where a corporation acquires (directly or indirectly) property of another corporation where the basis in the property acquired is determined by referring to the basis in the hands of the transferor. Section 269(a)(2).
Finally, Section 269 also applies to a liquidation that occurs according to a plan that was adopted within the last two years involving a qualified stock purchase where no Section 338 election was made. Section 269(b).
b. Is the test under Section 269 determined by an “objective” or “subjective” standard?
As mentioned the IRS must prove that the taxpayer’s “principal purpose” for entering into one of the three prohibited transactions (described above) was the “evasion or avoidance . . . of income tax by securing the benefit of a deduction, credit, or other allowance,” where the acquiring corporation would not otherwise be entitled to it.
Ultimately, this determination by the IRS is a subjective one. However, the Treasury Regulations do provide some guidance for both (1) “control acquisitions” and (2) “property acquisitions.”
A control acquisition is deemed to have a tax evasion or avoidance purpose if (a) a corporation has large profits and it acquires the control of a corporation with credits, deductions, net operating losses, etc. and the acquisition is “followed by transfers or other action is necessary to bring the deduction, credit, or other allowance into conjunction with the income.” Treas. Reg. 1.269-3(b)(1). Moreover, a prohibited purpose is deemed to exist if (b) a person organizes two or more corporations in order to secure the benefit of multiple minimum accumulated earnings credits; Treas. Regs. §1.269-3(b)(2). Finally, a prohibited purpose also is deemed to exist when an individual with high-earning assets transfers them to a newly organized controlled corporation retaining assets producing net operating losses that are used in an attempt to secure refunds. Treas. Regs. §1.269-3(b)(3).
A property acquisition is deemed to have a tax evasion or avoidance purpose if (a) a corporation acquires property with a basis greater than its fair market value, and then proceeds to use the property to create deductions. Treas. Regs. §1.269-3(c)(1). Moreover, a prohibited purpose is also deemed to exist (b) when a subsidiary with large net operating loss from business X operations ends up acquiring a profitable business Y from its Parent (and the Subsidiary files separately from Parent); and the Parent would not have attained to losses had the subsidiary been liquidated. Treas. Regs. §1.269-3(c)(2).