C and S Corporations for Estate Planners: The (Repealed) General Utilities Doctrine
Examining a significant hurdle in corporate taxation
This article is part of a broader series on C and S corporations for estate planners. For the first article in this series and a series index, click here.
Table of Contents
Intro and Background
Video and text-based social media platforms are full of tax advice nowadays, much of which falls flat or is, at best, incomplete. But, if you have ever seen the sentiment of “S corporations are terrible for holding real estate,” you may have wondered why this is the case. It is no surprise that many soundbites like this leave out important context, so in this article we are going to shine some light on this issue.
As a bit of a history lesson, the 1935 U.S. Supreme Court case of General Utilities & Operating Co. v. Helvering, 296 U.S. 200 dealt with the issue of the distribution of appreciated property by a corporation to its shareholders. (Keep in mind, at the time, the only corporate tax rules where what we now know as the C corporation tax rules – S corporations did not exist at the time.)
In short, General Utilities dealt with another common issue we have covered for C corporations – double taxation. As you recall, there is a C corporation tax rate of 21% that applies to a corporation’s net earnings and, while some corporate income may be excluded from corporate income, these net earnings (taxed and often tax-exempt) get tracked in an accounting entry known as earnings and profits, or E&P. Then, when a corporation distributes its earnings to shareholders, the distribution is first treated as coming from E&P – all of which is taxed to the shareholder as capital gain if the dividend is qualified or as ordinary income if the dividend is not qualified.
In General Utilities, the corporation (General Utilities) owned stock in another corporation (Island Edison) with another shareholder. All Island Edison shareholders were approached with an offer to purchase their stock by a third party. However, the president of General Utilities recognized that there would be a double tax if General Utilities were to sell its stock, so he proposed to have the stock first distributed to the shareholders of General Utilities who would then sell the stock to the third-party purchaser.
And while the outcome was taxpayer-friendly, one common misconception is that this outcome was based on the merits of the case. However, it was primarily due to procedural missteps in the appeals process. The Board of Tax Appeals (predecessor to the Tax Court) denied the Commissioner’s theory that taxable income was incurred by General Utilities by (1) first declaring a cash dividend, creating an indebtedness to its shareholders, and then (2) satisfying that indebtedness in-kind with Island Edison stock. On appeal the 4th Circuit affirmed that outcome, but took it upon itself to consider a question that was not heard by the Board of Tax Appeals – whether the General Utilities shareholders had acted as agents for General Utilities in carrying out the sale, such that General Utilities should have recognized the gain on the sale of the Island Edison stock.
On this latter question, the 4th Circuit determined that there was gain to General Utilities through this agency theory. However, the Supreme Court reversed, noting that this question was not presented to the Board of Tax Appeals and thus should not have been ruled upon as a determination of fact at the 4th Circuit level.
If we fast forward over 50 years to the Tax Reform Act of 1986, this outcome was reversed legislatively – thus presenting our current conundrum when it comes to corporate taxation, and an answer to the question of why S corporations perhaps are not optimal for holding real estate (except, perhaps, for transactions such as a Bramblett land bank that are beyond the scope of this article that do not avoid gain but instead change the character of gain).
Repeal of General Utilities, and Comparison to (Tax) Partnerships
Under IRC Section 311(b), we find the following:
(b) Distributions of appreciated property
(1) In general
If—
(A)
a corporation distributes property (other than an obligation of such corporation) to a shareholder in a distribution to which subpart A applies, and
(B)
the fair market value of such property exceeds its adjusted basis (in the hands of the distributing corporation),
then gain shall be recognized to the distributing corporation as if such property were sold to the distributee at its fair market value.
This Code Section is Congress’s codification of the repeal of the General Utilities doctrine. It generally prevents any appreciated property from being distributed by a (C or S) corporation to its shareholders without recognition of gain as if the property had been sold for its fair market value. In the case of a C corporation, this means application of the 21% corporate tax rate at the level of the C corporation. In the case of an S corporation, this generally means what would be corporate-level gain is instead allocated to the shareholders for taxation at their individual rates in proportion to their holdings unless a corporate-level tax (like the built-in gains tax) applies.
When we compare this to a tax partnership, which is usually the default form of taxation for any state-law partnership or for any LLC with more than one member, we find that IRC Section 731(b) provides that there is no gain or loss recognized by a partnership on a distribution of property or money.
On that note, however, it is important to recognize that the tax rule for corporations here only applies to appreciated property. In the case of loss property – i.e., property with a basis (in the hands of the corporation) that is greater than its fair market value – no loss is recognized by the corporation on distribution. Instead, under IRC Section 312(a)(3), the corporation’s E&P (for a C corporation) is reduced by its (higher) basis in the distributed loss. Then, under IRC Section 301(d), a shareholder’s basis in the distributed loss property is the property’s (lower) fair market value. So, while there is no loss recognized on the distribution, there is a greater reduction in E&P and thus a greater reduction to potential dividends – especially when we consider that the corresponding part treated as a dividend is only the fair market value of the property under IRC Section 301(b)(1).
In an S corporation, there are some deeper questions about the preservation of loss on a distribution of loss property as compared to a C corporation. This is a subject for another article.
Before moving on, however, it is helpful to note that the shareholder receiving a distribution of appreciated property gets the benefit of a stepped-up basis. Of course, this comes at a cost in the form of a corporate-level income tax and shareholder-level dividend tax (in the case of a C corporation) or shareholder-level passthrough of the recognized gain (for an S corporation), in each case based on the fair market value of the property on distribution with respect to a shareholder (to the extent of E&P, or for an S corporation the shareholder’s basis and possibly the corporation’s accumulated adjustments account).
Exceptions to IRC Section 311(b)
There are some workarounds to IRC Section 311(b)’s deemed sale treatment of a distribution of appreciated property to shareholders, which generally apply to both C and S corporations. However, these workarounds are fairly limited and may have many conditions to prevent their abuse as a device to avoid corporate-level gain and/or dividend treatment.
Corporate Liquidations, and IRC Section 337
We will cover corporate liquidations in later articles, but for the time being note that IRC Section 336(a) generally causes a liquidating corporation to recognize gain or loss on a distribution of property in complete liquidation of the corporation itself. In this sense, this differs from IRC Section 311(b), which does not permit recognition of loss.
But, there is an exception found in IRC Section 337(a), which provides that there is no recognition of gain or loss by a corporation in a liquidating distribution to an “80-percent distributee,” as defined in IRC Section 332(b). Generally, an 80-percent distributee will be a domestic parent corporation (not an individual, partnership, or estate/trust) owning 80% or more of the stock of the liquidating corporation by vote and value. This 80% requirement will be a common theme in other areas of corporate taxation to later be explored, such as the opposite of liquidation – the contribution of property to a corporation in exchange for stock, under IRC Section 351.
While there are several requirements to satisfy this nonrecognition treatment, a comprehensive overview of these requirements is beyond the scope of this article.
Stock Issuance
The aforementioned IRC Section 351 generally provides no recognition of gain or loss where property or cash is contributed by one or more shareholders to a corporation solely in exchange for its stock, so long as the contributing shareholders (in the aggregate) hold 80% of the stock in the corporation by vote and value after the contribution. Gain recognition can still occur if the corporation is an investment company, or if a shareholder receives property other than stock in the exchange (such ineligible property received in what would otherwise be a nonrecognition exchange is colloquially called boot). But if the requirements are satisfied, the corporation itself is generally not taxed on the distribution of its stock – even if the fair market value of that stock exceeds the value of the property received by the corporation by the contributing shareholder(s).
Regardless of whether or not IRC Section 351 creates nonrecognition treatment, it typically applies at the time someone becomes a new shareholder or receives additional shares. Note, however, that becoming a shareholder is a necessary prerequisite to the application of the other Code Sections we have been exploring so far – IRC Sections 301-304 for dividend and redemption purposes, and IRC Section 311(b) for distributions to a shareholder.
Stock Distributions
Having covered IRC Sections 301-304 in reasonable detail, the next chronological Code Section is IRC Section 305. This Code Section generally provides that no income is incurred by a shareholder if the shareholder (who is already a shareholder after application of IRC Section 351, above) receives a distribution of a corporation’s own stock, but with some exceptions (such as the receipt of stock in lieu of a cash dividend, or the receipt of certain preferred stock). The corollary to this on the corporate side is found in IRC Section 312(d), which generally provides that a corporation’s distribution or issuance of its own stock will not be a distribution of the corporation’s earnings and profits so long as the distribution is covered by IRC Section 305(a), or if the distribution of the corporation’s own stock is granted nonrecognition treatment in another Code Section.
Reorganizations and Spin-Offs
One of the most complex areas of corporate taxation deals with the nonrecognition transactions found in IRC Sections 354, 355, and 368. These Code Sections generally deal with mergers, spin-offs, and exchanges of corporate stock and assets. Each transaction has its own requirements – many of which fit into certain themes such as 80% control by vote and value, continuity of shareholder interest(s) for a certain amount of time before the transaction, and continuity of business enterprise by the corporation itself. These topics are beyond the scope of what the typical estate planning practitioner needs to know.
But, if all of these complex requirements can be met, IRC Section 361(a) generally creates nonrecognition of gain or loss for a corporation that is a party to a reorganization.
Key Takeaways for Practitioners
As alluded to in prior articles, many estate planners deal with shareholders in corporations but don’t necessarily deal with corporations themselves. Nonetheless, recognizing the effects of IRC Section 311(b) from the repeal of the General Utilities doctrine can be essential to assisting individuals with these tax issues – especially for S corporations, where the shareholder(s) in question may suffer the effects of these tax issues due to the pass-through nature of an S corporation, or for closely-held corporations that are controlled by an estate planner’s individual client (or their estate or trust(s)).
In practice, appreciated property can leave a corporation in one of two ways. First, it can be sold or exchanged – which would usually result in corporate-level gain anyway. Second, it can be distributed – which usually serves as a one-way transaction that, in many circumstances, would lead to carryover basis treatment but for the effect of IRC Section 311(b). So, in effect, the repeal of the General Utilities doctrine preserves corporate-level taxation by treating most distributions the same as a sale to a third party.
When compared to a tax partnership, this can create a mismatch between a shareholder’s basis (often called outside basis) and the basis of a corporation in the property it holds (often called inside basis). This mismatch always represents potential tax, but tax partnerships allow workarounds to resolve this mismatch – including at the death of a partner – under IRC Sections 743 and 754 (although subject to the precontribution gain rules of IRC Section 704(c), and some new and proposed regulations on the reporting and application of some of these sections). IRC Section 311(b) prevents this mismatch from being resolved for a wide variety of estate planning and administration transactions, but with some narrow exceptions for an S corporation (whereby 311(b) gain recognition can create “super-basis” in stepped-up basis stock after the death of a shareholder, which may be offset in part or in full by a shareholder-level loss on liquidation under IRC Section 331 in the same tax year).
Of course, in the administration of an estate or trust, the ownership of all or a substantial majority of corporate stock by a trust or estate (especially for a decedent who was in charge) can cause the estate or trust to be in control of a corporation. In such a case, awareness of the corporate-level tax implications in the administration of the estate gains heightened importance.