The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 11, June 2002, Panel Publishers, New York, NY.


Section 269 of the Code has long been a weapon with which the IRS can disqualify an asserted tax benefit. Although Section 269 is a threat, it is clearly more a blunt object than it is a rapier. And, the Service has not had much success litigating Section 269 cases, making this Code provision more of an impediment in administrative proceedings than it is anywhere else.

Letter Ruling 200205003 gives a glimpse of the circumstances in which the IRS wants to use Section 269, as well as the way in which Section 269 pairs it with its kindred spirit, Section 482. Letter Ruling 200205003, issued as a supplement to two prior rulings (Letter Rulings 200023016 and 200043007), involves D corporation, formed by E, its parent in a consolidated group. The E consolidated group includes A, B, C as well as D. E formed D as a subsidiary, but did not take back any stock. Indeed, the only shareholder of D at the time it was formed was an individual incorporator holding one share of D stock.

Thereafter, C, an indirect subsidiary of E, acquired D, in a transaction intended to qualify under Section 351. A and B (sister companies of C) contributed income producing properties in exchange for D common stock and nonvoting preferred. At the same time as the 351 transaction, additional shares were sold to private investors. One of the earlier rulings (200023016) concluded that Section 351 requirements were met. Then, the second ruling (200043007) concluded that the transfer of worthless properties by A to D did not qualify as a nontaxable contribution under Section 351.

Later, C sold some of its shares to outside investors and reported a loss. In year 1, D began to sell or abandon certain high basis, low value C-contributed properties, taking corresponding loss deductions. D's remaining C-contributed properties were all nonproducing and had a low basis. D filed a separate tax return, not being part of the E consolidated group.

Loss Disallowance

Letter Ruling 200205002 concludes that the IRS can disallow any loss by D on the sale or disposition of the worthless properties. The applicable provision? Section 269. The IRS found that there was a lack of common control between the transferor and the transferee immediately before the transfer.

After all, E was not a shareholder of D immediately before the transfer of property from C to D. While E owned all of the stock of C before the transfer, E did not receive any stock of D upon D's formation. Since E did not receive any stock in exchange for any contribution made in forming D, E was not a shareholder of D immediately before the transfer of property from C to D. Although E owned all of the stock of C before the transfer, E did not receive any stock in D upon D's formation. Thus, E was simply not a shareholder of D immediately before the transfer of property from C to D.

The lynchpin of Section 269 is bad intent. The IRS found that a principal purpose of the acquisition was to evade or avoid federal income tax. The regulations state that if a corporation acquires property having in its hands an aggregate carryover basis that is materially higher than its aggregate fair market value at the time of the acquisition, and if it uses the property to create losses, then, absent evidence to the contrary, the principal purpose of acquiring the property will be treated as evading or avoiding federal income tax. See Reg. §1.269-3(c)(1).

Here, the Service found that there was no substantial purpose for D to acquire the worthless properties from C — other than tax avoidance. The taxpayer stated that the purpose for the transfer was to raise cash through the sale of the transferred properties. The IRS, though, found that the business purpose of raising cash did not require D to be incorporated. In addition, properties that were worthless at the time of the transfer did not produce any cash.

The "but for" analysis of Section 269 requires that to invoke its draconian disallowance, the acquisition must secure the benefit of a deduction, credit, or other allowance that the acquiring party would not otherwise have enjoyed. Here, when D acquired the worthless built-in loss property from C, it secured a loss that it would otherwise not have enjoyed. Finding no business purpose for the transfer of the properties, the IRS found this statutory requirement to be met.

Furthermore, the acquirer, D, had a basis in the transferred properties that was determined by reference to C's basis in the properties. Recall that D acquired the properties from C in a Section 351 transaction. The IRS put these pieces together and concluded that Section 269(a)(2) could be applied to disallow any loss by D on its sale or disposition of the worthless properties it received from C.

482, Too

Section 269 is often paired with Section 482, another amorphous Code provision that, at least domestically, has not been terribly helpful to the Service. Although Section 482 appears on its face to allow the IRS to make allocations of income or other items among commonly controlled persons, like Section 269, a bad intent is a requisite element. In this case, the IRS concluded that upon D's abandonment of the worthless properties contributed by C, Section 482 allowed the IRS to make appropriate allocations to C and D as well as conforming adjustments to the basis of C's stock in D. The IRS invoked Section 482 in order to prevent the replication of losses that had effectively been sustained as of the time of the Section 351 transfer, and to prevent the evasion of taxes and to clearly reflect income. That's a mouthful. Still, the IRS does not give a rationale for these allocations, other than noting that it has broad authority under Section 482 in the context of Section 351 transfers. See National Securities Corp. v. Commissioner, 137 F.2d 600 (3d Cir.), cert. denied, 320 U.S. 794 (1943).

Section 269 and Acquisitions, Vol. 10, No. 11, The M&A Tax Report (June 2002), p. 7.