Congress enacted IRC section 304 to prevent companies from trying to improperly withdraw earnings and profits from a company through the use of brother/sister corporations. Without proper attention to what section 304 forbids, unsuspecting taxpayers may be trapped in its web.
Gary Combrink formed Cost Oil Operating Co. in 1983 to operate “working interests” in oil and gas wells. In 1992 he created Links Investment Inc. to operate a golf course. During the 1990s Cost lent Combrink $56,000. He repaid some of the money. In 1995 Cost paid some $44,000 of Combrink’s personal liabilities related to Links. In 1996 Cost transferred $45,000 to Links, which Cost booked as loans to Combrink.
The parties treated all of the money advanced to Links as loans from Combrink. On October 15, 1996, the parties converted these loans into a $77,481 note payable to Combrink and $175,000 of paid-in capital. On December 1, 1996 Combrink transferred his Links stock to Cost in exchange for releasing him from any liability for the amounts borrowed. He did not report this transaction. The IRS reclassified it as a dividend under IRC sections 301 and 304.
Result. For the IRS. Section 304 reclasses the sale of stock of a controlled corporation to another controlled corporation as a stock redemption. Under IRC section 302, such a redemption will generate dividend income unless it qualifies for sale treatment under section 302(b). (All parties agreed that the section 302(b) exceptions did not apply to this case.) Section 304 exempts from redemption classification any liability the acquiring corporation assumes, provided the liability was incurred to buy the transferred stock.
Combrink argued that section 304 should not apply because his transaction did not have as its motive “bailing out” earnings and profits. The court refused to create an exception based on a policy argument when Congress did not incorporate one in the code section itself.
The court then evaluated whether section 304 applied to the transaction and if the acquisition debt exception applied. It decided section 304 did apply and because assumption of a liability is equivalent to a property distribution under sections 301 and 317. The court discounted as irrelevant the fact that the taxpayer used the term “release of liability” instead of “liability assumption.” It found the terms synonymous.
The special exception Combrink cited applies only to debt incurred to purchase the transferred stock. The court was willing to accept that the debt previously reclassed as paid-in capital was acquisition debt. However, the remainder was intended to be real debt and therefore not acquisition indebtedness. The liability the acquiring corporation released was deemed redemption proceeds under section 304 and was taxable as a dividend under section 301.
If the taxpayer had shown that the corporation had used all of the money in its business and if the loan had been reclassed as equity before the stock transfer, it’s likely the transaction would have fallen under the acquisition liability exception. Failure to reclassify the debt as equity on the corporation’s books led to its being taxed. The fact that tax avoidance or earnings bailout were not intended was irrelevant. CPAs need to carefully monitor section 304 on stock transfers between commonly controlled corporations.
Gary D. Combrink v. Commissioner, 117 TC no. 8.
Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.