Firm-and-Fixed-Plan Rule Reaffirmed

The Second Circuit Court of Appeals affirmed the Tax Court’s decision in a case involving Merrill Lynch. Although the actual transactions were complicated and involved consolidated returns, the court’s conclusion is applicable to many stock redemptions outside of affiliated groups.

Merrill Lynch’s board had approved the sale of a subsidiary, Merrill Lynch Capital Resources (MLCR). As a preliminary step to finding a buyer, MLCR sold a second-tier subsidiary to yet another subsidiary of Merrill Lynch. Because the sale was to a related party, IRC section 304 treated it as a stock redemption; Merrill Lynch reported the transaction as a dividend. The government reclassified the redemption as a sale under IRC section 302(b)(3), which deals with complete termination of interest, arguing there was a “firm-and-fixed” plan for MLCR to lose control of the second-tier subsidiary and, therefore, the sale fit the definition of a complete termination of interest. The Tax Court agreed with the government. Merrill Lynch appealed.

Result. For the IRS. The Second Circuit said any analysis of section 302(b)(3) must permit the integration of several transactions into the redemption transaction. In other words, the step transaction doctrine is available for use by the government and the courts to prevent the nullification of section 302(b)(3) when the transaction is broken into several pieces. The court then said applying the step-transaction doctrine based solely on the intent of the taxpayer would be too subjective and unmanageable. In the past the courts have used the “firm-and-fixed-plan” test to determine when to integrate multiple steps into one transaction. Since neither party presented an alternative test, the court used the firm-and-fixed-plan test to determine the taxation of the stock sale.

Both parties agreed the firm-and-fixed-plan test should be applied at the time of the sale of the lower-tiered subsidiary. They disagreed on the need for a binding contract to sell MLCR at that time to meet the test and so reviewed the history of the test. In the first case to use it by name, Niedermeyer (62 TC 380 (1974), aff’d 575 F2d 500 (CA-9, 1976)), the court refused to allow the taxpayer to combine steps under this test where there was no written plan and no binding requirements, and where the taxpayer could choose not to follow the plan. However, it did not make these prerequisites for applying the test. In Bleily (72 TC 751 (1979), aff’d 647 F2d 169 (CA-9, 1981)), a case in which the majority shareholder of a corporation wanted to buy out the minority shareholders, the Tax Court used the firm-and-fixed-plan test to determine the taxation of the transaction. The court stated that “a plan need not be in writing, absolutely binding, or communicated to others to be fixed and firm although these factors all tend to indicate that such is the case.” In other words it would consider multiple factors, with a binding contract being just one. Looking at all the factors, the Tax Court had adequate evidence that a plan existed.

Merrill Lynch argued that under Paparo (71 TC 692 (1979)), the test could not be applied without a fixed and binding plan. The Second Circuit acknowledged that individual sentences in the opinion could produce this conclusion. However, it was the control that an independent third party had on the transactions, rather than the absence of a binding agreement, that caused the court in Paparo to refuse to treat the multiple transactions as one transaction. Therefore, the Second Circuit dismissed Merrill Lynch’s argument that a binding agreement was necessary.

This case clearly supports the application of the firm-and-fixed-plan test even without a binding agreement. In those cases in which the agreement is missing, taxpayers will need to have sufficient other factors to prove the existence of a plan and the certainty of its completion. In the future, it is likely a taxpayer will be held to a higher standard of proof if an actual binding contract is absent.

There is one additional interesting note about this case. The Court of Appeals remanded the case to the Tax Court to consider a new argument by Merrill Lynch—that ownership should have been measured at the parent- and not the subsidiary-level. The decision on this issue will be of great interest to corporations that sell subsidiaries to related parties.

Merrill Lynch & Co. v. Commissioner, 2004 US App. Lexis 20382 (CA-2).

Prepared by Edward J. Schnee, CPA, PhD, Hugh Culverhouse Professor of Accounting, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.