In PLR 202538013, a ruling obtained by professionals at EY, the IRS ruled a real estate investment trust (REIT) may make a consent dividend under IRC Section 565 in the year of its liquidation.

Facts

A third party (Third Party) and its regarded subsidiary will form a partnership (Acquirer LP), which will acquire Taxpayer, a publicly traded REIT. Third Party will contribute its own stock as merger consideration to Acquirer LP's disregarded subsidiary (Merger Sub). Merger Sub will merge with and into Taxpayer with Taxpayer surviving (Merger), resulting in Taxpayer becoming a wholly owned subsidiary of Acquirer LP. The parties will treat the Merger as Acquirer LP's taxable acquisition of all Taxpayer stock. Taxpayer's former shareholders will recognize all the gain or loss in their Taxpayer stock, and Acquirer LP will have fair-market-value basis in its Taxpayer stock.

Immediately after the Merger, Taxpayer will adopt a plan of liquidation and convert to a limited liability company that is disregarded from Acquirer LP. Taxpayer will be treated as liquidating into Acquirer LP for US federal income tax purposes (Liquidation). Taxpayer represented that, as a result of the Liquidation, Acquirer LP will be treated as receiving all of Taxpayer's assets in exchange for Acquirer LP's Taxpayer stock, and Taxpayer will recognize all the gains and losses in its assets under IRC Section 336.

Taxpayer also represented that its debt exceeds its total adjusted basis in its assets. Therefore, without a consent dividend, Taxpayer's income for its final tax year ending on the Liquidation date, including gain recognized under IRC Section 336 in the Liquidation, would exceed Taxpayer's dividends-paid deduction for its final tax year. Accordingly, Taxpayer intends to file a timely consent dividend election under IRC Section 565 for an amount up to the excess of its taxable income for its final tax year over the net fair market value of Taxpayer's assets distributed in the Liquidation plus any other distributions during the tax year.

Taxpayer's consent dividend plus its actual distributions for the year of the Liquidation will not exceed Taxpayer's earnings and profits for the tax year, taking into account the gains and losses recognized in the Liquidation. Taxpayer represented that no distribution made pursuant to the plan of liquidation, including the consent dividend, will be a preferential dividend under IRC Section 562(c). In addition, the Taxpayer is not a personal holding company under IRC Section 542 for its tax year ending on the Liquidation date.

Law

IRC Section 857(a)(1) requires, in part, a REIT's dividends-paid deduction for a tax year to equal or exceed 90% of its REIT taxable income (REITTI) for that year (determined without regard to the dividends-paid deduction and by excluding any net capital gain). IRC Section 857(b)(2)(B) defines REITTI as the REIT's taxable income with certain adjustments, including the dividends-paid deduction (as adjusted for certain items).

Under IRC Section 561(a), the deduction for dividends paid equals the sum of the dividends paid during the tax year, the consent dividends for the tax year determined under IRC Section 565; and, for a personal holding company, the dividend carryover under IRC Section 564. IRC Section 561(b) requires the provisions of IRC Section 562 (establishing dividends eligible for the dividends-paid deduction) to be applied in calculating a REIT's dividends-paid deduction.

For purposes of IRC Sections 561 through 565, IRC Section 562(a) generally defines the term "dividend" to include only dividends described in IRC Section 316 (i.e., any distribution of property made by a corporation to its shareholders out of its earnings and profits). For a complete liquidation occurring within 24 months of the adoption of a plan of liquidation, however, IRC Section 562(b)(1)(B) treats any distribution within that period pursuant to such plan as a dividend for purposes of computing the dividends-paid deduction to the extent of the corporation's earnings and profits (computed without regard to capital losses) for the tax year in which the distribution is made. IRC Section 562(b)(1)(B) does not apply to a personal holding company described in IRC Section 542. With certain exceptions, any distribution that is a preferential dividend under IRC Section 562(c) is not considered a dividend for purposes of computing the dividends-paid deduction.

If a person that owns consent stock in a corporation on the last day of the corporation's tax year agrees to treat an amount specified in a consent filed with the corporation's federal income tax return as a dividend, IRC Section 565(a) will treat that amount as a dividend for purposes of IRC Section 561.

Under IRC Section 565(b), however, a consent dividend does not include an amount specified in a consent that (1) would be a preferential dividend under IRC Section 562(c) if distributed in money or (2) would not be a dividend under IRC Section 316 if the total amounts specified in consents had been distributed in money to shareholders on the last day of the corporation's tax year.

Under IRC Section 565(c), a consent dividend is treated as distributed in money by the corporation to the shareholder on the last day of the corporation's tax year and contributed to the capital of the corporation by the shareholder on the same day.

IRC Section 565(f)(1) defines "consent stock" as "the class or classes of stock entitled, after the payment of preferred dividends, to a share in the distribution (other than in complete or partial liquidation) within the taxable year of all the remaining earnings and profits, which share constitutes the same proportion of such distribution regardless of the amount of such distribution."

Analysis

The IRS explained that the legislative history of the predecessor of IRC Section 565 provides insight into the meaning of "consent stock." Under Section 28 of the Revenue Act of 1938, the consent dividends credit allowed corporations, in cooperation with their shareholders, to retain their capital and obtain the tax benefits of an actual distribution of earnings by avoiding tax on their undistributed profits while allowing the government to tax dividends actually received by shareholders. Section 28(a) defined consent stock identically to IRC Section 565(f)(1), including the phrase "other than in complete or partial liquidation." Under Section 28(b), the consent dividends credit was not available to a corporation for a particular tax year if the corporation had taken steps in pursuit of a plan of complete or partial liquidation of all or part of the consent stock. When IRC Section 565 was enacted, the language of Section 28(a) was retained, but the limitation in Section 28(b) was not. Therefore, IRC Section 565 limits the availability of consent dividends to those classes of stock that would be entitled to nonliquidating dividend distributions, as opposed to stock having preferences pursuant to a plan of liquidation.

Based on Taxpayer's facts and representations, the IRS concluded the following:

• Taxpayer may make a consent dividend under IRC Section 565 in the year of the Liquidation for an amount up to the excess of its taxable income in the year of the Liquidation, including any gain recognized under IRC Section 336, over the net fair market value of the assets distributed in the Liquidation (together with any other distributions made that year).
• Taxpayer should include the consent dividend in calculating its dividends-paid deduction for purposes of IRC Section 857(b)(2)(B).
• Acquirer LP should treat the consent dividend as liquidating proceeds received under IRC Section 331 (which treats distributions received by a shareholder in a complete liquidation of a corporation as received in full payment in exchange for the stock) and a deemed contribution by Acquirer LP of that amount to Taxpayer under IRC Section 565(c), thereby increasing Acquirer LP's adjusted basis in its Taxpayer stock.

Implications

PLR 202538013 is the third ruling that permits a REIT to effect a consent dividend in connection with its liquidation, thus generally allowing a REIT whose liabilities exceed its total asset basis to eliminate all of its taxable income with a dividends-paid deduction. See PLRs 201202014 (Tax Alert 2012-0117) and 201103001 (Tax Alert 2011-173). In both PLRs 201202014 and 201103001, the IRS concluded that the REIT was not precluded from making a liquidating consent dividend. In PLR 201202014, the IRS also addressed the shareholder's treatment of the consent dividend, ruling that the consent dividend would be treated by the shareholder as a liquidating distribution to it by the REIT, followed by a deemed contribution of those proceeds by the shareholder to the REIT as a contribution to capital.

Of the three rulings, PLR 202538013 offers taxpayers the clearest statement regarding the IRS's view of the proper treatment of a REIT's liquidating consent dividend for both the REIT and its shareholder. PLR 202538013 includes conclusions that (1) the REIT should include the consent dividend in calculating its dividends-paid deduction for purposes of IRC Section 857(b)(2)(B) and (2) the shareholder should treat the consent dividend as liquidating proceeds received under IRC Section 331 (as opposed to IRC Section 316 dividend income), providing clear confirmation of the treatment of each aspect of the consent dividend to the REIT and its shareholder.

REITs considering the use of liquidating consent dividends should seek the advice of their tax advisors and may want to consider seeking their own rulings.