Your client, (the Shareholder), a Massachusetts resident, held a fifty percent interest in a New Jersey Corporation, (the New Jersey Corporation). The New Jersey Corporation sold its assets in 1983 and liquidated in a (former) Code § 337 transaction. The shareholder received, as part of a liquidating distribution, $3,000,000 in principal amount of industrial revenue bonds (the IDBS) issued by the New Jersey Economic Development Authority.. These obligations stated an interest rate of 14.28% per annum which was federally tax exempt. All interest and principal on the IDBs was payable at maturity on April 15, 1988, although one unscheduled interest prepayment was made in 1986.
You state that the Shareholder's basis in his shares of the New Jersey Corporation was $410,494. However, you represent that the IDBs were installment obligations within the meaning of Code § 453. Therefore the Shareholder's gain from the liquidation of the New Jersey Corporation was not recognized in 1983 but was reportable on an installment basis as payments were actually made. The Shareholder posted bond in 1983 in order to elect installment sale treatment for Massachusetts purposes under G.L. c. 62, § 63.
In February 1988, just before the maturity of the IDBS, 1 1 the Shareholder organized (the Massachusetts Corporation) and transferred the IDBS, along with all interest due, to the Massachusetts Corporation in exchange for 100% of its stock, in a Code 5 351 transaction. You represent that the Massachusetts Corporation will engage is no activities other than holding the IDBs for investment and reinvesting the proceeds paid upon the maturity of the IDBS. The Massachusetts Corporation has elected federal S corporation treatment. We assume that its total receipts for its 1988 taxable year are less than $6 million.
You state that the Shareholder incorporated the IDBs in order to limit liability in future investing activities, to simplify his financial accounting by separating these assets and the activities associated with their investment from other-investment activities and business ventures of the Shareholder, and to have an investment vehicle to continue after the Shareholder's death to allocate and to manage assets for the benefit of family members. The Shareholder's ruling requests and our conclusions follow.
You have requested rulings on the following issues:
Is the gain realized from the IDBs taxable to the Shareholder or to the Massachusetts Corporation? Is the interest income payable with respect to the IDBs after the date of the transfer taxable to the Shareholder or to the Massachusetts Corporation? Is the Massachusetts Corporation eligible to be classified as a security corporation under G.L. c. 63, S 38B? Is the Shareholder entitled to a return of his security?
We assume, without deciding, that the Shareholder's representations regarding the federal law treatment of the transaction are correct. Specifically, we accept that the IDBs acquired by the Shareholder from the liquidation of the New Jersey Corporation are installment obligations under Code § 453, and that the contribution of the obligations to the Massachusetts Corporation in return for its stock was a "tax free" incorporation 2 under Code 5 351. The gain and interest payable upon the maturity of the IDBs must therefore be recognized by the Massachusetts Corporation and not by the Shareholder. We conclude, however, that the Massachusetts Corporation did not meet the requirements of G.L. c. 63, 5 38B, in its 1988 tax year. It is taxable not as a security corporation, but as a Massachusetts S corporation. Because the Shareholder will be personally taxed on his 100% distributive share of the S corporation's income, including gain recognized at the maturity of the bonds, and has not yet paid this tax, the bond that he posted under G.L. c. 62, 5 63 will not yet be released.
To be eligible for taxation as a security corporation under G.L. c. 63, 5 38B, a domestic corporation must be "engaged exclusively-in buying, selling dealing in or holding securities in its own behalf and not as a broker...... This class of corporations includes only those corporations which acquire securities for investment. Industrial Finance Corp. v. State Tax Commission, 367 mass. 360 (1975).
In State Tax Commission v. POGM Co., 369 mass. 611 (1976), a corporation which had been engaged in the production of jams, jellies, and preserves, sold its plant, equipment and other assets and ceased manufacturing activity. However, it retained a mortgage note which it acquired from the sale of certain real estate that it had owned, and reported gain on the sale of this real estate on an installment basis. The Supreme Judicial Court held that POGM was not entitled to security corporation status because it did not acquire the installment obligation for investment purposes. The Court stated:
Although the mortgage note representing the unpaid portion of the purchase price of PoGM's real estate may be a "security," we do not regard such a note as the type of security which the Legislature had in mind in S 38B. PoGm did not acquire the mortgage note in the normal course of investment but rather acquired it as the apparently unavoidable consequence of the circumstances under which it had to sell its real estate. Thus the mortgage note was not acquired for investment but was taken as a means of financing the sale of PoGM's real estate. it lacks the characteristics of a security bought and held for investment purposes ....
Id. 369 Mass. 611, 613. We must consider whether the holding in PoGm precludes security corporation status for the Massachusetts Corporation under the facts of this ruling. If the Massachusetts Corporation did not acquire and hold the IDBS for investment purposes, it cannot qualify as a security corporation in its 1988 taxable year, even though its activities after the maturity of the IDBs appear to satisfy the requirements of G.L. c. 63, § 38B.
You assert that the Massachusetts Corporation clearly acquired the IDBs for investment purposes because obligations contributed to a newly formed corporation are inherently acquired for investment purposes if the new corporation is formed as an investment vehicle. We disagree. The purposes for which an asset is acquired cannot so readily be transformed. The POGM decision would be rendered meaningless if, for example, the corporation in that case could have obtained taxation of its mortgage note at security corporation rates merely by contributing it to a wholly owned subsidiary. When a wholly owned corporation exchanges its stock for an asset already held by its sole shareholder, the purposes of the shareholder in acquiring the asset are fairly attributable to the corporation, and the manner in which such a shareholder acquired the asset must be examined. Under the facts here, the asset is an installment obligation that the Shareholder acquired in order to finance the sale of a business which he half owned. It was not acquired for investment within the meaning of PoGm.
We emphasize the importance of your representation that the IDBs acquired by the Shareholder 3 are installment obligations under Internal Revenue Code 5 453. In order to qualify as an installment obligation, rather than as immediate "payment" that must be included in income upon receipt, a note cannot be "readily tradable in an established securities market." IRC § 453(f)(4) - 453(f)(5).
In general, an obligation is treated as readily tradable "if it is regularly quoted by brokers or dealers making a market in such obligation or is part of an issue a portion of which is in fact traded on an established securities market." Temp. Treas. Reg. §15A.453.1(e)(4)(iii). Given that the IDBs acquired by the Shareholder are installment obligations, we conclude that they are not and cannot be marketable securities even if they are freely assignable.
The status of an obligation as a marketable security or, conversely, one that is not readily marketable, reflects upon the purposes for which it is acquired and held 4 At least in the hands of a seller of business assets, we presume that an unmarketable installment obligation is acquired and held because the seller has no reasonable alternative to finance his sale. The facts here demonstrate that the Shareholder's purposes in acquiring the IDBs was the financing of a sale, and not investment.
You point out that the sale of business assets in exchange for IDBs was conducted by the New Jersey Corporation, not by the Shareholder, who technically received the obligations in exchange for his stock. You assert that the Shareholder obtained the IDBs for investment even if the New Jersey Corporation did not. This objection is one of form over substance. The Shareholder acquired the IDBs through a liquidation of a closely held corporation. The sale of assets and distribution of proceeds in this circumstance was an integrated transaction executed under a plan of complete liquidation-within a twelve month period. See former IRC S 337. It is entirely reasonable and appropriate to view the Shareholder's acquisition of the IDBs as a means of financing the sale of business assets.
You also assert that this situation is not governed by the POGM decision because the liquidation of the New Jersey Corporation and the reincorporation of some of its assets does not, under the facts here, constitute a reorganization for purposes of federal law. While acknowledging that the New Jersey Corporation could not qualify as a security corporation when it held the IDBS, and that the Massachusetts Corporation would likewise be disqualified from security corporation status if the liquidation and subsequent incorporation were a reorganization, you argue that the absence of a reorganization for purposes of federal law precludes the application of POGM.
We disagree with this analysis. We do acknowledge that if a reorganization were present, POGM would almost certainly preclude the Massachusetts Corporation from acquiring security corporation status. Assuming for purposes of argument, however, that the liquidation and reincorporation of assets in this case is not a reorganization under the Internal Revenue Code, it does not follow that POGM is inapplicable. The issue in this ruling is one of state law whether the installment obligations here were acquired for investment purposes and are therefore the kind of "security" that the Legislature had in mind in adopting G.L. c. 63, S 38B. Federal cases interpreting the liquidation-reincorporation doctrine do not address this issue. Even if the Massachusetts Corporation is not the "alter ego" of the New Jersey Corporation for purposes of federal law, we conclude that it did not satisfy the requirements of G.L. c. 63, § 38B. 5
Very truly yours,
Commissioner of Revenue
February 9, 1989
1 Although the IDBs were scheduled to mature on April 15, 1988, they were called prematurely on February 1988. You state that this premature retirement of the bonds was not expected. The Massachusetts Corporation was formed three days before the IDBs were retired. Apparently the IDBs were the only property contributed to the new corporation.
2 The Shareholder represents that the contribution of installment obligations to a wholly owned corporation under IRC § 351 does not, under the facts of this ruling, trigger the recognition of gain on the obligations to the Shareholder. We assume, without deciding, that this representation is correct.
3 Especially before the Tax Reform Act of 1986, IDBs were often small-issue obligations that financed what, for all practical purposes, were private business sales. This appears to be true of the transaction under review in this ruling. we observe that although the Shareholder now refers to the IDBs as "New Jersey bonds," he described them on his 1983 federal tax return exclusively as "purchase money notes."
4 The Department has previously taken the position that the term "security" under G.L. c. 63, § 38 generally refers to marketable securities. See DOR Directive 86-34. The Shareholder asserts that two earlier Letter Ruling, LR 86-1, LR 82-8, are inconsistent with this position. We note that neither of these rulings discussed marketability. Furthermore, even if some inconsistency exists, the facts of the Directive, which expressly considered the status of installment obligations under G.L. c. 63, § 38B, are much closer to those of this ruling than to those of either of the other rulings cited.
5 The Shareholder withdrew his letter ruling request in this case before a ruling was issued. This document, therefore, is merely a proposed ruling. The proposed ruling is nevertheless being published to inform the public of the Department's position on the important issues that it addresses.