Have Earnings & Profits Become the New Tax Basis in Partial Dispositions of Corporate Stock?

In recent years, corporate deal structures have increasingly involved partial stock sales, known as "carve-outs," where a company sells part of its stock in a subsidiary rather than the entire holding. This shift has raised questions on whether earnings and profits (E&P) now act as a form of tax basis, especially when using certain tax provisions to optimize the tax implications of these partial sales.

Key Considerations

1. Earnings and Profits (E&P) Role: E&P has become a valuable tool in tax planning, offering advantages similar to traditional stock basis. When a corporation sells part of its shares, E&P may help reduce recognized gain and tax liabilities, similar to the role of stock basis in reducing taxable gain in traditional transactions.

   
   

2. Code Sec. 245A Dividends Received Deduction (DRD): This tax provision allows for tax-free receipt of dividends out of E&P, reducing the gain before any basis recovery. This can be especially favorable in partial dispositions, allowing companies to structure transactions to reduce tax liabilities.

   
   

3. Comparison of Tax Scenarios: Different transactions—such as Code Sec. 1001 exchanges, Code Sec. 351 reorganizations, and Code Sec. 301 distributions—produce varying tax outcomes. Code Sec. 301 distributions, for example, may allow for more tax-efficient returns on capital compared to other methods. In some cases, liability assumptions in reorganizations (under Code Sec. 357) can also provide tax-efficient structures.

   
   

4. Planning with E&P and Liabilities: By leveraging E&P in certain reorganizations and partial stock dispositions, corporations can create transactions that balance gain recognition and tax minimization. The article includes several examples demonstrating how different corporate transactions yield distinct tax results depending on E&P and liability handling.

E&P offers corporations flexibility in structuring partial stock sales, mimicking the benefits of basis in reducing gain realization. This approach can optimize tax outcomes, particularly when paired with deductions and exclusions, such as the DRD under Code Sec. 245A. As such, corporate taxpayers can achieve favorable tax results by strategically using E&P to minimize recognized gains in partial stock sales.