What Is Section 269 for Tax Avoidance Acquisitions?
Understand how the IRS analyzes the intent behind corporate acquisitions, disallowing tax benefits when a transaction's primary goal is tax avoidance.
Internal Revenue Code Section 269 is an anti-abuse provision giving the Internal Revenue Service (IRS) the authority to address certain corporate acquisitions. Its function is to prevent taxpayers from entering into transactions structured primarily to evade or avoid federal income tax. The rule allows the IRS to disallow a tax benefit, such as a deduction or credit, when it determines the main driver for an acquisition was to obtain that specific advantage. This provision is not meant to interfere with transactions conducted for legitimate business reasons, but instead targets situations where securing a tax benefit is the primary motivation for the deal.
Acquisitions Subject to Scrutiny
Section 269 applies to two categories of transactions. The first involves a person or group acquiring direct or indirect control of a corporation, particularly when the acquired company possesses valuable tax attributes. The second is when a corporation acquires property from another corporation it does not control, and the property’s tax basis is determined by its basis in the hands of the transferor, a method known as a “carryover basis.”
“Control” is defined as owning stock with at least 50% of the total combined voting power of all voting stock, or at least 50% of the total value of all classes of the corporation’s stock. This dual test prevents structuring ownership to narrowly avoid the rule while still effectively controlling the target company and its tax benefits.
An example of the first scenario is a profitable company buying a struggling business with significant net operating losses primarily to use those losses to offset its own income. For the second, a corporation might transfer a high-basis, low-value asset to an affiliate in a carryover basis transaction. The intent would be for the affiliate to sell the asset and generate a large tax loss.
The Principal Purpose Test
The “principal purpose” test is a subjective inquiry into the motives behind an acquisition. The IRS must determine whether the primary reason for the transaction was the evasion or avoidance of federal income tax. According to Treasury Regulations, the principal purpose is the one that “exceeds in importance any other purpose,” meaning tax avoidance must be the single most important factor driving the decision.
To make this determination, the IRS scrutinizes the circumstances surrounding the transaction and looks for evidence of legitimate, non-tax business purposes. A transaction supported by a well-documented, credible business strategy is less likely to be challenged. Such purposes could include:
- Expanding into new markets
- Acquiring proprietary technology
- Achieving operational synergies
- Securing a talented workforce
Certain facts indicate a tax avoidance motive. These include negotiations that focus heavily on the value of tax attributes like net operating losses (NOLs) or tax credits. The timing of an acquisition can also be revealing, such as a profitable company acquiring a loss-generating shell corporation just before the end of a tax year. The absence of any meaningful change in business operations after the acquisition also suggests the target was acquired for its tax profile.
The burden of proof generally falls on the taxpayer to demonstrate that tax avoidance was not the principal purpose of the acquisition. This requires maintaining thorough documentation that substantiates the business rationale for the transaction from its earliest stages. Memos, board meeting minutes, and financial projections that emphasize business goals over tax benefits can be persuasive evidence.
Consequences of Application
When the IRS successfully applies Section 269, the direct consequence is the disallowance of the tax benefit that was the primary objective of the acquisition. The IRS has broad authority to deny any “deduction, credit, or other allowance” that was improperly obtained. This means specific tax attributes that made the target company attractive—such as its accumulated net operating losses (NOLs), capital loss carryovers, or unused business tax credits—are nullified.
The scope of the disallowance is tailored to prevent the intended tax avoidance, and the IRS has the discretion to disallow the entire tax benefit or only a portion of it. The agency can also take other actions, such as reallocating gross income, deductions, or credits between the involved corporations to clearly reflect income and prevent distortion.
This power is corrective, not punitive, and it does not invalidate the business transaction itself. The acquisition remains legally valid, but the anticipated tax advantages are stripped away. This makes the original economic calculation for the deal far less favorable and serves as a significant deterrent against structuring acquisitions around tax avoidance.