The active trade or business rules are detailed and highly fact specific, and the IRS continues to refine its view on the qualification requirements.
In order to separate two businesses housed in one corporation or in a corporate group such that they are held independently by the corporation’s shareholders and corporate and shareholder-level income is avoided on the division, the detailed requirements of Section 355 of the Internal Revenue Code must be satisfied. In a Section 355 transaction, one corporation (Distributing) distributes to its shareholders the stock of another corporation it controls (Controlled), effectively spinning out the business held by Controlled (which may have been contributed to Controlled by Distributing prior to the distribution). If the distribution does not satisfy the requirements of Section 355, Distributing would be treated as recognizing federal taxable gain (but not loss) equal to the difference between the fair market value of the Controlled stock distributed and Distributing’s tax basis in such stock, and the receiving shareholders generally would have dividend income equal to the fair market value of the Controlled stock received.
Many criteria must be met for a particular distribution to qualify under Section 355 and thus be tax-free. Significant among them is the active trade or business test, which requires that, immediately after the distribution, each of Distributing and Controlled be engaged in the active conduct of a trade or business that has been conducted for each of the five years prior to the distribution. The businesses of each of Distributing and Controlled’s "separate affiliated group" (SAG, Distributing’s SAG [DSAG], and Controlled’s SAG [CSAG]) count, respectively, towards satisfying Distributing and Controlled’s active business requirements. A SAG, generally, is a chain of corporations (of which either Distributing or Controlled is the parent after the distribution) in which stock of one corporation possessing at least 80 percent of the vote and value is held by another corporation.
The active trade or business relied on by Distributing for Section 355 purposes must be the same throughout the five-year period. Controlled’s active trade or business must satisfy the same test. A trade or business can be considered a single trade or business, however, even if it grows or develops through expansion. The potential ability to distribute a business that represents an expansion of an existing business may be particularly relevant, for example, to corporations with new product lines using the same technology or new customer applications developed from existing activities. Treating a trade or business that has grown through expansion as a single trade or business may be very helpful in satisfying the Section 355 active trade or business requirement as all or part of the expanded business can be separated in the transaction and still count for purposes of the five-year requirement.
Expansion Through Purchases
In evaluating the businesses conducted by Distributing or Controlled that may satisfy the active trade or business test, assets that have been purchased in the last five years will not count towards satisfaction of the test if such assets are related to the operation of a new business. Assets acquired in a taxable purchase during such period will count, however, if considered part of an expansion of one or more of Distributing or Controlled’s existing five-year active trades or businesses.1 Generally, this will be the case if the assets are used in the operation of an existing five-year business conducted by Distributing or Controlled.2 For example, in a private letter ruling, the IRS concluded that the purchase by the Distributing corporation of property it had previously leased and used to operate its business, which was subsequently contributed to a Controlled corporation and then distributed to certain of its shareholders in a split-up transaction, satisfied the active trade or business test with respect to Controlled because, presumably, the Distributing corporation was using that property in its five-year business in each of the previous five years.3
The purchase of partnership interests also may count towards satisfaction of the test if the partnership is conducting either Distributing’s or Controlled’s five-year active business, as applicable, and Distributing or Controlled, as applicable, holds the requisite ownership therein, generally requiring a 33.3 percent ownership interest in the partnership operating the business.4 In addition, an argument can be made that the purchase of the stock of a corporation that becomes a member of either the DSAG or CSAG and that is engaged in the historic five-year active trade or business of its DSAG or CSAG (as applicable) can be treated as part of a qualifying active trade or business within its DSAG or CSAG because the acquisition of a subsidiary that becomes part of a SAG is treated as if the SAG acquired that subsidiary’s assets.5 Notably, Proposed Treasury Regulations Section 1.355-9(d), which disregards certain transactions in which Distributing or Controlled attempts to acquire assets such that its five-year active business asset percentage is at least 5 percent for purposes of satisfying the active trade or business requirement, clarifies that this anti-abuse rule generally does not apply to a nontransitory acquisition or disposition of assets, other than an acquisition from or disposition to certain related persons.6
Expansion Through Organic Efforts
Similar to the rule with respect to purchased assets, if Distributing or Controlled creates an entirely new business, with new customers and product offerings, that is not viewed as an expansion of its existing business, the new business will not be treated as a five-year business for purposes of Section 355.7 The determination of whether or not an organically developed business is considered part of the same business as the existing business and, thus, eligible to be treated as an expansion of the existing business is very fact dependent and may be difficult to document. In one private letter ruling, a Distributing corporation produced and marketed a product for many years.8 During the five years prior to the distribution, the corporation expanded its product line to produce a technologically enhanced version of the existing product to complement the historic product line. The shareholders of the Distributing corporation disagreed as to how to grow the business, with one wanting to expand the historic product line and the other wanting to expand the technologically enhanced product line. The IRS determined that, under these facts, the business could be separated along the lines of the historic product line and the technologically enhanced product line, with each business meeting the five-year active trade or business requirement.
Separation of a Single Business — Similar to Organic Expansion Cases
Unique challenges can also arise in the case of the division of a single five-year active business between Distributing and Controlled. These cases can be factually similar to the organic expansion cases because both involve the operation of what has historically been operated as one business. In the case of a separation of a single business, issues arise with respect to how to separate the business without negatively impacting the ability of each "slice" of the business to operate as a standalone entity after the distribution. In these instances, even though the business has been conducted by the same employees in the same locations and with the same management, the business can nevertheless be separated into two separate businesses if, after the distribution, each of the separate parts of the historic business will have their own employees, income and expenses representing an active business and their own separate management. The device test may be implicated, however, if, for example, the only customer for the distributed business conducted by Controlled is the Distributing corporation.9
Drilling Down — Punch-List for Active Trade or Business Test
Detailed information needs to be assembled to demonstrate that each of Distributing and Controlled satisfy the active trade or business test. The key information to be assembled includes, but is not limited to, the following:
1. Full description of each of the active trades or businesses of both Distributing (and its DSAG) and Controlled (and its CSAG)
a. Information should provide a history of the businesses, how long they have been conducted, and whether they have changed significantly within the past five years.
2. After finalization of the new Proposed Regulations,10 calculation of the percentage of the fair market value of the active trade or business assets as compared to the total assets of each of Distributing and Controlled (such percentage must be at least 5 percent for each corporation)
3. Employee information: If either Distributing or Controlled had fewer than 50 full-time employees during any of the past five years, taxpayers should assemble the following information for each of the past five years for each active trade or business relied on in the Section 355 distribution:
a. Job titles of employees
b. Function (managerial, operational or other)
c. Number of persons employed in each position
d. Brief description of the type of duties performed by each category
e. Nonemployee information regarding any persons who are not employees, such as independent contractors that were used in the business in any of the past five years, including:
i. Description of duties performed by the independent contractors
ii. Description of activities they performed for each of Distributing or Controlled
4. Description of the acquisition or creation of any new businesses or divisions
5. The previous five years of profit and loss statements for each active trade or business to be relied on for the Section 355 distribution. These statements must show income and expenses for each of the businesses to be relied on in the 355 distribution for each of the past five years.
6. A pro forma balance sheet for each of Distributing and Controlled as of the distribution date
7. Indication of whether there is a plan or intent to sell either of the active trades or businesses being relied on in the 355 distribution
8. Indication of whether there will be any "shared services" between Distributing and Controlled and, if so, provision of detailed information on the time period anticipated for such services, whether there is a formal contract providing for payment of such services, and a transition plan to enable each of Distributing and Controlled to operate independently
Pepper Perspective
Each of Distributing and Controlled must satisfy the active trade or business requirement for the distribution of Controlled to Distributing’s stockholders to qualify under Section 355. If one or more of the businesses of Distributing or Controlled has grown through acquisitions or organic development of new services or product lines, certain key information must be identified, including the factual background of such acquisitions, where the acquired assets are located (if a DSAG or CSAG is at issue), the relationship of the newly acquired or newly developed businesses to the historic businesses, and whether any acquisitions of Controlled stock are taxable or tax-free. The active trade or business rules are detailed and highly fact specific, and the IRS continues to refine its view on the qualification requirements. Because of the complexity of the active trade or business requirement, as well as the complexity of the numerous other requirements for a Section 355 distribution, taxpayers contemplating such a transaction should seek the assistance of tax professionals with experience in this area of tax law.11
Endnotes
1 Treas. Reg. § 1.355-3(c)(ii).
2 Treas. Reg. § 1.355-3(c), Example (8); Rev. Rul. 2003-18, 2003-1 C.B. 467; Rev. Rul. 2003-38, 2003-1 C.B. 811. See also Priv. Ltr. Rul. 201624004 (Feb. 24, 2016) (purchase of business assets prior to a distribution was considered a business expansion under Treas. Reg. § 1.355-3(c)(ii)).
3 Priv. Ltr. Rul. 201403002 (Sept. 18, 2013).
4 Rev. Rul. 2007-42, 2007-2 C.B. 44.
5 But see Section 355(a)(3) for treatment of the stock of Controlled that was acquired by purchase within the five-year period prior to the distribution.
6 Prop. Reg. § 1.355-9(d). We note that the Proposed Regulations are not final regulations and are proposed to be effective once they are published as final regulations in the Federal Register.
7 Treas. Reg. § 1.355-3(b)(3)(ii).
8 Priv. Ltr. Rul. 9646109 (Aug. 16, 1996).
9 Treas. Reg. § 1.355-3(c), Examples (9) –(12). In each of these examples, the formally integrated businesses were separated into two operational businesses, each of which satisfied the active trade or business test, i.e., manufacturing and research and development; processing of meat and sales of meat; manufacture of steel and operation of a coal mine; and operation of a bank and ownership, management, and leasing of a building. In three of the four examples, however, caution is indicated because of the "related function" device factor.
10 IRS REG-134016-15 (July 14, 2016).
11 Summary List of Factors for Section 355 Qualification
In general, in order for a taxpayer to qualify under Section 355 and obtain tax-free treatment for a distribution of a controlled corporation, several factors must be present. In simplified form, the factors include, but may not be limited to: (1) Immediately prior to the distribution, Distributing must be in "control" of Controlled (i.e., Distributing must own 80 percent or more of the Controlled stock); (2) Distributing must distribute to its shareholders all of the stock and securities in Controlled held by it immediately before the distribution; (3) The distribution cannot be used principally as a device for the distribution of earnings and profits of Distributing, Controlled or both, taking into account the existence of "nonbusiness" assets in determining whether device is present (taking into account proposed changes to Treasury Regulations Section 1.355-2(d) issued in August 2016); (4) Each of Distributing and Controlled (or members of their SAGs) must be engaged immediately after the distribution in the active conduct of a trade or business that has been conducted for each of the five years prior to the distribution. After finalization of Proposed Treasury Regulations Section 1-355-9, the active trade or business determination will include applying a 5 percent test, such that each business must meet the 5 percent threshold requirement with respect to the relative value of the active trade or business assets; (5) The distribution must be undertaken for a non-tax-motivated and immediate corporate business purpose; (6) There must be "continuity of shareholder interest" maintained in connection with the distribution; (7) Each of Distributing and Controlled must continue its respective business enterprise following the distribution; (8) The distribution of the Controlled stock cannot be a "disqualified distribution," which generally relates to a shareholder receiving Controlled stock after he or she purchased a significant amount of the Distributing corporation stock within the past five years; (9) The distribution of the Controlled stock cannot be a distribution that allows either the owners of Distributing or Controlled to reduce their ownership below 50 percent of the historic ownership in either Distributing or Controlled, within a certain time period; (10) The distribution of the Controlled stock cannot be a distribution with respect to certain investment corporations; and (11) The distribution cannot be with respect to entities that are treated as real estate investment trusts (REITs) (certain exceptions apply if both the Distributing and Controlled corporations are REITs before and after the distribution).
