SPLITTING CORPORATIONS UNDER SECTION 355

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1 ABA SECTION OF TAXATION / SECTION OF REAL PROPERTY, TRUST & ESTATE LAW JOINT PROGRAM Denver, Colorado October 22, 2011 NEXT GENERATION DISPUTES IN THE FAMILY BUSINESS: NAVIGATING THE REMEDIAL, ETHICAL AND TAX QUAGMIRES - A CASE STUDY SPLITTING CORPORATIONS UNDER SECTION 355 By Morton A. Harris and Carl A. Rhodes Hatcher, Stubbs, Land, Hollis & Rothschild The Authors are grateful to administrative assistant, Mary G. Ray for her help in the preparation of this outline.

2 ABA SECTION OF TAXATION / SECTION OF REAL PROPERTY, TRUST & ESTATE LAW JOINT PROGRAM Denver, Colorado October 22, 2011 SPLITTING CORPORATIONS UNDER SECTION 355 I. Overview of Section 355 Transactions By Morton A. Harris and Carl A. Rhodes Hatcher, Stubbs, Land, Hollis & Rothschild Section 355 provides that when certain judicial and statutory requirements are satisfied, a corporation can be divided into two or more separate corporations on a tax-free basis. The rationale is that a corporate division is merely a change in the form of business which continues to be owned and operated by the same shareholders. II. Types of Corporate Divisions A. Spin-Offs A "spin-off' is a pro-rata distribution of a subsidiary corporation to its existing shareholders. A spin-off resembles a dividend in kind. The stock of a subsidiary corporation is distributed pro-rata to the shareholders of the parent without any surrender of stock by them. If the spin-off fails to qualify under Section 355, the parent corporation would be taxed under Section 311 on the appreciation (if any) in the value of the subsidiary stock that is distributed and the shareholders would be taxable under Section 301 on the receipt of the stock as a dividend. B. Split-Off A "split-off' is a non pro-rata distribution of stock by the parent corporation of a subsidiary corporation to some of its shareholders in exchange for their stock in the parent. Example: A and B are two equal shareholders of the parent corporation. The business is divided and one part of the business is transferred to a newly formed subsidiary followed by the parent distributing the subsidiary stock to A in redemption for all of his stock in the parent corporation. A split-off resembles a redemption. If the split-off fails to qualify under Section 355, the parent corporation would be taxed under Section 311 on the fair market value (in excess of basis) of the subsidiary stock distributed in redemption of the shareholder's stock in the parent; and the shareholder receiving the subsidiary stock would be taxed under Section 302 on the redemption of his stock in the parent

3 C. Split-Ups A "split-up" is when the parent corporation divides the business and transfers it to two new subsidiary corporations which are then distributed non pro-rata to all of the shareholders in exchange for their stock in the parent corporation. A split-up resembles a complete liquidation of the parent corporation. After a split-up, the shareholders own stock interests (either pro-rata or non pro-rata) in the two new corporations and the distributing corporation ceases to exist. If the split-up fails to qualify under Section 355, the parent corporation would be taxed under Section 336 on the distribution of the subsidiaries as if it had sold the subsidiaries at fair market value, and the shareholders would be taxed under Section 331 on the receipt of the stock. D. Divisive Reorganizations In many cases, the subsidiaries do not exist at the time the parent corporation wishes to separate its business. However, a divisive transaction can be done on a tax free basis using a corporate reorganization under Section 368(a)(s)(D), which allows the parent corporation to form a subsidiary to which the parent transfers part or all of its business as the first step in a plan to distribute the subsidiary's stock to shareholders. For example: A Type D Reorganization in a "split off' would involve the transfer of part of the parent corporation's business to a controlled subsidiary corporation in exchange for its stock and securities followed by a distribution of that stock (and securities) to certain shareholders of the parent corporation. Handling the transaction as a D reorganization can accomplish any of the tax free divisions described in Paragraphs A, B or C above. As in all types of tax free reorganizations, the judicial requirements of "business purpose", "continuity of business enterprise" and "continuity of interest" must also be met to satisfy the requirements of Section 355 whether or not accomplished through ad Reorganization. III. A Brief History of Section 355 The earliest predecessor of Section 355 was enacted as part of the Revenue Act of 1924 to permit tax-free separations of one or more active businesses formally operated by a single corporation or by a corporation and its subsidiary. In 1934, Congress eliminated the "spin-off' provisions out of concern that businesses were being divided and distributed for tax avoidance purposes. Congress reinstated the "spin-off' provisions in the Revenue Act of 1951 and added requirements to protect against tax avoidance. With the adoption of Section 355 as part of the Internal Revenue Code of 1954, an "active trade or business" requirement was added. In 1986, with the repeal of the General Utilities Doctrine which required corporations to pay tax on the appreciation of property distributed to shareholders, Section 355 became even more important as a means of qualifying the transaction for tax-free treatment

4 IV. Section 355 Requirements A. Statutory Requirements 1. Control. Immediately before the distribution, the parent corporation must control the subsidiary corporation whose shares are being distributed. The term "control" is defined by Section 3 68( c) to mean the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all classes of stock. Section 355(a)(1)(A). 2. Active Trade or Business. Both the parent distributing corporation and the controlled corporations must be engaged in the active conduct of a trade or business both before and after the distribution. This requirement is satisfied only if the trade or business was actively conducted throughout the five year period ending on the date of distribution and was not acquired within the five year period in a taxable transaction. A corporation is considered to be actively engaged in the conduct for trade or business if it carries on activities, including the collection of income and payment of expenses for the purpose of earning a profit. Managing income from passive assets such as investment securities does not qualify as an active trade or business. 3. Distribution of All Controlled Stock. The distributing corporation must distribute either all of the stock and securities in the controlled corporation or enough stock to meet the 80% control test and to satisfy the Secretary of the Treasurer that the retention of some of the stock in the controlled corporation was not for the principal purpose of avoidance of federal income tax. Section 355(a)(1)(D). 4. The Treasury Regulations under Section 355 state that a change in the trade or business during the five year period by adding new or dropping old products, or making changes in production capacity, etc., would not violate the five year rule. In particular, if a corporation engaged in a particular trade or business during the five year period purchased another trade or business in the same line of business, the acquisition would likely be treated as an expansion of the original business and not be a violation of the five year rule. 5. Not a Device. The transaction must not be used principally as a device for the distribution of earnings and profits of the distributing corporation, the controlled corporation or both. This is determined from all the facts and circumstances. B. Non Statutory Requirements 1. Corporate Business Purpose. Section 355 applies to a transaction only ifit is motivated in substantial part by one or more corporate (not shareholder) business purposes. Reg (b). A corporate business purpose is a real and substantial non-federal tax purpose germane to the business of the distributing corporation or the controlled corporation

5 2. Continuity of Shareholder Interest. For Section 355 to apply, one or more persons who were the owners of the corporation before the distribution or exchange must own in the aggregate an amount of stock sufficient to establish a continuity of interest in each of the distributed corporations after the distribution. Reg (c)(1) For advanced ruling purposes, the Service will generally view the requirement as being satisfied if the shareholders of the distributing corporation own at least 50% of the interest in both the distributing corporation and the controlled corporation. 3. Continuity of Business Enterprise. Section 355 contemplates the continued ownership and operation of the businesses of both the distributing corporation and the controlled corporation that existed prior to the distribution. The issue comes up if the distributed corporation is sold to a third party or is liquidated within a short period of time after the division. 4. Assumption of Liabilities. The parent distributing corporation may be relieved of some of its indebtedness by having the controlled subsidiary corporation assume some of its liabilities as part of the D Reorganization exchange. This relief of indebtedness is tax free to the distributing corporation under Section 357(a). v. History of IRS Ruling Policy The late 1980's marked an important time period for corporate taxation. The 1986 repeal of the General Utilities Doctrine eliminated a corporation's ability to distribute its appreciated assets on a tax free basis. Similarly, in 1989 the Treasury issued regulations emphasizing the importance of a business purpose in proposed 355 transactions. l The tightening of corporate distributions and intensely factual nature of the business purpose regulations established in the late 1980's led an increased number of taxpayers, in the early 1990's, to seek IRS guidance on proposed 355 transactions. The increased demand for IRS rulings prompted the Service to issue published guidance for taxpayers that would also limit the factual questions that the IRS would address in rulings. This came in the form of Rev. Proc , which set forth representations required of a taxpayer before the IRS would rule that a proposed transaction would meet 355 requirements. 2 The required representations and explanations were demanding on taxpayers and also caused the IRS to devote even more resources to determining the factual details of each proposed transaction. 3 Again, the IRS took steps to devote fewer resources to factual determinations and focus on legal rulings4 by issuing Rev. Proc which limited the guidance by the IRS regarding factual matters and changed the required representations for taxpayers who desired a ruling. 5 Specifically, the IRS National Office decided to no longer issue a ruling on whether a distribution of the controlled company's stock was carried out for a business purpose, whether 1 BNA Tax Management Portfolio 776-3rd (I)(D) "IRS Ruling Policy", Ridgway, 776-3rd T.M., Corporate Separations. 2 REV. PROC , C.B Ridgway, 776-3rd (I)(D) T.M., Corporate Separations. 4 Id. 5 REV. PROC , I.R.B. 86 (7/21/2003)

6 the distribution was used as a prohibited device to distribute earnings, or whether the distribution and acquisition were part of a plan under 355(e). The effect of Rev. Proc was that the IRS denied making determinations regarding these factual issues. The IRS guidance reflects the Service's unwillingness to issue private letter rulings on 355 issues in favor of its policy to increase publicly available IRS guidance. 6 However, in Rev. Proc the IRS reserved the limited right to issue rulings regarding 355(e)? Furthermore, the IRS generally does not issue private letter rulings related to a portion of a larger transaction. However, in IRS Rev. Proc , the IRS reserved discretion to issue a private letter ruling that related to part of, or a significant issue in, a proposed 355 transaction without ruling on the overall proposed transaction. VI. Examples - Active Conduct of a Trade or Business A. Rev. Rul Corporation D has been engaged under a dealer franchise in the sale and service of brand X automobiles since Year 1. For over five years before Year 8, these operations had been carried on in two buildings (L and M) within the same city. In Year 8, D acquired a franchise for the sale and service of brand Y automobiles and purchased the inventories, equipment, and leasehold of a former brand Y automobile dealer who operated in a building adjoining D's building L. Shortly thereafter, D relocated the inventory of brand X automobiles from building L to building M. Thereafter, D used building M exclusively for the sale and service of brand X automobiles and used building L and the adjoining leasehold exclusively for the sale and service of brand Y automobiles. In Year 10, D transferred all of the assets, including building M, and liabilities of the brand X automobile dealership to a new corporation, C, in exchange for the stock of C, and distributed the stock of C pro rata to its shareholders. The service ruled this an expansion and not a new acquisition, and thus this met the active business requirement of 355 (b). B. Treas. Reg (c) Active Conduct of a Trade or Business. The following examples contained in the Regulation illustrate section 355(b)(2) (A) and (B). However, a transaction that satisfies these active business requirements will qualify under section 355 only if it satisfies the other requirements of section 355(a) and (hl. Example (1). Corporation X is engaged in the manufacture and sale of soap and detergents and also owns investment securities. X transfers the investment securities to new subsidiary Y and distributes the stocks ofy to X's shareholders. Y does not satisfy the requirements of section 355(b) because the holding of investment securities does not constitute the active conduct of a trade or business. Example (4). For more than five years, corporation X has conducted a single business of constructing sewage disposal plants and other facilities. X transfers one-half of its assets to new subsidiary Y. These assets include a contract for the construction of a sewage disposal plant in 6 Ridgway, 776-3rd (I)(D) T.M., Corporate Separations. 7 REV. PROC , I.R.B

7 State M, construction equipment, cash, and other tangible assets. X retains a contract for the construction of a sewage disposal plant in State N, construction equipment, cash, and other intangible assets. X then distributes the stock ofy to one of X's shareholders in exchange for all of his stock of X X and Y both satisfy the requirements of section 355(b). Example (5). For the past six years, corporation X has owned and operated two factories devoted to the production of edible pork skins. The entire output of one factory is sold to one customer, C, while the output of the second factory is sold to C and a number of other customers. To eliminate errors in packaging, X opens a new factory. Thereafter, orders from C are processed and packaged at the two original factories, while the new factory handles only orders from other customers. Eight months after opening the new factory, X transfers it and related business assets to new subsidiary Y and distributes the stock ofy to X's shareholders. X and Y both satisfy the requirements of section 355(b). See paragraph (b )(3) (i) and (ii) of this section. Example (9). For the past eight years, corporation X has engaged in the manufacture and sale of household products. Throughout this period, X has maintained a research department for use in connection with its manufacturing activities. The research department has 30 employees actively engaged in the development of new products. X transfers the research department to new subsidiary Y and distributes the stock ofy to X's shareholders. After the distribution, Y continues its research operations on a contractual basis with several corporations, including X X and Y both satisfy the requirements of section 355(b). See paragraph (b )(3)(i) of this section. The result in this example is the same if, after the distribution, Y continues its research operations but furnishes its services only to X See paragraph (b)(3)(i) of this section. However, see (d)(2)(iv)(c) (related function device factor) for possible evidence of device. Example (10). For the past six years, corporation X has processed and sold meat products. X derives income from no other source. X separates the sales function from the processing function by transferring the business assets related to the sales function and cash for working capital to new subsidiary Y. X then distributes the stock of Y to X's shareholders. After the distribution, Y purchases for resale the meat products processed by X X and Y both satisfy the requirements of section 355(b). See paragraph (b)(3)(i) of this section. However, see (d)(2)(iv)(C) (related function device factor) for possible evidence of device