Originally published July, 2003. To read this article in full, please click on the link at bottom of page

TABLE OF CONTENTS

I. INTRODUCTION

A. In General

B. Historic Focus

C. Current Importance

D. Future of Section 355 -- Subchapter C Study

E. Significant Developments

II. SECTION 355 -- OVERVIEW

A. Tax-Free Division

1. Types of tax-free divisions

2. Division of one or more businesses -- "D" reorganization

B. Tax Consequences of a Section 355 Transaction

1. No shareholder-level gain

2. No corporate-level gain

3. Gain on the distribution of boot

4. Basis of stock and securities

5. Tax attributes

III. REQUIREMENTS UNDER SECTION 355

A. In General

1. Statutory requirements

2. Non-statutory requirements

3. Interrelationship between requirements

B. Control Requirement

1. In general

2. Definition of control

3. Control in a "D" reorganization

4. Control and application of the step-transaction doctrine

C. Device Restriction

1. In general

2. Evidence of a device

3. Evidence of nondevice

4. Transactions not ordinarily considered a device

5. Additional factors not contained in the regulations

D. Five-Year Active Trade or Business Requirement

1. In general

2. Statutory requirements for an active trade or business -- Generally

3. Trade or business

4. Active conduct

5. Percentage of total assets that must be related to the active business

6. Five-year period

7. Acquisition of a trade or business, or of control of a corporation conducting

a trade or business, in a transaction without any gain or loss

8. Division of a functionally integrated business

9. Direct vs. indirect conduct of a business

E. Distribution of All or Substantial Ownership in the Controlled Corporation

F. Business Purpose Requirement

1. In general

2. Corporate vs. shareholder purpose

3. Business purpose for the distribution

4. Relation to device test

5. Ruling guidelines

6. Specific business purposes

G. The Continuity of Interest Requirement

1. In general

2. Degree of continuity

3. Post-distribution continuity

4. Pre-distribution continuity (i.e. historic continuity)

5. Continuity in both the distributing and the controlled corporations

6. Continuity issues arising from the division of a subsidiary as part of a "D" reorganization

H. Continuity of Business Enterprise Requirement

I. Section 355(d) Issues

1. In general

2. Disqualified distributions

3. Disqualified stock

4. Stock acquired by purchase

5. Fifty-percent test

6. Purpose exception

J. Section 355(e)

1. In General

2. Intragroup Spin-offs – Section 355(f)

3. Temporary regulations under section 355(e)

4. Examples

IV. PLANNING TRANSACTIONS/ALTERNATIVES TO SPIN-OFFS

A. "Synthetic" Spin-Offs

B. Subsidiary Tracking Stock

C. Dividend Followed by Public Offering

D. Option to Purchase Corporate Assets

E. Transaction to Thwart Hostile Takeovers

V. REQUESTING A PRIVATE LETTER RULING UNDER SECTION 355

A. In General

B. Checklist

C. Change in Facts

VI. APPENDIX A

I. INTRODUCTION

A. In General. Generally, corporate distributions of appreciated property are subject to tax on the amount by which the property’s value exceeds the corporation’s basis in the property. Under section 355 of the Internal Revenue Code of 1986, as amended (the "Code"), however, the distribution of stock of a subsidiary that is "controlled" by the distributing corporation may not be subject to tax either at the corporate level or to the recipient shareholders, provided a number of requirements are met.

B. Historic Focus

1. Traditionally, the focus under section 355 of the Code has been whether the transaction has been undertaken by the shareholders as a "device" in order to bail out earnings and profits at favorable capital gains rates.

2. Even in the absence of a rate disparity, the device issue remains relevant. A dividend distribution is taxed currently while a section 355 transaction is tax free. Moreover, a dividend is generally fully taxed (without recovery of any basis) while a transaction structured under section 355 followed by a sale permits the selling shareholder to recover basis. Furthermore, section 355 enables a distributing corporation to avoid the impact of the repeal of the General Utilities doctrine by the Tax Reform Act of 1986 (the "1986 Act").

C. Current Importance

1. The repeal of the General Utilities doctrine resulted in most distributions of appreciated property being subject to a corporate-level tax. Section 355 transactions are one of the few exceptions to this general rule. Accordingly, section 355 remains as one of the few valuable planning tools after the 1986 Act for avoiding the imposition of corporate-level tax on a distribution of stock of a subsidiary corporation.

2. However, this planning tool has been severely limited by several subsequently enacted provisions.

a. Congress has given the Internal Revenue Service (the "Service") broad regulatory authority under section 337(d) of the Code to prevent the avoidance of the tax consequences of the General Utilities repeal; i.e., the imposition of a corporate-level tax upon the distribution of appreciated property. This regulatory authority may be used to thwart section 355 transactions structured to avoid the imposition of corporate-level tax.

b. In addition, section 355(d) imposes a corporate-level tax on section 355 distributions if, immediately after the distribution, a shareholder holds a 50-percent or greater interest in the distributing or controlled corporation that is attributable to stock acquired by purchase within the preceding five-year period.

c. Moreover, the Taxpayer Relief Act of 1997 ("TRA 1997"), which added section 355(e) and (f), essentially eliminated tax-free "Morris Trust" transactions.

(1) Section 355(e) provides for a corporate-level tax on section 355 distributions that are part of a plan (or series of related transactions) pursuant to which one or more persons acquire directly or indirectly stock representing a 50- percent or greater interest in the distributing corporation or any controlled corporation.

(2) Section 355(f) provides that section 355 will not apply to the distribution of stock from one member of an affiliated group to another member if such distribution is part of a plan described in section 355(e).

d. TRA 1997 also granted the Service authority to provide adjustments (under section 358) to the adjusted basis of stock in the case of intragroup distributions to which section 355 applies, in order to appropriately reflect the proper treatment of such distributions.

3. Regulations

a. The current regulations, which were issued in 1989 and modified the original 1955 regulations, do not directly address the repeal of the General Utilities doctrine and its impact on section 355. However, many of the modifications that were made reflect the impact of General Utilities repeal.

b. These regulations appeared to shift the emphasis of section 355 from the device restriction to the business purpose requirement, substantially tightening the business purpose requirement. Moreover, the regulations clarified the continuity of interest test, and made certain changes in the device and active trade or business tests.

c. The regulations do not, however, reflect the amendments to section 355 made by the Revenue Act of 1987 (the "1987 Act") or the Technical and Miscellaneous Revenue Act of 1988 (the "1988 Technical Corrections Act").

d. Final regulations have been issued under section 355(d), and revised temporary and proposed regulations have been issued under section 355(e). The revised temporary and proposed regulations under section 355(e) address the issue of what constitutes a plan or series of related transactions. Additional regulations under section 355(e) and regulations under section 358 are expected in the future.

D. Future of Section 355 -- Subchapter C Study

There has been ongoing debate as to whether section 355 should be retained in light of the General Utilities repeal. This is a complex issue, the outcome of which depends upon the perceived policy goals of General Utilities repeal.

1. If General Utilities repeal stands for the proposition that assets should not be taken out of corporate solution without the imposition of a corporatelevel tax, then section 355 arguably is inconsistent with this policy. Under this view, stock of a subsidiary would be treated as an asset for General Utilities purposes.

2. However, several arguments can be made that section 355 should be retained; i.e., that stock of a subsidiary should not be treated as an asset.

a. The first is that, in repealing the General Utilities doctrine, Congress only intended corporate income to be subject to two levels of tax.

(1) The presence of sections 338(h)(10) and 336(e) both indicate that three levels of tax were not intended.

(2) On the other hand, by disallowing losses arising from certain basis adjustments, Temp. Treas. Reg. § 1.337(d)-2T makes it clear that the taxpayer may not always avoid a third level of tax on the sale of the subsidiary’s assets.

b. If an exception for section 355 is not retained, three levels of tax can be imposed; i.e., one to the distributing corporation upon the distribution of stock, one to the shareholders upon receipt of subsidiary stock, and one to the subsidiary when it sells its assets. A repeal of section 355 would thus be inconsistent with sections 338(h)(10) and 336(e).

c. In addition, the various restrictions contained in section 355 limit the potential for abuse. Abusive transactions falling within section 355 can be dealt with under section 337(d).

d. Further, in repealing the General Utilities doctrine, Congress gave no indication that it intended to disturb the policy underlying the tax-free treatment of reorganizations (i.e., to allow tax-free movement of assets in modified corporate forms). Thus, it would be anomalous to allow section 355 treatment where a D reorganization is involved, but not otherwise.

3. The issue turns, in part, on timing; i.e., whether a corporate-level tax should be imposed at the time of the distribution rather than on the subsequent sale of assets.

a. One can argue that section 355 allows an impermissible delay in taxation. Indeed, some view section 355 as a variation of the carryover basis scheme that was rejected by Congress in 1986.

b. Importantly, if the distribution is to be taxed, an inside basis stepup would be necessary to prevent three levels of tax. In effect, section 355 would be replaced by section 336(e).

4. However, immediate taxation would stifle valid, non-tax motivated corporate restructurings. To borrow from the section 382 arena, immediate taxation would not be tax neutral -- tax results would affect business decisions.

E. Significant Developments

In the past several years, there have been a number of significant developments under section 355. These developments have occurred in two areas:

1. First, the Service has initiated a significant examination and revision of the advance rulings process. Since 1996, this effort has concentrated on improving the transparency and candor of the rulings process. In particular, the Service adopted a more flexible fact-based approach to the business purposes that it would entertain as valid reasons for a section 355 transaction. This additional flexibility came at the cost of more onerous substantiation requirements.

Recently, however, the Service has revisited its section 355 rulings process in an effort to streamline it. In Rev. Proc. 2003-48, I.R.B. 2003- 29, the Service announced that it would no longer rule on inherently factual issues under section 355. Specifically, the Service would no longer rule as to whether a proposed or completed distribution of a controlled corporation’s stock is being carried out for one or more corporate business purposes, whether the transaction is used principally as a device, or whether a distribution and an acquisition are part of a plan under section 355(e). Instead, the Service plans to shift its resources to providing published guidance on legal questions involving these requirements.

2. Second, the government has been grappling with the application of the step-transaction doctrine to multi-step transactions that include section 355 distributions. In part, this reflects a general sense on the part of the Service that section 355 transactions are incompatible with General Utilities repeal and a desire to limit the use of such transactions. It also reflects a more general re-examination of the step-transaction doctrine in the context of corporate reorganizations. The government has issued a number of significant published and private rulings involving multi-step transactions that include section 355 distributions, and legislation has also affected this area.

II. SECTION 355 -- OVERVIEW

A. Tax-Free Division

Section 355 permits the separation of two or more existing businesses formerly operated, directly or indirectly, by a single corporation ("distributing corporation" or "Distributing") without the recognition of gain or loss by the shareholders or security holders of the distributing corporation.

1. Types of tax-free divisions

A section 355 transaction can be structured in one of three ways; i.e., as a spin-off, a split-off, or a split-up.

a. Spin-off

A spin-off is the pro rata distribution of the stock of a corporation that is controlled by the distributing corporation ("controlled corporation" or "Controlled"). In a spin-off, the shareholders of the distributing corporation do not surrender any stock.

b. Split-off

A split-off is the distribution of the stock of a controlled corporation (generally to some but not all of the shareholders). In a split-off, the recipient shareholders of the distributing corporation surrender stock of that corporation.

c. Split-up

A split-up is the distribution of the stock of two or more controlled corporations in complete liquidation of the distributing corporation.

2. Division of one or more businesses -- "D" reorganization

In a divisive "D" reorganization, part of the assets of the distributing corporation that constitute a business are transferred to a controlled corporation (often, but not necessarily, newly formed). The stock of the controlled corporation is then distributed to the shareholders of the distributing corporation in a section 355 transaction. Section 368(a)(1)(D).

B. Tax Consequences of a Section 355 Transaction

1. No shareholder-level gain

A distribution qualifying under section 355 will not result in the imposition of tax at the shareholder level.

2. No corporate-level gain

A distribution qualifying under section 355 will also not result in the imposition of any corporate-level tax, unless section 355(d), (e), or (f) applies.

3. Gain on the distribution of boot

Boot distributed as part of a section 355 transaction will, however, be subject to both corporate- and shareholder-level tax.

a. In Rev. Rul. 93-62, 1993-2 C.B. 118, the Service addressed the issue of when the distribution of boot in a section 355 transaction "has the effect of a distribution of a dividend" under section 356(a)(2).

(1) The Service concluded that boot should be treated as if received in a hypothetical redemption of stock prior to the section 355 transaction.

a) This differs from the treatment of boot in an acquisitive reorganization under Commissioner v. Clark, 489 U.S. 726 (1989), where the hypothetical redemption is deemed to occur after the reorganization.

b) The Service noted that the rationale of Clark is to compare the shareholder’s percentage ownership in the assets of the corporation following the reorganization with the percentage ownership that would have resulted if no boot had been received in the transaction. In an acquisitive reorganization, this requires comparing the stock owned in the acquiring corporation with the stock that would have been owned had no boot been received; in a divisive reorganization, this requires comparing the total stock owned in both Distributing and Controlled after the transaction with the stock that would have been owned had no boot been received.

c) Nonetheless, the Service noted that its conclusion was not inconsistent with Clark, because whether the distribution has the effect of a dividend is based on an analysis of the entire transaction.

(2) Whether the hypothetical redemption is equivalent to a dividend is determined under the principles of section 302.

a) This determination is made by comparing the recipient shareholder’s interest in Distributing before the exchange with the interest the shareholder would have retained if he had surrendered only the Distributing shares equal to the value of the boot.

b) Thus, for example, if A owns 400 of the 1,000 Distributing shares outstanding, and A receives stock of Controlled worth $200 and $200 cash in the distribution, A would be treated as holding 400 shares before the deemed section 302 redemption and 200 shares after.

b. The Service has concluded that stock purchase rights that are attached to the stock of the controlled corporation distributed does not constitute the distribution of stock or boot by the distributing corporation. See, e.g., P.L.R. 200137042 (June 20, 2001); P.L.R. 200131024 (May 8, 2001); P.L.R. 199919025 (Feb. 12, 1999); P.L.R. 9749018 (Sept. 11, 1997); P.L.R. 9610034 (Dec. 15, 1995); P.L.R. 9422057 (Mar. 11, 1994); P.L.R. 9245019 (Aug. 7, 1992).

(1) Stock purchase rights entitle the holder to purchase additional stock of the corporation upon the occurrence of certain triggering events (usually involving changes in corporate control).

(2) Such stock purchase rights generally must satisfy the requirements of Rev. Rul. 90-11, 1990-1 C.B. 10; i.e., they must remain contingent, non-exercisable, and subject to redemption if issued.

c. Under TRA 1997, "nonqualified preferred stock" will be treated as boot for purposes of sections 351, 354, 355, 356, and 368. See, e.g., section 355(a)(3)(D).

(1) Nonqualified preferred stock is defined in section 351(g) as preferred stock for which (1) the holder has the right to require the issuer to redeem or purchase the stock, (2) the issuer is required to redeem or purchase the stock, (3) the issuer has the right to redeem or purchase the stock and, as of the issue date, it is more likely than not that such right will be exercised, or (4) the dividend rate on the stock varies in whole or in part with reference to interest rates, commodity prices, or other similar indices.

(2) The first three rules above do not apply if (1) the right cannot be exercised within 20 years of the date the right is issued or is subject to a contingency that makes the likelihood of redemption or purchase remote, (2) the right may be exercised only upon the death, disability, or mental incompetency of the holder, or (3) the right to redeem or purchase is in connection with the performance of services for the issuer and may be exercised only upon the holder’s separation from service.

4. Basis of stock and securities

a. The basis of the stock and securities received in a section 355 transaction is determined with reference to the recipient’s basis in the stock and securities of the distributing corporation. See section 358(a)(1); 358(b)(2); but see section 358(g) (authorizing the Service to provide adjustments to the stock basis of members in connection with intragroup distributions).

b. The recipient’s aggregate basis in the stock and securities of the distributing corporation, before the distribution, is allocated based on relative fair market values between the stock and securities retained in the distributing corporation and the stock and securities received in the controlled corporation.

5. Tax attributes

a. Divisive "D" reorganization

(1) In a divisive "D" reorganization, the tax attributes of the distributing corporation, except for that corporation’s earnings and profits, will remain with the distributing corporation. See section 381(a).

(2) The distributing corporation’s earnings and profits will be allocated between the distributing corporation and the controlled corporation in proportion to the value of the retained and transferred assets. Treas. Reg. § 1.312-10(a).

b. Spin-off or split-off

(1) If a section 355 transaction is a spin-off or a split-off, the regulations provide that the earnings and profits of the distributing corporation are decreased by the lesser of (1) the amount of the adjustment that would have been made to the earnings and profits of the distributing corporation if it had transferred the stock of the controlled corporation to a new subsidiary in a divisive "D" reorganization, or (2) the net worth of the controlled corporation. Treas. Reg. § 1.312-10(b).

(2) The remaining tax attributes of the distributing corporation and the tax attributes of the controlled corporation are generally unaffected. However, in a non-pro rata split-off, section 382 may limit the carryover of the distributing or the controlled corporation’s losses.

c. Split-up

If the section 355 transaction is a split-up, the tax attributes of the distributing corporation disappear. The tax attributes of the controlled corporations are not affected.

III. REQUIREMENTS UNDER SECTION 355

A. In General

1. Statutory requirements

In order for section 355 to be applicable to the distribution of a controlled corporation’s stock, each of the following statutory requirements must be satisfied.

a. Control

The distributing corporation must be in control of the controlled corporation immediately before the distribution.

b. Device restriction

The transaction must not be principally a device for the distribution of earnings and profits.

c. Active trade or business requirement

(1) With respect to spin-offs and split-offs, immediately after the distribution, the distributing corporation and the controlled corporation must each be engaged in the active conduct of a trade or business.

(2) With respect to split-ups, immediately before the distribution, the distributing corporation cannot hold any assets other than stock or securities in controlled corporations, and immediately after the distribution, each of the controlled corporations must be engaged in the active conduct of a trade or business.

d. Distribution of all or substantial ownership in the controlled corporation

The distributing corporation must distribute either all of the stock and securities held by it immediately before the distribution, or it must distribute an amount of stock in the controlled corporation constituting control and establish to the satisfaction of the Service that the retention of stock or securities in the controlled corporation did not have the principal purpose of avoiding federal income tax.

e. Restrictions

Sections 355(b)(2)(D), 355(d), 355(e), and 355(f) impose further requirements as to the holding of stock in the distributing and controlled corporations, which must be met if the distribution is to be free of tax at the corporate level.

2. Non-statutory requirements

In addition to the statutory requirements described above, each of the following non-statutory requirements must be satisfied in order for section 355 to apply to the distribution of a controlled corporation’s stock.

a. Business purpose

The transaction must have a corporate business purpose.

b. Continuity of interest

The pre-distribution owners of the distributing and controlled corporations must maintain a continuing interest in those corporations after the distribution.

c. Continuity of business enterprise

The regulations under section 355 appear to impose a continuity of business enterprise requirement on section 355 transactions.

3. Interrelationship between requirements

Each of the above noted requirements must be separately satisfied. However, there is significant overlap among these requirements which, as will be seen, often makes it difficult to ascertain whether the distribution qualifies for tax-free treatment.

B. Control Requirement

1. In general

a. In order for section 355 to apply to the distribution of a corporation’s stock, the distributing corporation must be in control of the controlled corporation immediately before the distribution. Section 355(a)(1)(A). In addition, the distributing corporation must distribute all of its stock and securities in the controlled corporation or an amount that constitutes control. Section 355(a)(1)(D).

b. If a spin-off involves a threshold "D" reorganization, it is also necessary that either the distributing corporation or its shareholders control the controlled corporation "immediately after the transfer." Section 368(a)(1)(D).

2. Definition of control

a. A corporation is considered to control another corporation for purposes of section 355 if it owns stock possessing 80 percent of the total combined voting power of all classes of stock entitled to vote in the second corporation and at least 80 percent of the total number of shares of each of the other classes of stock of that corporation. Section 368(c); Rev. Rul. 59-259, 1959-2 C.B. 115.

(1) The key factor in determining voting control is the ability to elect directors. See Boris I. Bittker & James S. Eustice, Federal Income Taxation of Corporations and Shareholders, ¶ 3.07[2] (7th ed. 2000); Hermes Consol., Inc. v. United States, 14 Cl. Ct. 398 (1988); Rev. Rul. 69- 126, 1969-1 C.B. 218; see also Official Summary of P.L.R. 9802048 (July 11, 1997), 2000 TNT 250-56 (rejecting dicta in Hermes regarding the power to approve or disapprove fundamental changes in corporate structure and confirming that the power to elect directors is the key factor).

a) In certain circumstances, however, a court may look beyond the power to elect directors. See, e.g., Framatone Connectors USA, Inc. v. Commissioner, 118 T.C. 32 (2002) (stating in dicta that supermajority and unanimous approval requirements for certain corporate actions prevented the corporation from being a controlled foreign corporation); Alumax v. Commissioner 109 T.C. 133 (1997), aff’d, 165 F.3d 822 (11th Cir. 1999) (involving disproportionate voting rights as a result of certain class vote and veto provisions); Hermes, 14 Cl. Ct. at 405 (stating in dicta that the power to approve or disapprove fundamental changes in the corporate structure may be relevant in determining voting power of minority shareholders).

(2) Note that a nondivisive "D" reorganization must satisfy a different control requirement. Section 368(a)(2)(H) adopts the 50 percent vote or value test set forth in section 304(c).

(3) Other areas of the Code adopt other control definitions; e.g., sections 332, 338, 382, and 1504 use an 80-percent vote and 80-percent value requirement. Thus, for example, a public offering of stock by Controlled could result in a situation where Controlled is deconsolidated but nonetheless satisfies the control requirement of section 355. See P.L.R. 200103037 (Oct. 20, 2000).

b. It is not necessary that the distributing corporation’s control of the controlled corporation be "historic control." Steps may be undertaken prior to the section 355 transaction in order to satisfy the control requirement.

(1) A recapitalization of the controlled corporation prior to its distribution by the distributing corporation, which results in the control requirement being satisfied, will be respected as long as the recapitalization results in a permanent realignment of control. Rev. Rul. 69-407, 1969-2 C.B. 50; see also P.L.R. 200135039 (May 24, 2001); P.L.R. 200048030 (Aug. 30, 2000); P.L.R. 200007005 (Nov. 1, 1999); P.L.R. 199951014 (Sept. 22, 1999); P.L.R. 199935031 (June 2, 1999); P.L.R. 9836019 (June 8, 1998); P.L.R. 9547049 (June 2, 1995); P.L.R. 9544003 (Nov. 21, 1994); P.L.R. 9409043 (Dec. 9, 1993); P.L.R. 8744035 (Aug. 4, 1987).

a) The Service will generally require that the taxpayer represent that the recapitalization will not be undone. See Official Summary of P.L.R. 9644028 (July 31, 1998), 1999 TNT 182-39.

b) Nonetheless, the Service may permit a reversal of a recapitalization if the taxpayer can show that such a reversal is necessitated by unexpected events occurring after the distribution. See P.L.R. 200125083 (Mar. 27, 2001); P.L.R. 200118018 (Jan. 31, 2001); P.L.R. 200139011 (June 28, 2001); P.L.R. 200113019 (Dec. 27, 2000).

(2) The merger of two sister corporations that jointly own stock in a subsidiary resulting in the surviving corporation having control of the subsidiary will be respected. Rev. Rul. 70-18, 1970-1 C.B. 74.

(3) The transfer of assets for additional stock causing the transferor to be in control of the transferee will be respected. Rev. Rul. 71-593, 1971-2 C.B. 181. The Service, however, has declined to rule on whether the active business requirement has been satisfied if liquid or nonbusiness assets are transferred to obtain control. Rev. Proc. 2003-3, § 4.01(29), 2003-1 I.R.B. 113.

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