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Spin-off to separate two lines of business qualifies as D reorganization

In a private letter ruling (PLR), PLR 201338040, IRS has concluded that a series of proposed transactions to be entered into by a parent corporation and members of its affiliated group, in order to spin off a line of business to a newly formed controlled corporation, will generally qualify for tax-free treatment under Code Sec. 301(a) (dealing with distributions), Code Sec. 351(a) (property for stock), and Code Sec. 368(a)(1)(D) (reorganizations).

Background. Under Code Sec. 301(a), a distribution of money or other property from a corporation to a shareholder is taxed as a dividend to the shareholder to the extent the distributing corporation has earnings and profits (E&P). Any excess over the E&P is applied first against and reduces the shareholder’s adjusted basis in the stock; any remainder over that amount is treated as gain from the sale or exchange of property.

Under Code Sec. 351(a), no gain or loss is recognized upon a transfer of property to a corporation solely in exchange for stock of that corporation if, immediately after the transfer, the transferor or transferors are in control (as defined in Code Sec. 368(c)) of the corporation.

The Code provides general nonrecognition treatment for reorganizations specifically described in Code Sec. 368(a). Under Code Sec. 368(a)(1)(D), a type “D” reorganization includes a transfer of all or part of the assets of one corporation to another corporation if: (i) immediately after the transfer, the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the transferee corporation; and (ii) stock or securities of the corporation to which the assets are transferred are, under the plan, distributed in a transaction which qualifies under Code Sec. 354, Code Sec. 355 , or Code Sec. 356.

A corporate division may be accomplished on a tax-free basis in the form of a spin-off if certain requirements under Code Sec. 355 are met, including that the transaction isn’t used principally as a device for distributing the E&P of, and isn’t part of a plan under which one or more persons will acquire a 50%-or-greater interest in, either the distributing or controlled corporation. (Code Sec. 355(a)(1)(B); Code Sec. 355(e)(2)(A)(ii) ) In addition, to qualify for tax-free treatment, the regs require that the transaction serve one or more corporate business purposes. (Reg. § 1.355-2(b)) A corporation that meets these requirements may distribute the stock or securities of a controlled corporation to its shareholders or security holders with no gain or loss recognized to the distributees. The distributing corporation also generally recognizes no gain unless an exception applies. Code Sec. 355 is generally intended to permit a corporation’s historic shareholders to carry on their historic corporate businesses in separate corporations without triggering income tax.

Facts. Distributing is the common parent of an affiliated group of corporations that join in the filing of a consolidated federal income tax return (the “Distributing Group”). Distributing’s stock is publicly traded and widely held. Sub 1 is a direct, wholly-owned subsidiary of Distributing and a member of the Distributing Group that owns all of the stock of Subs 2, 3, and 4. Distributing and all of the Subs are State A corporations.

The Distributing Group is engaged in two lines of business, A and B. Distributing and members of its “separate affiliated group” under Code Sec. 355(b)(3)(B) (the “Distributing SAG”) conduct Business A, while Sub 1 and members of its SAG (after the proposed transaction, below, the “Controlled SAG”) conduct Business B. Although held by Sub 1 until the proposed transaction, Subs 2, 3, and 4 historically were engaged in Business A. Financial data for Businesses A and B show each has had gross receipts and operating expenses representing the active conduct of a trade or business for each of the past five years.

Proposed transaction. Distributing proposes to undertake the following transaction for what are represented to be valid business reasons. A series of representations were made in association with the transaction, several of which are stated below.

1. Sub 1 will borrow funds from a third-party lender.
2. Sub 1 will distribute all or a portion of the borrowing proceeds to Distributing.
3. Sub 1 will distribute all of the stock of Subs 2, 3, and 4 to Distributing (this, with (2), above, is referred to as the “Internal Distributions”).
4. Distributing will contribute four specified assets to Sub 1 (the “Sub 1 Contribution”). According to the associated representations, immediately after the Sub 1 Contribution, Distributing will be in control of Sub 1 under Code Sec. 368(c). In addition, the parties represented that Sub 1 would remain in existence and retain the use of the assets in a trade or business, and that the purpose of the Sub 1 Contribution is to align the ownership of the assets with their use and physical location.
5. Distributing will contribute all of the stock of Sub 1 to a newly formed controlled corporation (“Controlled”) in exchange for all of the stock of Controlled (the “Contribution”).
6. Distributing will distribute all of the common stock of Controlled to its shareholders pro rata (the “Distribution”). The parties represented that this distribution is intended to allow the management teams of Distributing and Controlled to each focus on their own priorities, allocate resources in accordance with their priorities, and enable investors to value the two businesses based on their respective financial characteristics.
7. Distributing and Controlled will enter into several “Continuing Agreements” necessary for the companies to achieve operational independence.

Rulings. With regard to the Internal Distributions, IRS determined that Sub 1’s distributions of Subs 2, 3, and 4 and the borrowing proceeds to Distributing were distributions to which Code Sec. 301(a) applies. Thus, the distributions will be treated as dividends to the extent of Sub 1’s E&P.

For the Sub 1 Contribution, IRS found that neither Distributing nor Sub 1 will recognize any gain or loss under Code Sec. 351(a), Code Sec. 357(a), or Code Sec. 1032(a), respectively. Sub 1 will have a carryover basis in the assets that it receives from Distributing under Code Sec. 362(a), and Distributing’s holding period will be tacked on under Code Sec. 1223(2). Distributing’s basis in the Sub 1 stock constructively received will be the same as its basis in the transferred assets, decreased by any liabilities assumed by Sub 1. (Code Sec. 358(a)(1) and Code Sec. 358(d))

Finally, IRS concluded that the Contribution and Distribution, together, will qualify as a “type D” reorganization under Code Sec. 368(a)(1)(D). Neither will recognize any gain or loss on the Contribution, and Distributing won’t recognize any gain or loss on the Distribution and no gain or loss will be recognized by (and no amount will be included in the income of) the Distributing shareholders upon the receipt of the Controlled stock. (Code Sec. 355(a)(1)) The basis of the Distributing stock and the Controlled stock in the hands of the Distributing shareholders after the Distribution will be the same as the basis of the Distributing stock held by them, allocated between the Distributing and Controlled stock in proportion to the fair market value of each under Reg. § 1.358-1(a) and Reg. § 1.358-2(a)(2). The holding period of the Controlled stock received by the Distributing shareholders will include the holding period of their Distributing stock with respect to which the Distribution was made, provided that such Distributing stock is held as a capital asset on the date of the Distribution. (Code Sec. 1223(1))

Caveats. IRS expressly stated that the PLR didn’t reach any conclusions on whether the proposed transaction (i) satisfies the business purpose requirement of Reg. § 1.355-2(b), (ii) is used principally as a device for the distribution of the E&P of Distributing and/or Controlled under Code Sec. 355(a)(1)(B), or (iii) is part of a plan (or series of related transactions) under Code Sec. 355(e)(2)(A)(ii).

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Meet Paul Raymond

Meet Paul Raymond

Mr. Raymond is a sought after speaker in tax controversy law by many attorney, accountant, and business groups and at the request of the Internal Revenue Service, has presented programs at the IRS Nationwide Tax Forum, attended by tax professionals throughout the United States.

Additionally, he continues to be an active member in the Section of Taxation, American Bar Association, where he was the Past Chair of the Employment Taxes Committee.

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