By Randy A. Schwartzman

In Brief

Changes to IRC sections 355(d) and 355(e)

Taxpayers have long complained that the statutory provisions designed to prevent disguised sales to avoid taxation have adversely affected tax-free spin-off transactions with legitimate business purposes. The IRS recently liberalized the rules regarding tax-free spin-offs. While the requirements for a tax-free spin-off remain stringent, the Treasury Department has made the disguised sale rules more manageable. The final provisions of IRC section 355(d) should result in fewer transactions that violate the intended purpose rules. The temporary regulations for post–spin-off stock activity under IRC section 355(e) also provide some welcome authoritative guidance. Despite these improvements, questions remain about precisely what constitutes an understanding or agreement to subsequently sell stock and when it is finalized.

A corporation that operates more than one business, directly or through subsidiaries, may decide to separate those businesses. If it does so by distributing to its shareholders and security holders the stock or securities of a subsidiary in a manner that satisfies the requirements of IRC section 355, two tax benefits are achieved: First, the distributing corporation (Distributing) will not recognize gain on the distribution of the stock of its subsidiary (Controlled), and second, its shareholders or security holders will not recognize gain or loss on the receipt of the stock or securities.

Background

Spin-offs (or split-off or split-up transactions) are undertaken to achieve a wide variety of business objectives. For a spin-off to be tax-free, a major requirement is that it be done for a valid business purpose (as opposed to a shareholder purpose). Commonly accepted business purposes include improving the borrowing capacity of the resulting separate corporations; reducing state, local, and foreign (but not federal) taxes; reducing regulatory cost; and even resolving shareholder conflicts that affect business continuity in closely held corporations.

Spin-offs have also been used to create an attractive structure to provide equity compensation to the key employees of a particular business, to position corporations for a public offering of stock or debt securities, or to tailor corporations for a tax-free reorganization. Unfortunately for taxpayers, the usefulness of spin-off for these purposes was hampered by IRC section 355(d) (with the repeal of the General Utilities doctrine under the Tax Reform Act of 1986) and further curtailed by IRC sections 355(e) and (f) (with the Taxpayer Relief Act of 1997).

These statutory provisions were enacted to prevent “disguised sales,” that is, the extraction of assets from corporate solution without the imposition of taxes that would normally apply. Taxpayers have consistently contended that these provisions adversely affect spin-off transactions for legitimate business purposes. Consequently, the IRS recently liberalized the application of these rules with the issuance of final regulations under section 355(d) and temporary regulations under section 355(e).

Basic Statutory and Judicial Requirements

A spin-off must satisfy the following four basic statutory requirements in order to qualify as a tax-free corporate division under IRC section 355:

In addition to these basic statutory requirements, other judicial requirements apply: business purpose (discussed above), continuity of business enterprise, and continuity of interest. Furthermore, even if a spin-off satisfies all of these requirements, if it is described in certain statutory disguised sale provisions, the spin-off will be taxable to Distributing (though not its shareholders).

Disguised Sale Statutory Provisions

A spin-off is disqualified under IRC section 355(d) if, after the spin-off, any person owns 50% or more of the stock of either corporation, and if that stock is disqualified stock. In general, stock is disqualified if it was purchased during the five years preceding the spin-off.

A spin-off is disqualified under IRC section 355(e) if both the spin-off and a change of ownership of 50% or more (voting power or value) of either corporation are part of a plan or series of related transactions. Such a plan or series is presumed to exist if the ownership change occurs within two years of the spin-off. The spin-off is disqualified whether the change of majority ownership occurs pursuant to a taxable acquisition or to a tax-free reorganization.

Final Section 355(d) Regulations

Purpose exception. The final regulations continue the approach of the proposed regulations, which made an exception for distributions that do not violate the purposes of IRC section 355(d). A distribution does not violate the purposes of section 355(d) if the distribution meets two tests: 1) it does not increase a disqualified person’s direct or indirect ownership in either corporation, and 2) it does not provide a disqualified person with a purchased basis in the stock of any controlled corporation.

A disqualified person is any person that, immediately after a distribution, holds disqualified stock in either corporation constituting a 50% or more interest under IRC section 355(d)(4) and proposed Treasury Regulations section 1.355-6(c). The definition of disqualified person in the proposed regulations could be read to include persons that hold disqualified stock in either corporation but did not directly or indirectly purchase that stock. This could disqualify certain distributions that do not otherwise violate the purposes of section 355(d). The final regulations clarify that “disqualified person” includes only such persons that purchase disqualified stock (or receive stock in Controlled with respect to stock that was purchased).

Related transactions. Commentators noted that certain “related acquisitions” of stock in either corporation prior to or following a distribution should not be taken into account in determining if the purpose rule applies. The IRS and Department of the Treasury were concerned that, under the proposed regulations, taxpayers could argue that related transactions allowed them to avoid IRC section 355(d) where a distribution of stock, if viewed independently, would constitute a disqualified distribution.

The final regulations addressed taxpayers’ concerns by removing “related transactions” from the purpose rule, while modifying the definition of disqualified stock to curb abuses feared by the IRS. The final regulations clarify that where a distribution of Controlled stock to a Distributing shareholder constitutes a disqualified distribution, a subsequent but related distribution of that stock will not “cleanse” that disqualified distribution.

Fractional shares. Some commentators requested that de minimis increases in ownership interest be disregarded when determining whether the purpose rule applies. The final regulations provide that an issuance of cash in lieu of fractional shares is disregarded for the purpose exception.

Disqualified stock. The final regulations modify the definition of disqualified stock, providing that stock in either corporation acquired by purchase within a five-year period (including stock indirectly acquired by purchase) will no longer be considered as such if the basis resulting from the purchase is subsequently eliminated.

Basis in the stock of a corporation is eliminated if and when it would no longer be taken into account when determining gain or loss on a sale or exchange. For example, a direct purchase by Distributing of all stock in Controlled followed by a distribution of Controlled stock would have been a disqualified distribution under the proposed regulations. It would not be under the final regulations, however, because the distribution of Controlled eliminates the basis from Distributing’s purchase of Controlled stock. The shareholders basis in Controlled would then be determined by their basis in Distributing. As a result, the Controlled stock would no longer be treated as purchased, and, therefore, not as disqualified.

This is a significant taxpayer benefit of the final regulations. Under the proposed regulations, stock in acquired subsidiaries was almost always considered disqualified stock, thereby preventing the spin-off of acquired subsidiaries during the previous five-year period. Subsidiaries acquired during the previous five-year period can now be spun-off tax-free if the shareholders do not receive Distributing’s purchased basis.

Two instances exist where basis would not be considered eliminated. First, the final regulations provide that basis resulting from a purchase of Distributing stock (as opposed to Controlled) that is exchanged for Controlled stock is not eliminated, notwithstanding the basis elimination rule. The purchased basis in Distributing is simply allocated between Distributing and Controlled. Second, basis is also not eliminated if it is allocated between the stock of two corporations under Treasury Regulations sections 1.358-2(a) or 1.355-6(b)(2)(iii).

Definition of purchase. A purchase generally means any acquisition except for property acquired in a carryover basis transaction, property with a stepped-up basis received from a decedent, and property acquired in certain IRC sections 351, 354, 355, or 356 exchanges. The final regulations provide specific analyses with respect to certain section 351 transactions and transfers among affiliated group members, section 338 transactions, and partnership transactions.

IRC section 351 transactions. The general rule is that stock is not considered purchased when it is acquired in a completely tax-free section 351 transaction, that is, when no boot is received. Section 355(d)(5)(B) provides an exception to this general rule where property is acquired in exchange for any cash or cash item, any marketable stock or security, or any debt of the transferor as a purchase transaction.

The proposed regulations contained an exception to the section 355(d)(5)(B) exception, the active business exception, which provides that an acquisition of stock in exchange for any cash or cash item, marketable stock, or debt of the transferor in a section 351 transaction is generally not a purchase if two requirements are met. First, the transferor must transfer the items as part of an active trade or business, and, second, the transferred items must not exceed the reasonable needs of the trade or business.

The proposed regulations require, in part, that the transferee continue the active conduct of the trade or business. Commentators were concerned that this requirement would prevent a retransfer of assets to a lower-tier corporation within an affiliated group. The final Treasury Regulations section 1.355-6(d)(3)(iv)(4)(E), however, clarified that a transfer of assets does not fail to meet the active business exception solely because the transferee transfers the assets to another member of an affiliated group. The requirements for the active business exception must still be met as if the assets were transferred directly to the final transferee.

Transfers within an affiliated group. The proposed regulations also contained an affiliated group exception. Under these rules, an IRC section 351 transaction with boot would not generally be considered purchased if the transferor, the transferee, and any distributed controlled corporation of the transferee corporation are members of the same affiliated group before the transaction. The final regulations make it clear that the boot must not have been acquired from a nonmember in a related transaction in which sections 362(a) or (b) determine the basis in the acquired assets. The final regulations also eliminate the requirement that distributed controlled corporations be a member of the group before the section 351 transaction, allowing transfers to newly formed corporations.

IRC section 338. By way of examples contained in the final regulations, stock that is acquired in a qualified stock purchase for which an IRC section 338 election [or a section 338(h)(10) election] is made would not be treated as acquired by purchase. If the old target corporation holds stock in another corporation, however, that stock would be treated as purchased by the new target corporation. Fortunately, a separate section 338 or 338(h)(10) election can also be made for the stock owned by the new target corporation.

Partnerships. The final regulations clarify that an acquisition of stock (or an interest in another entity) by a partner pursuant to the liquidation of a partnership interest is a purchase of the stock (or an interest in another entity). If the adjusted basis of stock held by the partnership is increased under IRC section 734(b), a proportionate amount will be treated as purchased at the time of the basis adjustment.

Fifty percent or greater interest. The final regulations provide rules for determining whether an individual possesses stock with at least 50% of the combined voting power and share value of all classes of stock. If two or more persons act together under a plan to acquire stock or securities, they are treated as one person for purposes of IRC section 355(d).

Commentators were concerned that the definition of disqualified person in the proposed regulations could include persons that hold disqualified stock, without directly or indirectly purchasing it. The final regulations make it very clear that “disqualified person” includes only a person that meets that definition through their own purchase of “disqualified stock.”

The final regulations clarify that if two or more persons do not act pursuant to a plan or arrangement when acquiring stock in a corporation, a subsequent exchange-basis acquisition will not result in such persons being treated as one person, even if the acquisition of a second corporation’s stock is pursuant to a plan or arrangement.

Absent actual knowledge to the contrary, a distributing corporation may presume that no less-than-5% shareholders acquired stock or securities by purchase during the five-year period. The final regulations clarify that application of statistical sampling procedures to estimate the basis of shares acquired in certain reorganizations does not effectively provide actual knowledge of a stock purchase beyond the sample group.

Certain section 355 and 305 distributions. Under the proposed regulations, stock acquired in an IRC section 355 distribution was not considered a purchase within the meaning of section 355(d), irrespective of whether the stock was distributed pro-rata. The final regulations modified this rule. If a shareholder recently purchased Distributing’s stock and Distributing distributes Controlled’s stock under section 355, then Controlled’s stock is deemed to be purchased by the distributee on the date the distributee acquired the recently purchased Distributing stock. For the purpose of this transaction, the five-year period applies.

The final regulations also added a similar rule for distributions of stock under IRC sections 305(a) and 307(a); it provides an exception to gross income for the distribution of stock or stock rights received by shareholders.

Options. Both the proposed and final regulations generally provide that outstanding options at the time of a distribution are treated as exercised when issued or last transferred if two criteria are met. First, if the deemed exercise would cause one to be a disqualified person. Second, if, immediately after the distribution, taking into account all the facts and circumstances, it is reasonably certain that the option will be exercised.

Commentators suggested that the “reasonably certain to be exercised” test be replaced with the “principal purpose to avoid IRC section 355(d)” standard used in the IRC section 382 regulations. The final regulations instead excluded specific instruments from the test: cash settlement options, phantom stock, stock appreciation rights, and national principal contracts. To the extent that such instruments are exercisable into stock, however, they would still be subject to the deemed exercise rule (as an “other instrument that provides for the right to purchase, issue, redeem, or transfer stock”).

Temporary Section 355(e) Regulations

Before the enactment of IRC section 355, it was possible to change ownership by combining a section 355 distribution with a tax-free reorganization. These transactions were referred to as Morris Trust transactions after the case that permitted them (Comm’r v. Morris, Mary Archer Trust, 1966, CA4, 367 F2d 794). The Taxpayer Relief Act of 1997 enacted IRC section 355(e) to ensure that a distributing corporation would recognize gain where it was intended that new shareholders would acquire ownership of a business in connection with a spin-off.

As discussed above, gain is recognized under section 355(e) if, pursuant to a plan or series of related transactions, one or more persons directly or indirectly acquire more than 50%, by vote or value, of the stock of either corporation.

The old proposed regulations, issued in 1999, provided the means by which a taxpayer could show that a distribution and an acquisition were not part of a plan. This guidance required the taxpayer to establish the absence of a plan with clear and convincing evidence. After comment, the IRS withdrew the old proposed regulations, issued new proposed regulations in January 2001, and then issued temporary regulations (incorporating most of the new proposed regulations) in August 2001.

The temporary regulations use a facts and circumstances approach to explain how a taxpayer can demonstrate that a distribution and an acquisition were not part of a plan under IRC section 355(e). In the case of an acquisition after a distribution, a plan exists if, on the date of distribution, either corporation or any of their controlling shareholders intended that a connected acquisition (or a similar acquisition) occur. Likewise, in the case of an acquisition before a distribution, a plan exists if, on the date of the acquisition, either corporation or any of their controlling shareholders intended that a connected distribution occur.

The temporary regulations list a variety of nonexclusive factors to consider in assessing whether an acquisition and a distribution are part of a plan. They also contain certain safe harbors that, if met, are not part of a plan. Where a safe harbor would not apply, the list of factors would be considered as part of the facts and circumstances analysis. The weight of each factor depends upon the particular case.

Safe harbors. The following facts and circumstances meet a safe harbor that shows a distribution and an acquisition are not part of a plan:

Plan factors. If the following facts and circumstances are present, they tend to show that a distribution and an acquisition are part of a plan:

If the following facts and circumstances are present, they tend to show that a distribution and an acquisition are not part of a plan:

Options

The temporary regulations provide that if stock of either corporation is acquired pursuant to an option, the option will be treated as an agreement to acquire stock. If, however, the distributing corporation establishes that, on the later of the date of the stock distribution or the writing of the option, the option was not more likely than not to be exercised, the option will not be treated as an agreement. In addition, certain other options (i.e., compensatory options, options that are part of a security agreement) are exempted from treatment as options unless they are written, transferred, or listed with a principal purpose of avoiding IRC section 355(e) treatment or avoiding the new temporary regulations.

Under the old proposed regulations, if stock was acquired pursuant to an option, the option is treated as an agreement unless the distributing corporation established by clear and convincing evidence that the option was not “more likely than not to be exercised.”

Effective Date

The final section 355(d) regulations apply to distributions occurring after December 20, 2000, but not to distributions under a written agreement binding (subject to customary conditions) on that date. The temporary section 355(e) regulations are effective for distributions occurring after August 3, 2001.

©2002 CPA Journal. Legal Notices