Corporate divisions involve the breaking of one corporation into multiple corporations. Such a transaction can be either taxable or tax-free. Corporate divisions tend to come in three basic flavors: spin-off, split-off, and split-up. Each variation involves a slightly different type of distribution of stock or securities. In general, if the transaction successfully runs the gauntlet of Internal Revenue Code Section 355, the tax treatment to the shareholders and the corporation will be the same regardless of whether the transaction is a spin-off, split-off, or split-up.
In a spin-off, the distributing corporation distributes stock of a controlled corporation (a subsidiary) to its shareholders. This subsidiary may be either a recently created subsidiary “spun off” through the parent corporation’s transfer of assets in return for stock or an existing subsidiary. The shareholders in a spin-off generally receive a pro rata share of the controlled corporation’s stock and do not transfer anything in return for this stock. If the transaction fails to qualify for no recognition under Section 355 of the Internal Revenue Code, the distribution is treated as a dividend to the shareholder distributes to the extent of the corporation’s earnings and profits and any gain on the distribution of the appreciated assets is taxable to the distributing corporation. See IRC Section 301.
A split-off is very much like a spin-off except that the parent’s shareholders receive stock in the subsidiary in return for some of their stock in the parent corporation. In other words, the transaction is structured more like a redemption than a dividend. If the transaction fails to qualify for Section 355 non recognition treatment, the distribution will be subject to the redemption provisions of Internal Revenue Code Section 302. Consequently, the redemption distribution might be treated by the shareholders either as a dividend under Section 302 of the Internal Revenue Code or a sale or exchange redemption under Internal Revenue Code Section 302(a).
In a split-up, the corporation transfers all of its assets to two or more new corporations (controlled corporations) in return for stock, which is then distributed to the shareholders of the parent corporation in return for all of the parent stock. If the transaction fails to qualify for Section 355 non recognition, the distribution will be treated as a complete liquidation to the shareholders, who will report gain or loss based upon the difference between the fair market value of the stock received and their basis in the original corporation’s stock. In addition, the corporation would be taxable on any gain upon a distribution of assets in complete liquidation. See IRC Section 336.
Overview of Internal Revenue Code Section 355
A distribution of stock or securities in a controlled corporation will be eligible for Section 355 non recognition treatment only if it meets numerous statutory and non statutory requirements.
1. Control immediately before the distribution- the distributing corporation must distribute solely stock or securities of a corporation which it controls immediately before the distribution; See IRC Section 336.
2. Distribution requirement– the distributing corporation must distribute all of the stock and securities in the controlled corporation held immediately before the distribution. See IRC Section 355(a)(1)(D)(i). As an alternative, the distributing corporation may distribute an amount sufficient to constitute control. In such a case, however, the distributing corporation must also establish that any retention of stock was not in pursuance to a tax avoidance plan;
3. Trade or business requirement– both the distributing corporation and the controlled corporation must be engaged immediately after the distribution in the active conduct of a trade or business. The “trade or business” requirement actually incorporates both a post-distribution and a pre-distribution rule since the statutory definition of an “active trade or business” requires that the corporation’s trade or business have been “actively conducted throughout the five-year period ending on the date of the distribution. See IRC Section 355(b)(2)(B).
4. Non-device requirement– the transaction was not used principally as a device to distribute earnings and profits of the distributing corporation, the controlled corporation, or both. See IRC Section 355(a)(1)(B).
In addition to these statutory requirements, Internal Revenue Code Section 355 incorporates several judicially developed requirements paralleling those required for the reorganization provisions generally. These include business purpose, continuity of the business enterprise, and continuity of proprietary interest requirements. See Treas. Reg. Section 1.355-2(c).
Control “Immediately Before the Distribution”
Tax-free treatment under Internal Revenue Code Section 355 is limited to corporate distributions of stock or securities of a controlled corporation. Such distribution of stock or securities in a controlled subsidiary to shareholders of the parent arguably reflects a “mere change in form.”
Distribution of Control
A further requirement for an Internal Revenue Code Section 355 tax-free transaction involves the amount of stock or securities distributed. The distributing corporation must either distribute all of the stock or securities of the controlled corporation held immediately before the distribution or enough stock to constitute control. Although Section 355 requires distribution of all, or a controlling amount, of the controlled subsidiary stock, the distributing corporation has substantial flexibility regarding the structure of the distribution. This flexibility can be especially useful in structuring corporate separation to resolve conflicts among shareholders.
Active Trade or Business Requirement
Much of Section 355’s complexity enters through the “active trade or business” requirement of Internal Revenue Code Section 355(b). In addition to the requirements already mentioned, Section 355 requires that both the distributing corporation and the controlled corporation or corporations be “engaged immediately after the distribution in the active conduct of a trade or business.” In the case of a split-up, the distribution effectively is a liquidated distribution of stock in multiple controlled corporations after which the distributing corporation will cease to exist. In such cases, each of the controlled corporations must be “engaged immediately after the distribution in the active conduct of a trade or business.” See IRC Section 355(b)(1)(B). The post-distribution active trade or business requirement is designed to assure that the distributing corporation is actually breaking off in part, or parts, of the business that will continue to operate after the distribution rather than simply distributing assets to shareholders.
The “definition” subsection of Internal Revenue Code Section 355(b)(2) offers virtually no guidance on the meaning of words “active conduct of a trade or business.” However, the regulations define the definition of a corporation engaged in a “trade or business” as:
“a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such a group includes every operation that forms a part of, or step in, the process of earning income or profit. Such a group of activities ordinarily must include the collection of income and the payment of expenses.” See Treas. Reg. Section 1.355-3(b)(2)(ii).
Whether or not the corporation is actively, as opposed to passively engaged in a trade or business will depend upon the facts and circumstances. To be considered an active trade or business, however, the corporation generally is “required itself to perform active and substantial management and operational functions.” See Treas. Reg. Section 1.355-3(b)(2)(iii). Activities performed by persons outside the corporation, such as independent contractors, do not count as activities performed by the corporation. Nevertheless, the corporation can meet the active trade or business requirement even though “some of its activities are performed by others.” If the corporation can establish that it provides significant operation and management services, the business will be considered an active trade or business. The regulations specifically eliminate from the active trade or business definition the holding of stock, securities, land or other property, for investment purposes as the stock or securities of the controlled corporation held immediately before the distribution or enough stock to constitute control. Although Section 355 requires distribution of all, or a controlling amount, of the controlled subsidiary stock, the distributing corporation has substantial flexibility regarding the structure of the distribution. This flexibility can be especially useful in structuring corporate separation to resolve conflicts among shareholders.
Active Trade or Business Requirement
Much of Section 355’s complexity enters through the “active trade or business” requirement of Internal Revenue Code Section 355(b). In addition to the requirements already mentioned, Section 355 requires that both the distributing corporation and the controlled corporation or corporations be “engaged immediately after the distribution in the active conduct of a trade or business.” In the case of a split-up, the distribution effectively is a liquidated distribution of stock in multiple controlled corporations after which the distributing corporation will cease to exist. In such cases, each of the controlled corporations must be “engaged immediately after the distribution in the active conduct of a trade or business.” See IRC Section 355(b)(1)(B). The post-distribution active trade or business requirement is designed to assure that the distributing corporation is actually breaking off in part, or parts, of the business that will continue to operate after the distribution rather than simply distributing assets to shareholders.
The “definition” section in Internal Revenue Code Section 355(b)(2) offers virtually no guidance on the meaning of words “active conduct of a trade or business.” However, the regulations define the definition of a corporation engaged in a “trade or business” as:
“a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such a group include every operation that forms a part of, or step in, the process of earning income or profit. Such a group of activities ordinarily must include the collection of income and the payment of expenses.” See Treas. Reg. Section 1.355-3(b)(2)(ii).
Whether or not the corporation is actively, as opposed to passively engaged in a trade or business will depend upon the facts and circumstances. To be considered an active trade or business, however, the corporation generally is “required itself to perform active and substantial management and operational functions.” See Treas. Reg. Section 1.355-3(b)(2)(iii). Activities performed by persons outside the corporation, such as independent contractors, do not count as activities performed by the corporation. Nevertheless, the corporation can meet the active trade or business requirement even though “some of its activities are performed by others.” If the corporation can establish that it provides significant operation and management services, the business will be considered an active trade or business. The regulations specifically eliminate from the active trade or business definition the holding of stock, securities, lCorporations sometimes purchase stock in other corporations to hold for investment or purchase assets from other corporations to hold for investment or to use for business operations. The tax lawyer generally would not refer to these day-to-day corporate purchases of stock or assets as corporate acquisitions. A “corporate acquisition” generally refers to an acquisition of control by one corporation over another. (For purposes of this article, “control” refers to the 80 percent control requirement under Internal Revenue Code Section 1504). One corporation may acquire control over another through two different transaction types. First, a simple asset acquisition from the target corporation itself offers the purchaser direct control over the selling corporation’s assets. Second, a stock acquisition from the target corporation’s shareholders provides the purchaser with indirect control over the selling corporation’s assets through its ownership of the target corporation’s stock.
In a stock purchase, the purchasing corporation (P) acquires a controlling interest in the target corporation (T) stock from the target’s shareholders, then becomes a parent to its newly acquired subsidiary (T). The parent may continue to operate T as a complete liquidation. In the case of a stock purchase followed immediately by a liquidation of T, the purchasing corporation acquires control over T’s assets upon the liquidation distribution.
Taxable Acquisition vs. Tax-Free Reorganization
The parties to a corporation acquisition must first decide whether the transaction is to proceed as a taxable acquisition or a tax-free reorganization. A taxable acquisition is when a selling corporation is taxable upon the sale of its assets or that the selling shareholders are taxable upon the sale of its assets or that the selling shareholders are taxable upon the sale of their stock. Any particular transaction will be classified as a tax-free reorganization only if it fits within one of the precise meanings of the term “reorganization” as defined in Internal Revenue Code section 368.
Stock vs. Assets
The second basic decision required of the parties to a corporate acquisition is whether the purchaser will acquire stock or assets. Both buyer and seller will have several tax factors to consider in deciding between a taxable stock or asset sale. The taxable sale of assets results in an immediate taxable gain to the selling corporation and a cost basis in the assets to the purchasing corporation. The purchasing corporation’s desire to acquire assets will depend upon the extent to which the assets are depreciable or otherwise would benefit from a cost basis. The selling corporation’s willingness to sell assets will depend on the extent of the gain or loss reflected in the assets and the possibility of using any offsetting losses to reduce gains. The selling corporation also must consider the tax consequences to its shareholders.
After a simple sale of all of its assets for cash, the target company presumably will distribute the cash to its shareholders in a liquidation distribution taxable to the shareholders. Thus, an asset acquisition often involves a rather immediate double tax- the corporation recognizes gain or loss on the sale of its assets for cash and the shareholders recognize gain or loss on receipt of the cash proceeds upon the liquidation of their stock holdings. In contrast, a stock sale by the shareholders generally results in the immediate recognition of only the shareholder level tax- the shareholders recognize gain or loss upon the sale of their stock while the target corporation’s assets remain with the target and retain their historic basis.
The Transaction
In a typical taxable asset acquisition, the selling or target corporation (T) transfers all or substantially all of its assets to the purchasing corporation (P) or a P subsidiary (S) in exchange for cash and/or notes. As part of the taxable acquisition, the purchasing corporation often will assume some or all of the selling corporation’s liabilities. Generally, the target corporation will liquidate shortly after the exchange, distributing cash, notes, and other shareholder. Sometimes, however, T may be kept alive for various reasons. Another form of taxable asset acquisition is the target into P or P subsidiary (Merger of the target into a P subsidiary is called a “forward triangular merger’) for cash, notes, or other consideration that that would not qualify for tax-free reorganization, sometimes referred to as a “cash merger.” In this type of transaction the consideration is transferred directly by P to the T shareholders and there is no need for T to formally liquidate. For tax purposes, this transaction is treated as a taxable asset transfer by T followed by T’s complete liquidation.
Tax Consequences to the Target Corporation
In a taxable asset acquisition, the selling target corporation (T) will recognize a taxable gain or loss immediately upon the sale of assets under Internal Revenue Code Section 61(a)(3) and Internal Revenue Code Section 1001. T must include in its amount realized from the sale any liabilities assumed by the purchaser, and the amount of liability to which any property transferred was subject. In addition, if the purchasing corporation assumes liabilities for accrued, but as yet unpaid operating expenses of a target corporation, the liabilities assumed should be included in T’s amount realized from the sale. Once T has included the assumption of operating expense liabilities as proceeds from the sale, T should be entitled to deduct these assumed operating expenses.
After a sale of all or substantially all of the target’s assets, the target corporation is simply a “shell” holding the consideration received from the purchasing corporation along with any unsold assets. In most cases, a liquidation of the target will quickly follow the sale. Unless the target is making a liquidated distribution to a corporate parent, the subsequent liquidation distribution will be a taxable event to the distributing corporation.
Tax Consequences to the Target Shareholders
When the target corporation distributes cash and other assets to its shareholders in liquidation followed following T’s taxable asset sale, the shareholders generally will report gain or loss upon the liquidating distribution. Consequently, a taxable asset acquisition usually results in an immediate double tax- the selling target is taxed upon receipt of consideration for the assets sold and the target shareholders subsequently are taxed when the target distributes this consideration to its shareholders.
Taxable Acquisitions
In a typical stock sale, the selling shareholders transfer some or all of their target corporation (T) to the purchasing corporation (P) or a P subsidiary (S) in exchange for cash and/or notes. Assuming the purchase of a controlling interest, the purchasing corporation now becomes a parent to its newly acquired subsidiary. P may simply retain T as a distinct subsidiary. Since T remains intact as a corporate entity and remains liable to its creditors, P need not formally assume T’s liabilities. As an alternative, the purchasing corporation may completely liquidate T in an upstream merger. Upon such merger, P will become responsible for T’s liabilities.
Tax Consequences to the Selling Corporation and Its Shareholders
The selling target shareholders will report gain or loss from sale of their T shares to P. If the T shareholders receive P notes in exchange for their T shares, they may be entitled to report gain under the installment method pursuant to Internal Revenue Code Section 453. The target corporation itself bears no immediate tax consequence. T remains intact as a subsidiary of P. Each of T’s assets retains the same basis it had prior to the stock acquisition. It T liquidates it will recognize no gain or loss on the liquidated distribution. The Internal Revenue Code and its regulations address the extent to which the target corporation may continue to use any pre-existing net operating losses after the stock ownership change.
and or other property, for investment purposes as well as certain ownership and operation of real or personal property. See Treas. Reg. Section 1.355-3(b)(2)(iv). Ownership and operation of real estate tends to be largely an investment activity and typically is not a business involving significant management and operational activity. See Corporate Taxation, Cheryl D. Block, Aspen Law & Business (1998).
Thus, the regulations eliminate such activity from the definition of an active trade or business unless the owner performs significant services with respect to the operation and management of the property. The issues regarding real estate as a passive activity are similar to issues in connection with the passive loss activity rules of Internal Revenue Code Section 469. These investment-type activity exclusions from the active trade or business definition reflect the concerns underlying Internal Revenue Code Section 355.
Pre-Distribution Active Trade or business Requirement
The pre-distribution active trade or business requirement inelegantly in the statutory language. The language in Internal Revenue Code Section 355(b)(1) begins by including only a post-distribution trade or business requirement. The definition section that follows in Internal Revenue Code Section 355(b)(2) treats a corporation as engaged in the active conduct of a trade or business for purposes of paragraph (b)(1) only if the trade or business “has been actively conducted throughout the five-year period ending on the date of the distribution.” See IRC Section 355(b)(2)(B). Thus, the particular trade or business relied upon to meet this requirement cannot be a new trade or business, but must have a five-year history. Finally, the distributing corporation must not have acquired the trade or business, or control over the corporation conducting the trade or business, in a taxable transaction within five years prior to the distribution. See IRC Section 355(b)(2)(C), (D).
Vertical and Horizontal Division of a Single Business
Corporations may wish to separate particular functions, such as research or sales, into separate corporate entities. The potential problem here is that a corporate entity created to engage in a single function of a larger business enterprise may not independently produce income. The Section 355 regulations envision a corporation as engaged in a “trade or business” “if a specific group of activities are carried on by the corporation for the purpose of earning income or profit, and the activities included in such group include every operation that forms a part, or a step, in the process of earning income or profit.” See Treas. Reg. Section 1.355-3(b)(2)(ii). In order to satisfy the “active trade or business” requirement, the activities separated in the new corporation must represent a separate and independent trade or business.
Device for the Distributions of Earnings and Profits
In addition to all the restrictions and requirements discussed above, Internal Revenue Code Section 355 explicitly demands that “the transaction was not used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation of both. See IRC Section 355(a)(1)(B). The regulations state
that “Section 355 recognizes provisions of the Code through the subsequent sale or exchange of stock of one corporation and the retention of the stock of another corporation.” See Treas. Reg. Section 1.355-2(d)(1). All the restrictions and requirements found in Internal Revenue Code Section 355 are directed at the goal of preventing bailout of corporate earnings and profits without paying a “dividend” toll.
Tax Consequences to the Corporation
A corporation distributing stock or securities of a controlled subsidiary in a transaction meeting the requirements of Internal Revenue Code Section 355 will recognize no gain or loss upon the distribution. Section 355(c) provides such non-recognition for Section 355 distributions that are “not in pursuance of a plan or reorganization for purposes of Section 355 distributions are “not in pursuance of a plan or reorganization.” See IRC Section 355(c)(1).
Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on domestic and international tax planning for multinational companies, closely held businesses, and individuals. Anthony has written numerous articles on international tax planning and frequently provides continuing educational programs to other tax professionals.
He has assisted companies with a number of international tax issues, including Subpart F, GILTI, and FDII planning, foreign tax credit planning, and tax-efficient cash repatriation strategies. Anthony also regularly advises foreign individuals on tax efficient mechanisms for doing business in the United States, investing in U.S. real estate, and pre-immigration planning. Anthony is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.
This article is not legal or tax advice. If you are in need of legal or tax advice, you should immediately consult a licensed attorney.