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Introduction to the Taxation of Corporate Divisions

Introduction to the Taxation of Corporate Divisions

 By Anthony Diosdi

Internal Revenue Code Section 355 allows a corporation to make a tax-free distribution to its shareholders of stock and securities in one or more controlled subsidiaries. Corporate divisions involve the reverse- breaking the investment reflected in one corporation into investments in multiple corporations. The reasons for a corporate division or separation can be varied. A divisive transaction can be either taxable or tax-free. To illustrate a “taxable division,” imagine a corporation with two individual shareholders that has been operating a hotel business and a restaurant business as separate divisions. The corporation might arrange a corporate division simply by distributing the hotel business assets to one shareholder and the restaurant business assets to the other in a complete liquidation. Such a liquidating distribution would be taxable to the shareholders under Section 331 and to the distributing corporation under Section 336.

In contrast to a “taxable division,” the corporation in the above illustration could arrange a tax-free division by using special rules in the “Corporate Organizations and Reorganizations” provisions appearing in Part III of Subchapter C of the Internal Revenue Code. See IRC Section 351 through 368. A tax-free division usually refers to the separation of one corporation into two or more corporations, along with an accompanying distribution of stock or securities to the shareholders or security holders of the original corporation in a distribution that qualifies for nonrecognition under Section 355. This division or separation may or may not be a “reorganization.” 

Some Introductory Terminology: Spin-Offs, Split-Offs, and Split-Ups

Corporate divisions tend to come in three basic flavors: spin-offs, split-off, or split-up. Each variation involves a slightly different type of distribution of stock or securities. In general, if the transaction successfully applies the rules of 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 nonrecognition under Section 355, the distribution is treated as a dividend to the shareholder distributees 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 311.

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. If the transaction fails to qualify for Section 355 nonrecognition treatment, the distribution will be subject to the redemption provisions of Section 302. 

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 the parent stock. If the transaction fails to qualify for Section 355 nonrecognition, the distribution will be treated as a complete liquidation to the shareholders, who will report gain or loss based on the difference between the fair market value of the stock received and their basis in the original corporation’s stock. 

Overview of Section 355 Requirements

Distribution of stock or securities in a controlled corporation will be eligible for Section 355 nonrecognition treatment only if it meets numerous statutory and nonstatutory requirements. 

The statute itself requires:

  1. Control immediately before the distributions- the distributing corporation must distribute solely stock or securities of a corporation which controls immediately before the distribution;
  2. Distribution requirement- the distributing corporation must distribute all the stock and securities in the controlled corporation held immediately before the distribution;
  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;
  4. Non-device requirement- the transaction was not used principally as a device to distribute earnings and profits of the distributing corporation, and controlled corporation, or both. 

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 Sections 1.355-2(b) – 1.355-2(c). The following sections of this article will consider each of these statutory and nonstatutory requirements.

Control “Immediately Before the Distribution”

Non Recognition under Section 355 is limited to corporate distributions of stock or securities of a controlled corporation. Such distributions of stock or securities in a controlled subsidiary to shareholders of the parent arguably reflects a “mere change in form.”  One may think of a Section 355 tax-free stock distribution as a complement to the Section 351 tax-free transfers to a corporation which the transferring shareholders control immediately after the exchange. Reversing directions, a parent corporation under Section 355 distributes stock or securities in a corporation which it controls “immediately before the distribution.” See IRC Section 355(a)(1)(A. The distributing parent may distribute stock or securities in either a preexisting or a newly created subsidiary. As a practical matter, corporations planning for a division frequently create new subsidiaries for purposes of effecting a spin-off or split-up. 

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.

Pre-Distribution Active Trade or Business

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 Divisions of a Single Business

Although unresolved for a time, it is now well settled that Section 355 treatment is possible upon the corporate division of a single trade or business, sometimes referred to as vertical division. In its early regulations, the Treasury and IRS took the position that the division of a single business was not eligible for Section 355 nonrecognition,arguing that the active trade or business requirement was met only if there were two or more separate and distinct businesses operating immediately after the distribution. However, the Fifth and Sixth Circuit Court of Appeals declared these regulations invalid. See Coady v. Commissioner, 289 F.2d 490 (6th Cir. 1961); United States v. Marett, 325 F.2d 28 (5th Cir. 1963). Since losing these cases, the Treasury and IRS has conceded that the division of a single business into two separate businesses can qualify under Section 355. Recall that to meet the “active trade or business” requirement, the distributing and controlled corporations must not only be engaged in an active trade or business immediately after the distribution, but such trade or business must have been actively conducted during the five-year period preceding the distribution as well. 

Horizontal or Functional Divisions 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. 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 Distribution of Earnings and Profits

In addition to all of the restrictions and requirements discussed above. Section 355 requires 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 or both.” See IRC Section 355(a)(1)(B). The regulations on the “device” requirement list a number of “device factors” to be considered in making a facts and circumstances analysis to determine whether the transaction was used to bail out earnings and profits. 

Business Purpose

The regulations under Section 355 explicitly incorporate an “independent business purpose” test under which the overall transaction must be motivated, “in whole or substantial part, by one or more corporate business purposes.” See Treas. Reg. Section 1.355-2(b)(1).

Continuity of Proprietary Interest

The judicially developed “continuity of proprietary interest” doctrine goes to the heart of the “mere change in Form” rationale behind the nonrecognition rules. The idea is to provide nonrecognition treatment in transactions where the investors holding an interest before the transaction remain substantially invested in the restructured corporate enterprise after the transaction. Continuity of interest is built in to the Section 368(a)(1)(D) divisive reorganization definition since the transferor corporation, or one or more of its shareholders, must be in control of the corporation acquiring the transferor’s assets immediately after the transfer. Moreover, continuity of interest principles apply to Section 355 tax-free distributions tat do not meet the Section 368(a) reorganization definition. 

Overlap of Section 368(a)(1)(D) and Section 355 Divisive Reorganizations

Many, but not all, distributions of stock in a controlled corporation will simultaneously be “reorganized” under Section 368(a)(1)(D) and also distributions under Section 355. A Type D reorganization involves transfer of “all or a part of {a corporation’s] assets to another corporation if immediately after the transfer, the transferor, or one or more of its shareholders …, or any combination thereof, is in control of the corporations in which the assets are transferred. See IRC Section 368(a)(1)(D). In addition, stock or securities of the corporation to which the assets were transferred must be distributed pursuant to the requirements of Sections 354, 355, or 356. 

Tax Consequences to Shareholders

If all of the requirements for a tax-free division or tax-free reorganization are met, the shareholders will not report gain or loss or otherwise include any income upon receipt of stock in the controlled subsidiary from the distributing parent corporation. See IRC Section 355(a)(1). 

Tax Consequences to the Corporation

A corporation distributing stock or securities of a controlled subsidiary in a transaction will recognize no gain or loss upon the distribution. Section 355(c)(1) provides such nonrecognition for Section 355 distributions that are “not in pursuance of a plan of reorganization.” Similar nonrecognition is provided to the distributing corporation in a Type D divisive reorganization through Section 361(c), and Section 361(c)(4) explicitly states that Section 311 shall not apply, If any appreciated property, other than stock in the controlled corporation, is distributed as boot in connection with the Section 355 separation distribution, the corporation will be required to recognize gain upon the distribution of the boot. 

We have substantial experience advising clients ranging from small entrepreneurs to major multinational corporations in cross-border tax planning and compliance. We have also  provided assistance to many accounting and law firms (both large and small) in all areas of international taxation.

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.