United States

Proposed rules address section 355 non-business asset distributions

Rules would create per se device test and create minimum ATB value

TAX ALERT  | 

On July 14, 2016, the Treasury and IRS issued proposed regulations that add rules requiring comparison of corporations’ business and non-business asset values in spin-offs. Spin-offs with non-business assets having values that are too high in relation to the value of the business assets would not qualify for tax-free treatment under the proposed rules.   

In a spin-off, a corporation distributes stock of a subsidiary to its shareholders. To qualify for tax-free treatment, the distributing corporation and the distributed corporation both must conduct an active trade or business (ATB), the spin-off must not be a device for the distribution of corporate earnings and profits (a device), and various other requirements must be met.   

The question of whether the business assets of the distributing and distributed must be valuable in relation to the corporation’s other assets has been the topic of numerous discussions recently. For example, what if the spun-off corporation actively operates a hot dog stand business worth $20,000 and also has non-business assets worth $2 million? Previously, government guidance did not necessarily deny tax-free treatment to a ‘hot dog stand’ spin-off. The proposed regulations address this hot dog stand issue.

The proposed regulations would establish a new minimum relative value of the business being relied upon to satisfy the ATB requirement and provide additional detailed rules surrounding whether a distribution represents a device. Proposed rules on the device test were expected as a follow up to earlier guidance from the IRS and Treasury in the wake of the Yahoo/Alibaba proposed spin and a series of section 355 transactions followed by REIT conversions. For previous guidance on this issue, read our article, IRS adds RIC/REIT and investment rich (e.g., Yahoo) spins to no-rule list.

The device test

The proposed rules would augment the device rules to put a focus on comparative value of the ’business’ and ‘non-business’ assets of the distributing and distributed corporations. Recently there have been a number of high profile completed and proposed transactions that separated significant non-business assets from the operating assets of corporations tax-free while relying on a relatively small ATB. The IRS concern is that allowing such transactions is inconsistent with the purpose of section 355, which is intended to allow a corporation to separate two active businesses tax-free, not remove significant non-business assets from a corporation as a device for the distribution of earnings and profits. The rules would also adopt tests for determining whether stock of subsidiaries and interests in partnerships are considered business or non-business assets.

In addition, the proposed regulations would create new a per se device rule. A distribution would be a per se device if at least two-thirds of the assets of either corporation are non-business assets and the non-business assets of the other corporation are disproportionately small in comparison. As a result, the distribution would fail to qualify for tax-free treatment under section 355, generally triggering tax at the corporate level and the shareholder level.

The ATB requirement

To qualify for a tax-free spin-off, both corporations must operate an ATB immediately after the distribution and generally must have operated the ATB for the five years prior to the distribution. The proposed rules would require a minimum ATB value for each corporation of 5 percent of the corporation’s total assets. To many corporate taxpayers, this would not be viewed as a significant change because the 5 percent minimum threshold is consistent with the IRS’ prior private letter ruling requirements.   

Summary

As promised, the IRS and Treasury have issued proposed guidance intended to further limit the separation of business and non-business assets tax-free under the guise or a tax-free section 355 distribution. The proposed rules would reach beyond the scope of existing guidance and create certain per se device transactions irrespective of business purpose of a distribution. Companies considering a distribution of subsidiary stock where there is a disproportionate separation of business and non-business assets should carefully consider these proposed regulations and seek tax advice.

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