Pre-revenue companies pursuing R&D may meet active trade or business requirement

Executive summary: IRS recognizes extended R&D period for pre-revenue businesses

Companies engaged in research and development activities for new products may want to consider spin-off transactions under section 355¹ as a way to attract new capital investment to specific segments of its business.

Until relatively recently, the IRS has required there to be collection of income to meet the active trade or business (ATB) requirement as a condition for issuing a favorable private letter ruling, or PLR. However, the IRS now recognizes that certain industries, including the pharmaceutical and technology industries, may have an extended R&D period and regulatory approval processes during which there is no revenue or collection of income, but during which activities otherwise indicative of an active business are being conducted. As a result, the IRS is now willing to entertain PLR requests along these lines; they may consider ruling favorably on the ATB requirement in certain cases where no income has yet been collected.

Pre-revenue companies pursuing R&D may meet active trade or business requirement

Background: Collection of income and the ATB requirement

Section 355 allows for the tax-free distribution of a line of business (or businesses) through a controlled subsidiary, subject to certain statutory and regulatory requirements. One of the key requirements is the ATB requirement under section 355(b). The ATB requirement mandates that the taxpayer carry on a group of activities for the purpose of earning income or profit for each of the five years immediately preceding the distribution. The regulations state that such activities "ordinarily" include the collection of income and the payment of expenses for each of those five years.²

Historically, the IRS required collection of income as a condition for issuing a private letter ruling to meet the ATB requirement. This requirement posed a significant obstacle for certain industries, particularly life sciences and technology companies engaged in extensive R&D activities. These companies often face an extended R&D period and regulatory approval processes during which there is little if no collection of income.

Favorable developments since 2018

In 2018, the IRS announced³ that it intended to undertake a study regarding the ATB requirement and certain types of ventures in which the collection of income is significantly delayed. The statement noted that the IRS had "observed a significant rise in entrepreneurial ventures whose activities consist of research and development in lengthy phases" and that it would consider such ventures in its private letter ruling program.

In connection with this change in letter rulings policy, the IRS now recognizes that certain industries, including the pharmaceutical and technology industries, may have an extended R&D timeline and regulatory processes during which there is no collection of income, but otherwise show indicia of the active conduct of a trade or business. As a result, the IRS is now willing to issue PLRs in certain cases even where there has yet been no collection of income.

Since the 2018 announcement, the IRS has issued PLR 202009002, PLR 202150004 and PLR 202246008 consistent with this new approach.

The most recent and most advantageous PLR (PLR 202246008) involved a privately held corporation in the life sciences industry engaged in R&D activities for Product X and Product Y. The corporation had not yet collected income associated with either product but had incurred substantial, continuing operating expenses representing the active conduct of a trade or business with respect to researching and developing Product X and Product Y for each of the past five years. Despite not having any income (including grant income) in the preceding five years, the IRS ruled privately that the corporation's spin-off of Product Y was non-taxable under section 355.

Taxpayer takeaways

Companies engaged in R&D for new products face long lead times and significant expenses before they can commercialize their products. In many cases, there will be a business need to separate certain lines of business from others, for example, to obtain needed capital. The IRS's recognition of this fact, and the often-lengthy regulatory approval processes, have moved the agency to allow for greater flexibility in meeting the ATB requirement. Moreover, additional changes in the letter rulings program provide for a faster processing period of 12 weeks in some cases.⁴

This recent change in IRS policy regarding the ATB requirement provides an opportunity for companies in this industry to satisfy this requirement. Interested companies should consult with tax advisors to determine whether they may qualify for a tax-free distribution under section 355, even without the collection of income.

^{1 All section references are to the Internal Revenue Code of 1986, as amended, or to underlying regulations.
2 Treas. Reg. sec. 1.355-3(b)(2)(ii)
3 IRS statement regarding the active trade or business requirement for section 355 distributions, dated Sept. 25, 2018, available on the IRS website.
4 Rev. Proc. 2022-10, 2022-6 IRB (Jan. 14, 2022).}