In PLR 201930011, released July 26, 2019, the Service ruled that the splitting up of a business between discordant shareholders of a closely held business qualified as a tax-free transaction pursuant to sections 368(a)(1)(D) and 355 (a divisive D reorganization). This ruling illustrates that given the right facts and circumstances and careful structuring, breaking up might not be as hard to do…at least for federal income tax purposes.
This PLR is one of several rulings that the Service has issued since announcing the temporary reversal of its no-ruling policy with respect to section 355 distributions under Rev. Proc. 2017-52, 2017-41 I.R.B. 283. PLR 201930011 implies that business partners going their own way may meet the business purpose requirement under section 355.
In PLR 201930011, the distributing corporation (Distributing) was an S corporation for federal income tax purposes. Distributing’s four shareholders, A, B, C and D held equal interests in Distributing. Distributing was engaged in a single line of business (the Business) that it actively conducted for each of the past five years leading up to the proposed transaction described below. Distributing’s total gross assets were valued at approximately $a. Distributing also owned a general partnership interest in a partnership that was valued at approximately $b.
A and B were at odds with C and D as to how the Business should be conducted so the shareholders negotiated a plan to split the business into two equal parts. The parties requested a private letter ruling for the following proposed split-up:
- Distributing will form two corporations, Controlled 1 and Controlled 2, each of which will make an S election for federal income tax purposes.
- Distributing will then contribute to Controlled 1 50% of the assets and liabilities of the Business, including 50% of the general partnership interest, 50% of Asset 1, 100% of Assets 2, 3, and 4, and $c cash (Contribution 1).
- Distributing will contribute to Controlled 2 the remaining 50% of the asset and liabilities of the Business, including 50% of the general partnership interest, 50% of Asset 1, 100% of Assets 5, 6, 7, 8, and 9, and $d cash (Contribution 2).
- Distributing will subsequently distribute to A and B all of the stock of Controlled 1 in exchange for all of A and B’s shares of Distributing stock (Distribution 1).
- Distributing will simultaneously distribute to C and D all of the stock of Controlled 2 in exchange for all of C and D’s shares of Distributing stock (Distribution 2).
- Distributing will then liquidate as part of the reorganization.
- Controlled 1 and Controlled 2 will sell Asset 1 as soon as the necessary steps required by the applicable state law are completed.
Section 355 in general
Section 355 distributions allow taxpayers to distribute appreciated property from a corporation in a tax-free manner. As an area that is perceived as ripe for abuse, Congress established a strong set of requirements to meet in order to qualify for tax-free treatment for both the corporations and the shareholders:
- Business purpose: The distribution must have a significant non-tax business purpose, which generally would not include the immediate sale of the distributed or retained business.
- Device test: The distribution must not be a device for the distribution of earnings and profits, which is a facts and circumstances test impacted by the strength of business purpose, whether distributions are ratable and subsequent sales of Distributing or Controlled.
- Disqualified distribution: In general, 50% or greater of Distributing or Controlled cannot be held by a person that acquired their interest via purchase during the prior five years.
- Anti-Morris Trust rule: Neither Distributing nor Controlled can undergo a change in control (50% or more) pursuant to a plan at the time of the distribution. The Treasury and IRS have established a number of safe harbors for taxpayers to look to in determining satisfaction of this test under Reg. 1.355-7.
- The Active trade or business (ATB) test: In order to satisfy the ATB requirement both Distributing and Controlled must operate an ATB immediately after the distribution, which is assessed based on the generation of revenue.
Business purpose requirement
The objective of the business purpose requirement is to limit tax-free treatment only to those distributions that are “incident to readjustments of corporate structures required by business exigencies and that effect only readjustments of continuing interests in property under modified corporate forms.”1 In order to meet the requirement under section 355, a distribution must have “a real and substantial non Federal tax purpose” that is germane to the business of Distributing, Controlled or the affiliated group in which Distributing and Controlled are members.2
There are several, generally accepted corporate business purposes published in Appendix A of Rev. Proc. 96-30, 1996-1 C.B. 696, including key employee, borrowing, stock offering, and fit and focus. Though the revenue procedure has been superseded by Rev. Proc. 2017-52, there are several rulings that cite them as acceptable business purposes. Though a transaction may have an acceptable business purpose, “if [the] corporate business purpose can be achieved through a nontaxable transaction that does not involve the distribution of stock of a controlled corporation and which is neither impractical nor unduly expensive” then the distribution would fail to meet the business purpose requirement.
In the PLR, the taxpayer’s stated business purpose was to “resolve differences of opinion among the shareholders as to how the [b]usiness should be conducted.” This purpose would often fall under the “going your own way” business purpose where the activities are split so that each business can make its own business decisions.
In line with previous “going your own way” rulings,3 the Service ruled that the proposed split-up described above qualified as a nontaxable divisive D reorganization.
PLR 201930011 affirms that “going your own way” is an acceptable business purpose for a section 355 distribution. Any company considering a split-up transaction should consult with a tax adviser who can analyze and interpret these various requirements to determine if such a transaction is a viable restructuring option.
3.See, e.g., Rev. Rul. 64-102, 1964-1 C.B. 136 (the Service ruled that the distribution of subsidiary stock to minority shareholders qualified under section 355 where the minority shareholders were in disagreement with the majority shareholders over managerial policy); and Rev. Rul. 69-460, 1969-2 C.B. 51, Situation 1 (In Situation 1, the Service ruled that two business partners splitting up the business in a non pro rata distribution of subsidiary stock in order to resolve business problems caused by the discord between the two shareholders satisfied the business purpose requirement under section 355).