A business with no profits? IRS blesses pre-revenue spin-off
Continued favorable development for research-intensive businesses
TAX ALERT |
On Feb. 28, 2020, the IRS released a private letter ruling (PLR 202009002) holding that the absence of revenue in a spun-off subsidiary’s business did not prevent such business from constituting a trade or business in determining it met the active trade or business (ATB) requirement and that the transaction qualified as a tax-free distribution under section 355.
Section 355 allows a corporation to distribute the stock of a controlled corporation to its shareholders (i.e., a spin-off) in a tax-free transaction, provided that all the requirements listed in the code and regulations are met. For a discussion of the requirements and section 355 in general, refer to our prior article Tax-free spin offs prior to product sales stage could become a reality. Among the requirements is the ATB requirement, which states that both the distributing and controlled corporations must operate an ATB immediately after the distribution. Historically, in order to be considered a trade or business to meet the ATB requirement, “the collection of income and the payment of expenses” was ordinarily required.1 However, since 2018, and as discussed in our prior article, Spin-off ruling on subsidiary with no independent current revenue, the IRS has indicated flexibility in its ruling policy by relaxing this collection of income requirement.
With the issuance of PLR 202009002, the IRS continues to indicate its willingness to lessen this strict requirement, in particular in the context of research-intensive businesses. In the PLR, the IRS ruled that the absence of income collection from the business (Business 2) held by the spun-off subsidiary did not prevent the business from constituting a trade or business in order to meet the section 355 ATB requirement. Under the facts of the PLR, significant salary and wage expense for operational and managerial employees was incurred by the distributing corporation in connection with Business 2. Additionally, the distributing corporation believed that Business 2 has had the potential to generate income through various commercial arrangements prior to the date of the proposed spin. The distributing corporation, however, decided to forgo those historic income opportunities “in favor of the prospect of collecting significantly greater income” at a later stage in the development process of its product. The facts further highlight that it is anticipated Business 2 would generate income through royalties, milestone payments or profit-splits at such a future date. It is unclear from the PLR the extent to which the IRS relied on this prospect of future income in determining its ruling. However, PLR 202009002 demonstrates a further indication that the IRS will allow, at least in particular circumstances, the element of trade or business of the ATB requirement for a section 355 spin-off to be met, despite the business of the spun-off subsidiary lacking revenue (i.e., collection of income).
PLR 202009002 is a continued positive development in the IRS’ ruling policy on spin-off transactions, particularly for companies in the life science sector (i.e., businesses with significant focus on research and development). However, companies should note that this ruling indicates a relaxation of only one element of the ATB requirement. Other elements of the ATB requirement, together with the other section 355 requirements, still must be met in order for a spin-off to qualify for tax-free treatment. Due to the lack of existing authority addressing pre-revenue stage businesses as meeting the ATB requirement, a private letter ruling request would appear highly advisable. Taxpayers should consult a tax advisor if they are considering a spin-off transaction.
1 Reg. section 1.355-3(b)(2)(ii). See also Rev. Proc. 2017-52.