In an earlier post, we discussed the issue of splitting up the family-owned corporation, on a tax-free basis, so as to enable siblings to go their separate ways.
A recent IRS ruling considered the following situation: an S corporation (“Distributing”) had four equal shareholders, each of whom wanted to independently own and manage a separate business in accordance with each shareholder’s own goals and priorities. In order to effect the separation enabling each shareholder to go his separate way (the “business purpose” for the transaction described herein), Distributing proposed to create four new corporations (each a “Newco”), each with a single class of stock. Distributing would transfer substantially equal portions of all of its assets related to the conduct of its business to each Newco. In exchange, each Newco would issue 100% of its common stock to Distributing and would also assume any liabilities associated with those assets.
Immediately after these contributions, Distributing would distribute all of the Newco 1 stock to shareholder 1, all of the Newco 2 stock to shareholder 2, and so on, in each case in exchange for the shareholder’s stock in Distributing. Thereafter, each former shareholder of Distributing would own all of the stock of one of the Newcos. At that point, Distributing would dissolve, and each Newco would elect to be treated as an S corporation for tax purposes.
In connection with the ruling, the taxpayers made a number of representations to the IRS. For example, they represented that the fair market value of the Newco stock would approximately equal the fair market value of the S corporation stock surrendered, and that the fair market value of the assets of each Newco would exceed the amount of its liabilities.
They also represented that Distributing’s business had been actively conducted during the five-year period ending with the exchange, and that each Newco would continue, independently and with its separate employees, the active conduct of its share of all the integrated activities of the business conducted by Distributing prior to the consummation of the exchange.
They further represented that the transactions were not part of a plan or series of related transactions pursuant to which one or more persons would acquire stock representing a 50% or greater interest in any Newco.
The IRS ruled that the transactions would qualify as a tax-free reorganization. Thus, no gain would be recognized by Distributing, by any of the Newcos, or by any of the shareholders.
Why This PLR Matters
There is nothing extraordinary about the holding in this ruling. It represents a common form of “split-up” transaction in which the distributing corporation disappears entirely. This is to be contrasted with a spin-off, in which the corporation distributes the shares of a subsidiary corporation pro rata to all of its shareholders, and with a split-off, in which the subsidiary is distributed to some shareholders in exchange for their shares in the distributing corporation. (I will refer to such transactions generically as “spin-offs”.)
It should be noted, however, that the ruling was issued shortly after the IRS announced that it would no longer issue similar rulings on whether a transaction, like the one described above, would qualify for non-recognition treatment (so-called “comfort rulings”). Traditionally, taxpayers have been advised to seek a comfort ruling before undertaking a spin-off transaction. The ruling served to assure a taxpayer that the proposed distribution would not be treated as a taxable event to either the corporation or its shareholders. Considering the amount of the distribution that would typically be involved, and the size of the potential tax liability that would be incurred if the transaction failed to satisfy the requirements for tax-free treatment, this approach was justifiable.
Now, in an effort to conserve its limited resources, the IRS will only issue rulings that involve a significant “issue of law the resolution of which is not essentially free from doubt.” Thus, this ruling may represent one of the last comfort rulings in the “spin-off” area that we are likely to see from the IRS.
The IRS’s recent announcement regarding spin-off rulings does not represent the first instance in which it has limited the scope of its rulings. Years earlier, the IRS announced that it would not rule on the “business purpose” requirement for such transactions. Notwithstanding this limitation, the fact that the IRS continued to issue rulings on spin-off transactions gave taxpayers comfort that the IRS must have approved of the stated business purpose — otherwise the IRS would never have issued the ruling.
The more restricted ruling policy now in effect means that taxpayers can no longer look to the IRS for its “approval” of a proposed spin-off transaction.
Don’t Be Scared Off
However, this does not mean that such transactions should no longer be considered. They remain a viable option that, in the appropriate circumstances, may be utilized to resolve a number of business issues (including shareholder disputes) in a tax-efficient manner. As is the case with so many transactional and reorganizational alternatives, the complexity thereof should not deter taxpayers, or serve as an excuse to disregard what may be a viable option for attaining a valid business goal. Furthermore, the inability to get a comfort ruling from the IRS does not mean that a successful tax-free spin-off is now more difficult than it was in the past. With the proper advice and guidance in exploring and, if appropriate, in structuring a spin-off transaction, the absence of a comfort ruling should not be an obstacle.