In two earlier posts, we discussed how the division of a closely held, corporate-owned business may be effected on a tax-free basis. The IRS recently issued a ruling  that illustrates the variety of circumstances in which such a division may be appropriate and feasible.

Distributing was an LLC that was treated as an S corporation for federal income tax purposes (possibly because the owners preferred the governance provisions of the state’s LLC law to those of its corporate law; see the check-the-box regulations). Shareholder A and Shareholder B, who were related to one another, each directly owned X% of the equity of Distributing (the “Distributing Interests”). The remaining Y% of the Distributing Interests were held by a Trust (see our post here), the beneficial ownership of which was held equally by Shareholder A and Shareholder B.

Additionally, Shareholder A (together with trusts for the benefit of Shareholder A’s spouse and descendants) owned RelatedCo1, and Shareholder B owned RelatedCo2, each a corporation engaged in the same line of business as Distributing: Business A.

Distributing and RelatedCo1 were each engaged in Business A for many years. Distributing did not have any employees on its payroll. Rather, Shareholder A managed Distributing and the Operational Employees, who were formally employed by RelatedCo1 and performed Distributing’s operational activities. Since Distributing’s formation, Distributing and RelatedCo1 had an unwritten employee-sharing arrangement in place (the “Employment Arrangement”) under which the Operational Employees performed operational activities and some management services for both Distributing and RelatedCo1, RelatedCo1 compensated the Operational Employees for all of their work and provided them with benefits, and Distributing reimbursed RelatedCo1 for a portion of the Operational Employees’ compensation and benefits. Specifically, Distributing periodically made payments to RelatedCo1 for Z% of RelatedCo1’s costs for the Operational Employees’ salaries, benefits, workers’ compensation insurance, health insurance, and other employment-related expenses (apparently without an element of profit for RelatedCo1). The Z% was intended to approximate the portion of the Operational Employees’ work hours spent working on behalf of Distributing. When performing services on behalf of Distributing, the Operational Employees held themselves out to third parties as employees of Distributing.

Eventually, Shareholder A and Shareholder B stopped getting along.  As a result, they proposed to separate their interests in Distributing in order to avoid further disharmony in the management and operations of Business A, as well as to avoid litigation.

Specifically, the following transaction (the “Proposed Transaction”) was proposed:
(i) Distributing would form Controlled as a new corporation;
(ii) in exchange for the issuance of all of the Controlled stock, Distributing would transfer to Controlled the Contributed Assets (a portion of its Business A assets), as well as the financial accounts and the liabilities associated with these business assets (the “Contribution”);
(iii) the Trust would distribute one-half of its Distributing Interests to Shareholder A and the other one-half of its Distributing Interests to Shareholder B (the “Trust Distribution”);
(iv) Distributing would distribute all of the outstanding Controlled stock to Shareholder B in exchange for all of Shareholder B’s Distributing Interests (the “Distribution”), leaving Shareholder A as the sole owner of Distributing;

(v) after the Distribution, Controlled would elect to be an S corporation effective as of the date of formation, with Shareholder B as its sole owner; and

(vi) following the Proposed Transaction, Distributing and Controlled would each continue, independently and with its separate employees (or with operational employees of Related Co 1 or Related Co 2, respectively), the active conduct of its share of all of the integrated activities of Business A conducted by Distributing prior to consummation of the Proposed Transaction.

The IRS determined that the Contribution, followed by the Distribution, would qualify as a tax-free reorganization: (1) no gain or loss would be recognized by Distributing on its transfer of the Contributed Assets to Controlled in exchange for the assumption of liabilities and the issuance of the Controlled stock in the Contribution; (2) no gain or loss would be recognized by Controlled on its receipt of the Contributed Assets from Distributing in exchange for its assumption of liabilities and the issuance of its stock in the Contribution; (3) no gain or loss would be recognized by Distributing on the distribution of the Controlled stock to Shareholder B in the Distribution; and (4) no gain or loss would be recognized by Shareholder B upon the receipt of Controlled stock in exchange for the Distributing Interests in the Distribution.

In accordance with its ruling policies, the IRS did not determine whether the Distribution satisfied the business purpose requirement or whether Business A was an active trade or business.

It also did not rule on the income tax treatment of the Trust and the Trust Distribution, although a distribution of corpus is generally not a taxable event, either to the trust or to its beneficiaries.

This ruling is factually noteworthy for a couple of reasons. It involved an LLC (Distributing) that elected to be taxed as an S corporation. Distributing did not have its own employees but, rather, conducted its business through an employee-sharing agreement with a corporation that was owned by only one of Distributing’s owners. Shareholder A and Shareholder B were already separately engaged in the same line of business as Distributing through their own, separate corporations (and with their own workforces), possibly competing against one another; in other words, they may have already started the separation process.

It also illustrates one of the many scenarios in which the spin-off provisions of the Code may be utilized to separate shareholders on some rational basis – including a division of customers, workforce, geographic area, lines of business, etc., and possibly an equalizing payment – and without the emotional and economic costs of litigation.  Advisers to closely held businesses should be mindful of these provisions in any scenario that has the potential to turn into a litigated matter among shareholders.