In earlier posts, we discussed how the division of a closely-held, corporate-owned business may be effected without incurring an income tax liability for either the corporation or its shareholders. The ability to effect such a division on a tax-efficient basis may be especially important in resolving a dispute between shareholders who may have already incurred significant legal costs in trying to divorce themselves from one another.
Forms of Division
There are two basic forms of corporate division. In the “split-off” form of division, the parent (“distributing”) corporation distributes all of its shares in a subsidiary (“controlled”) corporation to one of more of its shareholders in a complete redemption of their shares in the parent corporation, leaving the parent corporation in the hands of its remaining shareholders. In the “split-up” form of division, the parent corporation distributes all its shares in at least two subsidiary corporations to at least two different sets of shareholders in a complete liquidation of the parent corporation. (In contrast, a “spin-off,” changes the relationship of the parent and subsidiary corporations to that of brother-sister corporations, with at least one of the parent shareholders also owning all the shares of the former subsidiary corporation.)
As the saying goes, however, “all good things come hard,” and a tax-free split-off or split-up is no exception, especially in the case of so-called “cash rich” divisions that continue to be closely scrutinized by the IRS.
Basic Requirements for a Tax-Free Division
The Code generally provides that, if certain requirements are satisfied, a distributing corporation may distribute the stock of a controlled corporation to its shareholders without the distributing corporation or its shareholders recognizing income or gain on the distribution.
However, numerous requirements must be satisfied in order obtain this result. One such requirement is that the distributing corporation and the controlled corporation must each be engaged in the active conduct of a trade or business immediately after the distribution (“active trade or business requirement”; i.e., a trade or business that has been actively conducted throughout the 5-year period ending on the date of the distribution). Another requirement is that the transaction must be carried out for one or more corporate business (not shareholder) purposes (“business purpose requirement”). In addition, the transaction must not be used principally as a device for the distribution of the earnings and profits of either the distributing corporation or the controlled corporation (a “device”).
The IRS Smells A . . .
The IRS recently announced that it was studying issues relating to corporate divisions having one or more of the following characteristics:
- ownership by the distributing corporation or the controlled corporation of investment assets having substantial value in relation to (a) the value of all of such corporation’s assets, and (b) the value of the assets of the active trade(s) or business(es) on which the distributing corporation or the controlled corporation relies to satisfy the requirements; or
- a significant difference between the distributing corporation’s ratio of investment assets to assets other than investment assets and such ratio of the controlled corporation; or
- ownership by the distributing corporation or the controlled corporation of a small amount of business assets in relation to all of its assets.
According to the IRS, these types of transactions may present evidence of a device for the distribution of corporate earnings and profits, may lack an adequate business purpose, may lack a qualifying active business, or may violate other requirements for tax-free treatment.
Nature of the Assets
The IRS is concerned about transactions that result in (i) the distributing corporation or the controlled corporation owning a substantial amount of cash, portfolio stock or securities, or other investment assets, in relation to the value of all of its assets and its qualifying business assets, and (ii) one of the corporations having a significantly higher ratio of investment assets to non-investment assets than the other corporation.
The IRS is also concerned about transactions in which the distributing corporation or the controlled corporation owns a small amount of qualifying business assets compared to its other assets (non-qualifying business assets).
The IRS announced that, while the above situations are under study, it ordinarily will not issue private letter rulings as to their tax status.
Specifically, it will not issue a ruling as to the tax-free qualification of a distribution if, immediately after such distribution, the fair market value of the gross assets of the trade(s) or business(es) on which the distributing corporation or the controlled corporation relies to satisfy the active trade or business requirement is less than five percent (5%) of the total fair market value of the gross assets of such corporation.
Nor will the IRS issue a ruling relating to the qualification of a distribution if, immediately after such distribution, each of the following conditions exist:
- the fair market value of the investment assets of the distributing corporation or the controlled corporation is two-thirds or more of the total fair market value of its gross assets; and
- the fair market value of the gross assets of the trade(s) or business(es) on which the distributing corporation or the controlled corporation relies to satisfy the active trade or business requirement is less than 10 percent (10%) of the fair market value of its investment assets; and
- the ratio of the fair market value of the investment assets to the fair market value of the assets other than investment assets of the distributing corporation or the controlled corporation is three times (3x) or more of such ratio for the other corporation (i.e., the controlled corporation or the distributing corporation, respectively).
However, there may be unique circumstances, the IRS noted, to justify the issuance of a ruling. In determining the existence of such circumstances, the IRS will consider all facts and circumstances, including, for example, whether a substantial portion of the non-qualifying business assets would be qualifying business assets but for the five-year requirement.
Advice to Taxpayer?
Over forty years ago, the IRS issued a revenue ruling in which it stated that there was no requirement in the rules for a tax-free corporate division that a specific percentage of the corporation’s assets had to be devoted to the active conduct of a trade or business. It noted, however, that the percentage of the active business assets was a relevant factor for purposes of determining whether the distribution constituted a device.
Then, about ten years ago, the IRS eliminated a relatively short-lived requirement, for ruling purposes, that the value of the corporation’s active trade or business assets had to represent at least five percent (5%) of its total asset value.
It remains to be seen what the outcome of the IRS’s recently-announced study will be. Whether it will lead to proposed legislation or regulations, or some other form of guidance for the subject transactions, is a matter of speculation at this point.
What is clear is that the IRS remains concerned about “cash-rich” corporate divisions. This explains its emphasis on the value of the corporation’s active trade or business assets relative to its investment assets, as well as its focus on the active trade or business, business purpose, and device requirements for a tax-free corporate division.
In the case of most divisions of close corporations, the concerns described above are not likely to be present. The corporate parties will have engaged in an active trade or business, and their assets will not include investment portfolios that are overly large relative to their business assets.
There may be situations, however, in which the “percentage guidelines” set forth above may prove helpful in planning for a division, as where a close corporation may have sold one line of business and, rather than distributing the net proceeds therefrom to its shareholders, or reinvesting the proceeds in another active business, it has acquired cash-equivalent or other investment assets.
If it later becomes necessary, from a business perspective, to divide the corporation and its remaining line(s) of business among its shareholders, the taxpayer’s advisers will have to be mindful of the relative value of the corporation’s investment assets, and they may have to plan for them accordingly.
In the meantime, it will behoove tax advisers to keep abreast of the IRS’s pronouncements in this area.