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Over the last few months, we’ve been working on a number of transactions that involve the division of a closely held corporation or partnership.

In each instance, the impetus for the division has been the desire of the business entity’s owners to go their separate ways so as to enable them to focus their energies on a distinct line of business without interference from the other owners, and to allow them to fully enjoy the rewards of their own efforts.

Although it is incumbent on every tax adviser to stay current on developments in the tax law, there are times when this becomes a seemingly Sisyphean task.[i] Just witness the aftermath of the 2017 tax legislation.

For that reason, it behooves the adviser, prior to embarking upon any transaction, to review the latest IRS rulings interpreting those provisions of the Code that are applicable to the transaction.

With respect to the projects described above, this legal “due diligence” included a review of IRS letter rulings under the regulatory “assets over” form of partnership division,[ii] and under the Code’s corporate reorganization provisions.[iii]

That’s when I came across the ruling – more specifically, the phrase within a sentence within the ruling – that is the subject of today’s post.

Before describing the ruling, let’s first consider the basic requirements for a “tax-free” corporate division.

Corporate Divisions

Underlying the corporate reorganization provisions of the Code is the principle that it would be inappropriate to require the recognition and taxation of any gain realized as a result of a transaction in which the participating taxpayers – the corporations and their shareholders – have not fundamentally changed the nature of their investment in, and their relationship to, the corporation’s assets or business.

One of these reorganization provisions allows a corporation to distribute to some or all of its shareholders all of the shares of stock of a subsidiary corporation on a “tax-free” basis, provided certain requirements are satisfied. The division of the “parent” or distributing corporation may be undertaken for many reasons and it may take many forms. In general, such a distribution may be pro rata among the parent corporation’s shareholders (a “spin-off”), it may be in exchange for all of the parent corporation’s stock held by certain of its shareholders (a “split-off”), or it may be in complete liquidation of the parent corporation (a “split-up”), where the stock of at least two subsidiary corporations is distributed.

The division must comply with certain statutory and non-statutory requirements in order to achieve tax-free status, including the following:

  1. The distributing parent corporation must “control” the subsidiary corporation the stock of which is distributed;
  2. The distribution must not be a “device” for distributing the earnings and profits of either corporation;
  3. Each of the corporations must, after the distribution, conduct an “active trade or business” that has been conducted by either of them for at least five years,[iv] and that has not been acquired in a taxable transaction within that time;[v]
  4. At least enough stock of the subsidiary corporation must be distributed to constitute control of such corporation;
  5. The transaction must have a corporate business purpose;[vi] and
  6. The continuity of interest requirement must be met.

From a “mechanical” perspective, a division – for example, a spin-off – may be effectuated by the parent corporation’s distributing to its shareholders the stock of an existing subsidiary,[vii] or it may be preceded by the parent’s contribution of part of its assets to a newly-formed subsidiary corporation in exchange for all of the stock thereof, which it then distributes in the spin-off.[viii]

Active Trade or Business

Of the foregoing requirements, the one that concerns us here is that of the “active trade or business.”

The Code requires that Distributing and Controlled must each be engaged in the active conduct of a trade or business immediately after the distribution. The rules for determining whether a corporation is engaged in the active conduct of a trade or business immediately after the spin-off, however, focus almost exclusively on the five-year period before the spin-off, by defining an active business as one that has been conducted throughout the five-year period ending on the date of the spin-off.[ix]

The Corporation’s Activities

A corporation will be treated as engaged in an active trade or business immediately after the distribution if “a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such group include every operation that forms a part of, or a step in, the process of earning income or profit. Such group of activities ordinarily must include the collection of income and the payment of expenses.”[x]

The determination whether a trade or business is actively conducted is made from all of the facts and circumstances and, generally, the corporation is required itself to perform active and substantial management and operational functions;[xi] in other words, to have an active business the corporation must perform active and substantial management and operational functions through its own employees – even though some of its activities are performed by others, including independent contractors.

Changes in the Active Trade or Business

A trade or business that is relied upon to meet the requirement for a tax-free spin-off must have been actively conducted throughout the five-year period ending on the date of the distribution.[xii]

The fact that a trade or business underwent change during the five-year period preceding the distribution – for example, by the addition of new or the dropping of old products, changes in production capacity, and the like – are disregarded, provided that the changes are not of such a character as to constitute the acquisition of a new or different business.

In particular, if a corporation, engaged in the active conduct of one trade or business during that five-year period, purchased, created, or otherwise acquired another trade or business in the same line of business, then the acquisition of that other business is ordinarily treated as an expansion of the original business, all of which is treated as having been actively conducted during that five-year period, unless that purchase, creation, or other acquisition effects a change of such a character as to constitute the acquisition of a new or different business.[xiii]

Business Interruption

In addition, the fact that there was a partial or temporary interruption, during the five-year period preceding the distribution, in a trade or business that had been actively conducted by a corporation, may not, under the right circumstances, adversely affect the conclusion that the corporation was engaged in the active conduct of a trade or business for the five-year period.

For example, the IRS has previously ruled that a proposed spin-off would satisfy the five-year active trade or business requirement where the controlled subsidiary corporation had collected income for only four of the five years preceding the distribution of its stock.[xiv]

The subsidiary had incurred expenses and engaged in substantial managerial and operational activities representative of the active conduct of a trade or business for each of the five years preceding the date of the distribution. Its failure to receive revenue during one of the five years was unforeseen, and was caused by events outside of its control; i.e., the bankruptcy of its sole customer.

The corporation took all reasonable steps to secure revenue by redesigning its limited use product and actively seeking new customers for such product; in the absence of any sales, it also shut down its plant and substantially reduced its workforce. Approximately one year later, its business began to generate revenues once again.

The IRS indicated that there may be exceptional situations where, based upon all the facts and circumstances, a group of activities will constitute an active trade or business for purposes of the spin-off rules even when “there is no concurrent receipt of income and payment of expenses.”

When these extraordinary facts were coupled with the subsidiary’s activities before the bankruptcy of its sole customer, along with its efforts to secure revenue, the IRS was able to conclude that the subsidiary was engaged in the active conduct of a trade or business for the five-year period preceding the date of the distribution of its stock by its parent corporation.

With the foregoing in mind, we can turn to the IRS’s recent ruling.

The Ruling

The ruling[xv] addressed a proposed transaction by which a corporation (“Distributing”) would transfer one segment of its business (“Business”) to its shareholders (the “Transaction”). Distributing was engaged in Business, which was comprised of Segments 1 through 4. Distributing was in the process of exiting Segment 3 while, at the same time, expanding into Segments 2 and 4.

Distributing proposed to form a new subsidiary corporation (“Controlled”) for the purpose of effecting the Transaction.

Distributing would contribute all of the assets, and related operations, associated with Segment 4 of the Business (the “Contribution”) to Controlled, solely in exchange for all of the stock of Controlled and the assumption by Controlled of all of the liabilities associated with such assets and operations.

Distributing would then distribute all of the Controlled stock, on a pro rata basis, to Distributing’s shareholders (the “Distribution”).

As part of the Transaction, and immediately following the Distribution, Controlled would issue shares of Controlled stock to one or more investors in exchange for cash, which Controlled would retain for use in its operation of Segment 4.[xvi]

Both corporations represented that they would satisfy the Code’s active trade or business requirement for a tax-free spin-off. With respect to the Business relied on by each of Distributing and Controlled to meet this requirement, Distributing represented that there had not been any substantial operational changes since the end of Distributing’s most recent taxable year, other than the termination of Segment 3.

Distributing and Controlled represented that, following the Distribution, they would continue certain inter-Segment relationships (“Continuing Relationships”), including the provision of certain services by Controlled (“Services”) – presumably part of the operation of Segment 4 – to Distributing (operating Segments 1 and 2) for a period of time.

The corporations represented that payments made in connection with all continuing transactions, if any, between Distributing and Controlled after the Distribution would be for fair market value, based on arm’s length terms, other than payments in connection with certain Continuing Relationships, which would be provided at cost.[xvii]

They also represented that no intercorporate debt would exist between Distributing and Controlled at the time of, or subsequent to, the Distribution, except for payables and receivables arising in connection with certain Continuing Relationships.[xviii]

There was no plan or intention for Distributing or Controlled to divest themselves of any of the historic business assets of Distributing before or after the Distribution, except for the termination of Segment 3 by Distributing.

However, it was also represented that once Controlled stopped providing the Services to Distributing, Controlled could cease to generate any revenue.

In that case, Controlled represented that it would “continue to seek to generate future revenue through future Events.”[xix]

The IRS ruled that the Contribution and the Distribution, together, would be treated as a “divisive D reorganization” for federal tax purposes. Consequently, neither Distributing nor Controlled would recognize gain or loss on the Contribution, no gain or loss would be recognized by Distributing on the Distribution, and no gain or loss would be recognized by (and no amount would otherwise be included in the income of) the Distributing shareholders upon their receipt of the Controlled stock in the Distribution.

A Shift in Thinking?

In order for the IRS to have ruled that the Transaction would qualify as a tax-free reorganization, it must have determined that Controlled would satisfy the active trade or business requirement after the Distribution.

In other words, the IRS must have concluded that Controlled would conduct an active trade or business that had been conducted by Distributing for at least five years prior to the Distribution – in particular, Segment 4 of Distributing’s Business, which the ruling tells us was expanding prior to the Transaction – notwithstanding Controlled’s representation that there may be periods after the Distribution, and after it stopped providing the Services to Distributing, during which Controlled would not collect any revenue.[xx]

As indicated earlier, the rules for determining whether a corporation is engaged in the active conduct of a trade or business immediately after a spin-off focus primarily on the five-year period prior to the spin-off, by defining an active business as one with a five-year history of active and substantial managerial and operational activities by the business’s employees.

According to the IRS, the activities of an active trade or business “ordinarily must include the collection of income.”[xxi] Generally, in the absence of exceptional circumstances beyond the business’s control,[xxii] the IRS historically has required a qualifying business to have collected income continuously for at least five years.

In this ruling, however, Controlled expected that there would be periods during which it would not generate any revenue; it assured the IRS that, during these times, it would look for business opportunities, presumably for the purpose of generating revenue.[xxiii]

So what gives? The situation that may be faced by Controlled will not involve unforeseen circumstances or events beyond its control. Did the IRS simply discount the possibility of Controlled’s not generating revenue and, therefore, did not consider this factor in its analysis?

Or does the ruling signify something else? We know that Distributing had begun to expand into Segment 4 of the Business prior to the Transaction; presumably, such expansion would be continued by Controlled after the Distribution.

Entrepreneurial Ventures

A couple of months ago,[xxiv] the IRS announced that it has been studying whether, and to what extent, corporations may utilize the tax-free separation rules of the Code to separate established businesses from newer “entrepreneurial ventures” that have not yet collected income, but that have engaged in substantial research and development (R&D) and other activities.

The IRS stated that it has observed a significant increase in entrepreneurial ventures that “collect little or no income during lengthy and expensive R&D phases.” However, it continued, these types of ventures often use the R&D phase to develop new products that will generate income in the future but do not collect income during that phase.

The IRS conceded that if a corporation wishes to achieve a corporate-level business purpose – i.e., a purpose that would support a tax-free corporate division – by separating one R&D segment from an established business, or from another R&D segment, the IRS’s historical application of the income collection requirement “likely would present a challenge for qualification” as a tax-free separation.

Query whether this signals the beginning of a more relaxed approach by the IRS in the application of the active trade or business requirement?

What’s Next?

Based on the foregoing, it appears that if the IRS takes a more liberal approach to the application of the active trade or business requirement of the spin-off rules, it may be limited to businesses that need longer periods of R&D to develop their products; for example, technology-driven companies.

If the above ruling does, in fact, signify this new approach, should it be limited to businesses that require long periods of R&D?

It is true that, in the case of a start-up technology business, product development may take several years. But what about the spin-off of a business that represents the expansion of a more “traditional” business, which requires the identification and acquisition of a new location, the securing of the necessary licenses, permits, or zoning, the raising of capital, the construction of improvements, and the employment and training of new personnel? All of these factors must be addressed, significant sums and efforts must be expended, and years may pass before the spun-off business will start generating any revenue, whether through the manufacture and sale of a product, the sale of a service, or otherwise. Surely, these and other preparatory activities should be accounted for in determining whether the active trade or business requirement has been satisfied.

Stay tuned.


[i] In Greek mythology, Sisyphus was the King of Corinth. Because of his trickery and hubris, Zeus consigned him to the Underworld where he was tasked with rolling a large boulder up a steep hill. Every time he neared the top of the hill, the boulder would roll back down. Thus, Sisyphus was condemned for eternity to the an impossible and never-ending task of staying current with developments in the tax law.

[ii] Reg. Sec. 1.708-1(d); relatively straightforward, and without the stringent requirements for the division of a corporation. Ah, the repeal of General Utilities.

[iii] IRC Sec. 355 and Sec. 368(a)(1)(D). More on these in just a minute.

[iv] That’s five full years; not five taxable years.

[v] Though the expansion of an existing business may be permitted.

[vi] As opposed to a shareholder purpose. In many cases, it will be difficult to distinguish between the two.

[vii] Which would be described in IRC Sec. 355 alone.

[viii] Which would be described in IRC Sec. 368(a)(1)(D) and Sec. 355; a so-called “divisive D reorganization.”

According to IRC Sec. 368(a)(1)(D), a D reorganization is:

“a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355 or 356.”

[ix] Furthermore, the trade or business must not have been acquired during the five-year period ending on the date of the spin-off in a transaction in which any gain or loss was recognized, and control of a corporation conducting such trade or business must not have been acquired by Distributing or any controlled corporation directly or through one or more other corporations within the five-year period preceding the distribution in a transaction in which any gain or loss was recognized.

[x] Emph. added. Reg. Sec. 1.355-3(b)(2)(ii).

[xi] Reg. Sec. 1.355-3(b)(2)(iii).

[xii] Whether a group of activities constitutes a “trade or business” is an issue that has enjoyed a resurgence as a result of the 2017 legislation; for example, does an activity rise to the level of trade or business for purposes of the 20-percent deduction under IRC Sec. 199A’s qualified business income rules, or for purposes of the gain deferral under Sec. 1400Z-2’s qualified opportunity fund rules?

[xiii] Reg. Sec. 1.355-3(b)(3)(ii).

[xiv] Rev. Rul. 82-219.

[xv] PLR 201920008, Release Date: 5/17/2019. Just a reminder: letters rulings are not precedent-setting, but they do give us a glimpse into what the IRS’s position may be on a given issue – thus, it makes sense to pay attention to them.

[xvi] Perhaps to help fund the expansion of Segment 4, which had begun under Distributing.

[xvii] Query whether this included the Services?

[xviii] Again, query whether this included the Services?

[xix] The term “Events” was not defined in the released version of the ruling; perhaps it refers to business opportunities that may present themselves as Segment 4 grows; however, it may also refer to the acquisition of a similar business; all speculation on my part.

[xx] Though it would continue to seek to generate future revenue.

[xxi] Reg. Sec. 1.355-3(b)(2)(ii).

[xxii] The “interruption” scenario described earlier.

[xxiii] But query how was Controlled going to fund its operations during these “down times?”

[xxiv] IRS Request for Information regarding the active trade or business requirement for section 355 separations of entrepreneurial ventures, dated May 6, 2019.