Sibling Rivalry

Many of us encounter family-owned corporations in which the founder’s children are engaged in the business to varying degrees. They may even own shares in the corporation, typically having received them as gifts from their parents.[i] These situations may develop in such a way that they present difficult succession planning considerations for the business.

It may be that two or more siblings actively participate in the business. The more capable among them may aspire to lead the corporation after their parents have retired or passed away. At some point, their competing goals, personalities, or divergent management styles may generate enough friction between the siblings, and within the corporation, so as to jeopardize the continued well-being of the business.[ii]

Alternatively, the siblings may be interested in different parts of the corporation’s business. Each sibling may be responsible for a different line of business; for example, a different product, service, or geographic region. Their differing interests may lead to disagreements as to the allocation of resources and the prioritization of goals.

The dispute between the siblings will sometimes fester – and their relationship will deteriorate – to the point where litigation, along with its attendant costs and disruption of the business, are inevitable.[iii]

Dividing the Business?

In that case, it may still be possible to de-escalate the situation, and avoid further bloodshed[iv] – not to mention expense and loss of revenue – if it can be demonstrated to the feuding siblings that the business may be divided between them on a tax-efficient (i.e., economical) basis, especially where they have already incurred significant legal costs in trying to divorce themselves from one another.

Of course, it would be preferable (and less expensive) if the siblings could separate from one another without first resorting to litigation, although it is often the case that such litigation becomes the impetus for a more constructive approach toward the settlement of the parties’ disputes.

Indeed, if the parents could reasonably foresee the risk of serious disagreement among their successors in the business, they may decide to explore with their tax and corporate advisers whether the business can be divided among the kids while the parents are still alive and before the business suffers the adverse consequences that typically accompany such infighting.[v]

There are two basic forms of corporate division by which two or more shareholders may go their separate ways. In the “split-off” form of division, the parent corporation distributes all of its shares in a subsidiary corporation[vi] 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.

There is also a third form of division – a “spin-off” – by which a parent corporation may distribute the stock of its subsidiary corporation to at least some of its shareholders by way of a “dividend,” thereby changing the form of the relationship to that of brother-sister corporations with some degree of common ownership.[vii]

“Tax-Free” Divisions

Whatever form of division is selected, there are numerous requirements that must be satisfied in order for the division to receive favorable tax treatment. In general,

    1. the distributing parent corporation must distribute to some or all of its shareholders all of the stock of a subsidiary corporation[viii] controlled by the parent,
    2. the distributing corporation and the subsidiary corporation must each be engaged in the “active conduct of a trade or business” immediately after the distribution,[ix]
    3. neither active trade or business was acquired in a taxable transaction during the five-year period preceding the distribution,
    4. there is a real and substantial business purpose for the distribution that cannot be accomplished by another nontaxable alternative which is neither impractical, nor unduly expensive,
    5. 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 subsidiary corporation,
    6. the distributee shareholders did not acquire their shares in the distributing parent corporation by “purchase” during the five-year period ending on the date of the distribution; and
    7. the distribution is not made pursuant to a plan by which at least 50% of parent or of the former subsidiary is acquired by third parties.[x]

In general, if these requirements are satisfied, (1) the shareholders will not recognize gain or loss upon the receipt of the subsidiary stock, (2) the distributing corporation will not recognize gain or loss upon the distribution of the subsidiary stock to the shareholders, (3) the aggregate basis of the subsidiary stock received by each shareholder immediately after the distribution will equal the shareholder’s aggregate basis in the distributing corporation stock surrendered in the distribution, and (4) the holding period of the subsidiary stock received by each shareholder will include the holding period of the stock in the distributing corporation with respect to which the distribution of the subsidiary stock is made.[xi]

If these criteria are not met, then the distributing corporation will be treated as having sold the distributed property for an amount equal to the property’s fair market value, it will have to recognize the gain realized on deemed sale of the property, and it will be taxed thereon. The shareholders will be taxed on their receipt of the property distributed by the corporation, either as a dividend of an amount equal to the fair market value of such property, or as a payment of the same amount in exchange for their shares of stock in the distributing corporation.

In order to avoid the adverse tax consequences described immediately above, it is imperative that each of the requirements for a “tax-free” division of the distributing corporation be satisfied.

Business Purpose

In the context of a family-owned corporation, the requirement that the distribution be carried out for a real and substantial corporate business purpose may present a unique challenge, at least where the ostensible business purpose for the division of the corporation is to enable competing siblings – who would otherwise succeed to the ownership and management of the corporation – to go their separate ways.

Specifically, it may be difficult in that case, depending upon the facts and circumstances, to distinguish between a corporate business purpose, on the one hand, and a personal non-business purpose of the shareholders, on the other.

That being said, it should be noted that one of the most commonly relied upon corporate business purposes for the distribution of a subsidiary as part of a corporate division is that it will enhance the success of each corporation’s business by enabling a significant shareholder or shareholder group to concentrate on a particular line of business, and to thereby resolve management or other problems that arise, or are exacerbated, by the operation of different businesses within a single corporation.[xii]

However, the IRS has long recognized the potential, in the context of a family-owned corporation, for such a distribution to also facilitate the personal planning (such as estate planning or gifts) of a shareholder.

In order to better understand how to prepare for an IRS challenge on such grounds,[xiii] the parties and their advisers will need to familiarize themselves, in the first instance, with the published guidance provided by the IRS itself, including the two rulings described below.[xiv]

Scenario One

The IRS once considered the case of a corporation (“Corp”) that operated an automobile dealership.[xv] Its franchise for the sale of automobiles was in Dad’s name; the franchise could not be held by the corporation, was renewable periodically, and was not transferable by inheritance or otherwise.

Dad managed Corp and owned a majority of its stock. He was elderly, and the Corp stock constituted the bulk of his estate. The balance of Corp’s stock was held equally by Dad’s five daughters, only three of whom were active in the business.

Corp’s wholly-owned subsidiary (“Sub”) was engaged in the business of renting automobiles.

The automobile manufacturer did not permit the granting or continuing of a franchise where there were inactive shareholders in the corporation unless an active majority shareholder held the franchise. Alternatively, the manufacturer permitted the granting or continuing of a franchise where there was no majority shareholder, provided the shareholders were few in number and all were active in the business.

The IRS noted that, upon Dad’s death or retirement, the present stock ownership of Corp, with proportionate bequests or gifts to Dad’s daughters, would preclude satisfaction of the active-shareholder criteria described above for the purpose of renewing the franchise.

In order to ensure that its remaining shareholders would be able to renew the franchise upon Dad’s death or retirement under the alternate conditions of the franchise policy – without chancing a potential interruption in the continuity of, or even the loss of, the franchise which might occur if nothing was done until after Dad’s departure – Corp distributed 75% of Sub’s stock to the two inactive-daughter shareholders in exchange for all of their stock in Corp. The remaining 25% of Sub’s stock was distributed to Dad in exchange for Corp shares of equal value.

Dad intended that, upon his death, the inactive-daughter shareholders would receive their inheritance in Sub stock (and assets other than Corp stock), while the active-daughter shareholders would receive his shares of Corp stock.

The IRS determined that distribution of the Sub stock to Dad furthered the objective of enabling Corp’s active-daughter shareholders to retain the franchise by increasing their percentage of ownership in Corp, and by providing Dad with Sub stock which he could bequeath or gift to the inactive-daughter shareholders, leaving his remaining Corp stock available for transfer to the active-daughter shareholders.

The IRS also found that Dad’s age presented an immediate problem, [xvi] and that the distribution of Sub’s stock was germane to the continuation of Corp’s business in the reasonably foreseeable future. Execution of the plan, therefore, was directly related to the retention of a franchise vital to Corp’s business and would forestall an impending disruption to such business by reason of the current active family group being unable to renew the corporation’s franchise upon Dad’s death or retirement.

Scenario Two

In another ruling[xvii] the IRS considered a corporation (“Corp”) the stock of which was owned equally by Parents, Son, and Daughter. Although Parents participated in some major management decisions, most of the management, and all of the operational activities, were performed by Son and Daughter.

Son and Daughter disagreed over the future direction of Corp’s business. Son wished to expand one line of business, but Daughter was opposed because this would require substantial borrowing by Corp. Daughter preferred to sell that line of business and concentrate on Corp’s other business. Despite the disagreement, the two siblings cooperated on the operation of the business in its historical manner without disruption. Nevertheless, it prevented each sibling from developing, as he or she saw fit, the business in which he or she was most interested.

Parents remained neutral on the disagreement between their children. However, because of the disagreement, Parents preferred to bequeath separate interests in the business to their children.

To enable Son and Daughter each to devote their undivided attention, and apply a consistent business strategy, to the line of business in which he or she was most interested, and to further Parents’ estate planning goals, Corp contributed one of its lines of business to a newly-formed and wholly-owned subsidiary corporation (“Sub”), and distributed 50% of Sub’s stock to Son in exchange for all of his stock in Corp. Corp then distributed the remaining Sub stock to Parents in exchange for half of their Corp stock.

Going forward, Daughter would manage and operate Corp and have no stock interest in Sub, and Son would manage and operate Sub and have no stock interest in Corp. Parents would also amend their wills to provide that Son and Daughter would inherit stock only in Sub and Corp, respectively. After the distribution, Parents would still own 50% of the outstanding stock of Corp and of Sub, and would continue to participate in certain management decisions related to the business of each corporation.

The IRS determined that the distribution would eliminate the disagreement between Son and Daughter over the future direction of Corp’s business, and would allow each sibling to devote their undivided attention to the line of business in which they were most interested, with the expectation that each business would benefit. Therefore, although the distribution was intended, in part, to further the personal estate planning of Parents and to promote family harmony, it was motivated in substantial part by a real and substantial non-tax purpose that was germane to the business of Corp. Thus, the business purpose requirement was satisfied.

Guideposts?

It is clear that the division of a family-owned corporation may be effectuated for the purpose of resolving or eliminating management disputes among siblings. It may also be undertaken for the purpose of staving off reasonably foreseeable or imminent harm to a business that is attributable to the composition of its shareholders.

Moreover, the division may be accomplished on a tax-efficient basis, provided the criteria set forth above are satisfied, including the requirement that the distribution by the family-owned corporation of the stock in its subsidiary be motivated in whole or in substantial part by a business purpose, as distinguished from a nonbusiness purpose. Specifically, can the parties to the transaction demonstrate that there is an immediate business reason for the distribution?

In each of the two scenarios described above, there were “clear and present” reasons for the divisive distribution; the failure to act would have resulted in significant harm to the business of either or both of the corporations. The difficulties anticipated were not remote, and the resulting harm to the business was not conjectural.

However, one can imagine a situation in which the immediacy of the stated business purpose may not be obvious to an outsider, or where the severity of the consequences to be avoided is not easily determinable. In the context of a family-owned corporation, the presence of these factors – a remote risk or an ill-defined harm – may call into question whether the distribution is motivated in substantial part by a bona fide business purpose; the failure to establish such a purpose may cause the corporation’s distribution of its subsidiary to be taxable.

For that reason, if a “divisive” transaction is to withstand IRS scrutiny, the closely held corporations and the shareholders that are parties to the transaction must be prepared to substantiate the corporate business purposes which they claim motivated the transaction in whole or substantial part. They must be ready to present documentation that provides complete factual support for the stated business purpose, that describes in detail the problems associated with the current corporate structure, and that demonstrates why the distribution will lessen or eliminate those problems. As always, this body of “evidence” should be compiled contemporaneously with the events that culminate in the division of the corporation – not after the IRS has selected the parties for audit.


[i] Or as partial gifts (as in the case of a bargain sale); rarely in exchange for capital contributions, or as compensation.

[ii] Regardless of the size of the social unit, be it a family, a business, or even a nation, the results can be severe. History gives us many examples. The Old Testament alone is full of references to the consequences of sibling rivalry: Cain and Abel, Isaac and Ismael, Esau and Jacob, then down to the sons of Solomon (ironic that the kingdom of the man who rendered the Judgment of Solomon – “suggesting” that a baby be split in half in order to ascertain its true mother – should be split in two after his death).

[iii] Forget about holidays and family gatherings – Thanksgiving is never the same.

[iv] Tax lawyers enjoy the figurative use of language because we are so rarely afforded the opportunity. Our exchanges (pun intended) with others are so often limited to words such as “gain, loss, deferral, recognition . . .” and, of course, “tax.”

[v] Too often, the parents don’t want to deal with the obviously gestating issues within their family. They tell themselves that the kids will learn to work together, or they will deny the problem altogether, leaving it for the kids to resolve it after the parents are gone. We know how that usually works out. Not the sort of legacy for which most folks yearn.

[vi] The subsidiary may be formed just prior to the distribution; for example, the parent corporation may contribute one line of business to a newly-formed subsidiary as a prelude to the distribution of the stock of the subsidiary, as described above; or it may be an existing entity that is engaged in a trade or business that is related to, or completely different from, the business conducted by the distributing corporation (or by its remaining subsidiary).

[vii] This is likely the form of division that parents would undertake in preparation for transferring different parts of their business to different children.

[viii] Often referred to as the “controlled corporation.”

[ix] I.e., a “trade or business” that has been “actively conducted” throughout the 5-year period ending on the date of the distribution. This requirement has spawned some litigation between taxpayers and the IRS.

[x] Underlying the divisive reorganization provisions of the Code is the principle that it would be inappropriate to tax a transaction as a result of which the participating taxpayers – the corporations and their shareholders – have not sufficiently changed the nature of their investment in the corporation’s assets or business, provided the transaction is motivated by a substantial non-tax business purpose.

[xi] IRC Sec. 355, IRC Sec. 368(a)(1)(D).

[xii] For example, in Example (2) of Reg. Sec. 1.355-2(b)(5), Corporation X is engaged in two businesses: the manufacture and sale of furniture and the sale of jewelry. The businesses are of equal value. The outstanding stock of X is owned equally by unrelated individuals A and B. A is more interested in the furniture business, while B is more interested in the jewelry business. A and B decide to split up the businesses and go their separate ways. A and B expect that the operations of each business will be enhanced by the separation because each shareholder will be able to devote his undivided attention to the business in which he is more interested and more proficient. Accordingly, X transfers the jewelry business to new corporation Y and distributes the stock of Y to B in exchange for all of B’s stock in X. The example concludes that the distribution is carried out for a corporate business purpose, notwithstanding that it is also carried out in part for shareholder purposes.

[xiii] An exercise that should be completed before the transaction is even undertaken.

[xiv] Although the IRS’s public pronouncements are generally limited to the application of the law to a specific set of facts, they nevertheless provide a useful glimpse into the IRS’s thinking on the issues examined therein.

[xv] Rev. Rul. 75-337.

[xvi] In contrast, the IRS described a decision where the court held, under a plan to avoid any remote possibility of interference in a business by future sons-in-law, that the spin-off had no immediate business reason, involved a personal motive, and had as its primary purpose a desire to make bequests in accordance with an estate plan. The difficulties anticipated were so remote that they might never come to pass. The daughters might never marry – thus eliminating completely any cause to worry about business interference by future sons-in-law. There was, at best, “only an envisaged possibility of future debilitating nepotism,” and the effect on the business was conjectural. Rafferty v. Commissioner, 452 F.2d 767 (1st Cir. 1971).

[xvii] Rev. Rul. 2003-52.

No, I am not referring to some fleeting summer romance. After all, “. . . summer friends will melt away like summer snows.” (George R.R. Martin, A Feast for Crows).

Rather, I am referring to the abundant guidance that the IRS has issued or proposed this summer regarding the requirements that must be satisfied in order for a corporate break-up to receive favorable tax treatment. (See example).

Among the concerns addressed by the IRS are those relating to distributions involving relatively small active businesses or substantial amounts of investment assets. These transactions may (i) present evidence of a prohibited “device,” (ii) may lack an adequate business purpose, or (iii) may fail to distribute a qualifying active business. (See October 13, 2015 blog post).

Statutory Requirements

Generally, if a corporation distributes property with respect to its stock to a shareholder, the amount of the distribution is equal to the fair market value (“FMV”) of the property. This amount is treated first as the receipt by the shareholder of a dividend to the extent of the corporation’s earnings and profits (“E&P”), then as the recovery of the shareholder’s basis in the stock, and finally as gain from the sale or exchange of the stock.

The corporation recognizes gain to the extent the FMV of the property distributed exceeds the corporation’s adjusted basis in the property.

However, the Code provides that, under certain circumstances, a corporation (Distributing) may distribute stock in a corporation that it controls (Controlled) to its shareholders without causing either Distributing or its shareholders to recognize gain on the distribution.

Numerous requirements must be satisfied in order for a distribution to be tax-free to Distributing and its shareholders.

For example, the transaction must not be used principally as a device for the distribution of the E&P of Distributing or Controlled, and Distributing and Controlled must each be engaged, immediately after the distribution, in the active conduct of a trade or business.

A qualifying business is one that has been actively conducted throughout the five-year period ending on the date of the distribution and that was not acquired within this period in a transaction in which gain or loss was recognized.

Distributions of Controlled stock generally take three different forms: (1) a pro rata distribution to Distributing’s shareholders (a spin-off), (2) a distribution in redemption of Distributing stock (a split-off), or (3) a liquidating distribution by Distributing which may be pro rata or non-pro rata (a split-up).

A Device?

In determining whether a transaction was used principally as a device for the distribution of the E&P of Distributing or of Controlled, consideration is given to all of the facts and circumstances of the transaction and, in particular, to the nature, kind and amount of the assets of both corporations immediately after the transaction, and to the ratio for each corporation of the value of assets not used in a qualifying business to the value of its qualifying business.

Thus, the fact that at the time of the transaction substantially all of the assets of each of the corporations involved are used in a qualifying business is considered evidence that the transaction was not used principally as a device, and a difference in the asset ratios for Distributing and Controlled is ordinarily not evidence of device if the distribution is not pro rata among the shareholders of Distributing, and such difference is attributable to a need to equalize the value of the stock distributed and the value of the stock exchanged by the distributees.

In addition, certain distributions are ordinarily not considered a device, including a distribution that, with respect to each distributee, would be a redemption of stock to which sale-or-exchange treatment applies, and distributions in which the corporations have no E&P.

The existence of assets that are not used in a qualifying five-year business is evidence of device. Such assets include liquid investment assets that are not related to the reasonable needs of the qualifying business.

The current regulations, however, are not specific as to the quality or quantity of assets relevant in the “nature and use of assets” device factor or the appropriate weighing of the device and non-device factors.

Active Business

The IRS previously noted there is no requirement that a specific percentage of a corporation’s assets be devoted to a qualifying business, provided its active business assets represent a “substantial portion” of the value of the corporation immediately after the distribution. Thus, the fact that Distributing’s or Controlled’s qualifying business is small in relation to all the total assets of Distributing or Controlled raises an issue as to whether a relatively small active business satisfies the active business requirement.

Proposed Regulations

The IRS recently proposed regulations to address concerns over distributions involving relatively small active businesses, but substantial amounts of investment assets, because these may present evidence of device, or may lack an adequate business purpose or a qualifying active business.

Specifically, the proposed regulations provide guidance regarding the device prohibition, and they also provide a minimum threshold for the assets of one or more active businesses of Distributing and of Controlled.

Device Regulations

The potential for device generally exists either if Distributing or Controlled owns a large percentage of “investment” assets not used in business operations compared to total assets, or if Distributing’s and Controlled’s percentages of these assets differs substantially.

Instead of focusing on investment assets, the proposed regulations compare a corporation’s assets used in an active business (“Business Assets”) to those not so used (“Nonbusiness Assets”).  Business Assets are the gross assets used in an active business – without regard to whether they satisfy the five-year-active-business requirement – including reasonable amounts of cash and cash equivalents held for working capital and assets required to be held to provide for exigencies related to a business or for regulatory purposes with respect to a business.

In addition, under the proposed regulations, if the ratio of  a corporation’s Nonbusiness Assets to its total assets (“Nonbusiness Asset Percentage”) is at least 20 percent, the ownership of the Nonbusiness Assets is evidence of device. Additionally, a difference in this ratio between Distributing and Controlled ordinarily would not be evidence of device if such difference is less than 10 percentage points or, in the case of a non-pro rata distribution, if the difference is attributable to a need to equalize the value of the Controlled stock and securities distributed and the consideration exchanged therefor by the distributees. Such circumstances would ordinarily be treated as not constituting evidence of device.

Corporate Business Purpose

The presence of a strong, bona fide business purpose is a non-device factor.

Under the proposed revision, a corporate business purpose that relates to a separation of Nonbusiness Assets from one or more Businesses, or from Business Assets, would not be evidence of non-device, unless the business purpose involves an exigency that requires an investment or other use of the Nonbusiness Assets in a Business. Absent such an exigency, such a separation would be viewed as evidence of a device.

Per Se Device Test

The IRS also proposes to add a per se device test. If designated percentages of Distributing’s and/or Controlled’s total assets are Nonbusiness Assets, the transaction would be considered a device, notwithstanding the presence of any other non-device factors. However, this per se device rule would not apply if the distribution is one in which the corporate distributee would be entitled to a dividends received deduction or if the distribution would qualify as a sale or exchange if it were a redemption.

The per se device test has two prongs, both of which must be met for the distribution to be treated as a per se device.

The first prong is met if Distributing or Controlled has a Nonbusiness Asset Percentage of 66 2/3 percent or more.

The second prong of the test compares the Nonbusiness Asset Percentage of Distributing with that of Controlled. This prong of the per se device test provides for three “bands” in making this comparison. Each of these bands represents a case in which the Nonbusiness Asset Percentages of Distributing and Controlled are significantly different. For example, in the first band, if one corporation’s Nonbusiness Asset Percentage is 66 2/3 percent or more, but less than 80 percent, the distribution would fall within the band if the other corporation’s Nonbusiness Asset Percentage is less than 30 percent.

If both prongs of this test are met, that is, if the Nonbusiness Asset Percentage for either Distributing or Controlled is 66 2/3 percent or more and the Nonbusiness Asset Percentages of Distributing and Controlled fall within one of the three bands, the distribution would be a per se device.

Minimum Size for Active Business

The Code does not literally provide a minimum absolute or relative size requirement for an active business to qualify. Nevertheless, the IRS has determined that the Code requires that distributions have substance, and that a distribution involving only a relatively de minimis active business should not receive favorable tax treatment because such a distribution is not a separation of businesses.

To ensure that these requirements are satisfied, the IRS proposes to add a new regulation to require that the percentage determined by dividing the FMV of each of Distributing’s and Controlled’s corporation’s five-year-active Business Assets by the FMV of its total assets must be at least five percent. These five-year-active-Business Assets would include reasonable amounts of cash and cash equivalents held for working capital and assets required to be held to provide for exigencies related to a five-year-active Business or for regulatory purposes with respect to such a business.

Timing of Asset Identification, Characterization, and Valuation

For purposes of the above rules, the assets held by Distributing and by Controlled immediately after the distribution must be identified, and their character and FMV must be determined.

The FMV of assets would be determined, at the election of the parties on a consistent basis, either (a) immediately before the distribution, (b) on any date within the 60-day period before the distribution, or (c) on the date of an agreement with respect to the distribution that was binding on Distributing on such date and at all times thereafter. The parties would be required to make consistent determinations between themselves, and use the same date, for purposes of applying the device rules and the five-percent minimum Five-Year-Active-Business Asset Percentage requirement.

Conclusion

Generally speaking, the proposed regulations should be welcomed by taxpayers. Although some may disagree with the thresholds established, and with the resulting increased reliance on valuations, the IRS is correct in its approach: the favorable tax treatment afforded by the Code for certain corporate separations is intended to apply only to genuine separations of businesses and business assets. The congressional purpose for adopting the active business requirement was to separate businesses, not to separate inactive assets from a business. Accordingly, when a corporation that owns only nonbusiness assets and a relatively de minimis active business is separated from a corporation with another active business, the substance of the transaction is not a qualifying separation of businesses.

 

Underlying the corporate reorganization provisions of the Code is the principle that it would be inappropriate to tax a transaction as a result of which the participating taxpayers – the corporations and their shareholders – have not sufficiently changed the nature of their investment in the corporation’s assets or business, provided the transaction is motivated by a substantial non-tax business purpose.

Corporate Separations
One of these reorganization provisions allows a corporation (Distributing) to distribute to some or all of its shareholders the shares of stock of a subsidiary corporation (Sub) on a tax-free basis. In general, such a distribution (a “Corporate Division”) may be made pro rata among Distributing’s shareholders (a “spin-off”), it may be made in exchange for all of the Distributing stock held by certain of its shareholders (a “split-off”), or it may be made in complete liquidation of Distributing (a “split-up”), where the stock of at least two subsidiary corporations is distributed.

There are many bona fide business reasons for a Corporate Division. The distribution of Sub may, for example: enable competing groups of shareholders to go their separate ways; shelter one line of business from liabilities that may arise from the operation of another line; permit the issuance of equity to a key employee in one line of business; facilitate borrowing; or resolve problems with customers or suppliers who compete with a line of business.

“Control”
In order to secure favorable tax treatment for a Corporate Division, the transaction must satisfy a number of requirements, among which is the requirement that Distributing must distribute stock of a corporation that it controls immediately before the distribution.

For this purpose, “control” is defined as ownership of stock possessing at least 80 percent of the total combined voting power of all classes of Sub stock entitled to vote and at least 80 percent of the total number of shares of each other class of Sub stock.

Given this “control” requirement, what is Distributing to do where it has determined that there are bona fide business reasons for separating from Sub, and that such a separation would satisfy the other requirements for tax-free treatment (including the requirement that both Distributing and Sub be engaged in an “active trade or business”), but where Distributing owns less than 80% of the voting power and/or number of Sub’s issued and outstanding shares?

Recapitalizations
The IRS has allowed certain recapitalizations of Sub that result in Distributing’s securing the necessary level of control. Some of these recapitalizations, which may themselves be effectuated on a tax-free basis, are illustrated by the following examples:

  • Corp M owned all of the voting common stock and 12% of the non-voting preferred stock of Corp N. Disputes arose among the M shareholders, and it was decided that M would distribute its N stock to one group of M shareholders in exchange for all their M stock. To qualify N as a “controlled” corporation, N issued shares of voting common stock to its preferred shareholders, other than M, in exchange for all their non-voting preferred shares in a recapitalization. After the recapitalization, M owned 93 percent of the outstanding N voting common stock and all of the outstanding N nonvoting preferred stock. M then distributed all of its common and preferred N stock to the departing shareholders in exchange for all their M stock.
  • A owned all the stock of Corp X, which owned 70 shares of the stock of corporation Y. A also owned the remaining 30 shares of Y stock. A contributed 10 shares of his Y stock to X, and, immediately thereafter, X distributed all of its 80 shares of Y stock to A. The IRS determined that X, the distributing corporation, did not have control of Y immediately before the distribution except in a transitory and illusory sense.
  • Corp X owned 70%, and A and B owned the remaining 30%, of the single outstanding class of stock of Corp Y. In exchange for the surrender of all the Y stock, Y issued Class A voting stock to A and B and Class B voting stock to X. The Class A stock issued to A and B represented 20% (a “low-vote” class), and the Class B stock issued to X represented 80% (a “hi-vote” class) of the total combined voting power of all classes of Y voting stock. Following the recapitalization, X distributed all of the Class B stock to its shareholders. The IRS determined that, immediately prior to the distribution, X had control of Y. The transaction was distinguished from the immediately preceding example because the recapitalization resulted in a permanent realignment of voting control of Corp Y.

Relaxed Standard?
Over the last several years, the IRS has recognized situations where the recapitalization that secured the necessary level of control had to be undone due to unforeseen but valid business circumstances. Consequently, it has relaxed its historical requirement that the recapitalization result in a “permanent realignment” of Sub’s capital structure in order for Distributing’s “control” to be respected.

Indeed, the IRS has stated that it will not automatically apply the step transaction doctrine to determine whether Sub was a controlled corporation immediately before a distribution solely because of any post-distribution acquisition or restructuring of Sub.

However, in otherwise applying the step transaction doctrine, the IRS has also stated that it will continue to consider all the facts and circumstances, including whether there was a “legally binding obligation” to undo the recapitalization after the distribution, and thereby render the recapitalization a sham.

In other words, even though the control requirement may be satisfied by an acquisition of control that occurs immediately before a distribution, an acquisition of control by Distributing will not be respected if it is transitory or illusory, as where the unwinding of the recapitalization was a foregone conclusion. The acquisition of control must have substance under general federal tax principles. Thus, the IRS may apply the step transaction doctrine to determine if, taking into account all facts and circumstances (including post-distribution events), a pre-distribution acquisition of control has substance such that Distributing has control of Sub immediately prior to a distribution of the Sub stock.

Revenue Procedure 2016-40
In recognition of the fact that determining whether an acquisition of control has substance for federal tax purposes can be difficult and fact-intensive, and that taxpayers may not be able to determine with sufficient certainty whether such an acquisition may proceed as a step toward an otherwise qualifying transaction, the IRS recently issued guidance that identifies certain “safe harbor” transactions in which the IRS will not assert that an acquisition of control lacks substance. [Rev. Proc. 2016-40]

These safe harbors apply to transactions in which–
(1) Distributing owns Sub stock not constituting control of Sub;
(2) Sub issues shares of one or more classes of stock to Distributing and/or to other shareholders of Sub, as a result of which Distributing owns Sub stock possessing at least 80% of the total combined voting power of all classes of Sub stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of Sub;
(3) Distributing distributes its Sub stock in a transaction that otherwise qualifies as a tax-free Corporate Division; and
(4) Sub subsequently engages in a transaction that substantially restores (a) Sub’s shareholders to the relative interests they would have held in Sub had the issuance not occurred; and /or (b) the relative voting rights and value of the Sub classes of stock that were present prior to the issuance.

The IRS will not assert that such a transaction lacks substance, and that therefore Distributing lacked control of Sub immediately before the distribution, if the transaction is also described in one of the following safe harbors:

  • No action is taken (including the adoption of any plan), at any time prior to 24 months after the distribution, by Sub’s board of directors, Sub’s management, or any of Sub’s controlling shareholders, that would (if implemented) result in an unwind of the recapitalization.
  • Sub engages in a transaction with one or more persons (for example, a merger) that results in an unwind, regardless of whether the transaction takes place more or less than 24 months after the distribution, provided that–
    (1) There is no agreement, understanding, arrangement, or substantial negotiations or discussions concerning the transaction or a similar transaction, relating to similar acquisitions, at any time during the 24-month period ending on the date of the distribution; and
    (2) No more than 20% of the interest in the other party, in vote or value, is owned by the same persons that own more than 20% of the stock of Sub.

Looking Ahead
These safe harbors apply solely to determine whether Distributing’s acquisition of control of Sub has sufficient substance for purposes of effecting a tax-free Corporate Division. The certainty they provide is a welcome development.

However, if a transaction is not described in one of the safe harbors, the determination of whether an acquisition of control has substance, and will therefore be respected for purposes of a Corporate Division, will continue to be made under general federal tax principles without regard to the safe harbors. In that case, Distributing and its shareholders should proceed with caution – they should consult their tax advisers – especially given the adverse tax consequences that may be visited upon them if Distributing’s control of Sub is determined to have been illusory.

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:

 

  1. 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
  2. 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
  3. 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).

No Rulings

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:

  1. 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
  2. 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
  3. 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.