The IRS announced in Rev. Proc. 2016-45¹ that it will once again issue private letter rulings on issues of corporate business purpose and device under §355, after a hiatus of 13 years. Section 355 provides rules for the tax-free division of a corporation into two or more corporations if each of the requirements of §355 are satisfied. Such divisions can take the form of a spin-off, a split-up or a split-off. Two key prerequisites to tax-free treatment are that (a) there must be a valid corporate business purpose for the division and (b) the distribution of one or more of the resulting corporations must not be a device for the distribution of earnings and profits.
The IRS previously would rule on issues of business purpose and device and had set out in Rev. Proc. 96-30² various factors to be addressed in a ruling request with respect to these issues, as well as other issues under §355. However, in Rev. Proc. 2003-48³ the IRS announced that it was ceasing to rule on issues of corporate business purpose and device, which was initially to be for a trial period of one year but was ultimately continued for more than a decade. Instead, taxpayers seeking a ruling with respect to a corporate division were required to represent to the IRS that the transaction was motivated by a valid business purpose and was not a device for the distribution of earnings and profits. As a result, taxpayers were essentially relegated to seeking some measure of comfort through a legal opinion of counsel as to these two important conditions to tax-free treatment.
While the no rule policy had a chilling effect on all corporate divisions it was particularly harsh on smaller transactions which may not have had the budget for a legal opinion or where greater certainty of outcome is desired. The announcement that the IRS will once again rule on business purpose and device issues is therefore welcome news. The IRS did caution that it may decline to issue a ruling letter on these issues when appropriate in the interest of sound tax administration or on other grounds when warranted by the facts of a particular case.
The business purpose must be a real and substantial business purpose (other than federal tax purposes) germane to the business of the corporation.
One fact pattern often recognized as providing a corporate business purpose for a corporate division is where there is disagreement among shareholders as to the involvement of the corporation in, or expansion of, different businesses. For instance, in Rev. Rul. 2003-524, which was issued shortly before the IRS ceased to rule on business purpose, the IRS addressed the proposed corporate division of a family owned corporation which was engaged in both the livestock and grain businesses. The stock was owned by a father, mother, son and daughter. The son wanted to expand the livestock business whereas the daughter thought the corporation should concentrate on the grain business. Because of the differences among the son and daughter the father and mother desired to bequeath the livestock business to their son and the grain business to their daughter. They were also concerned that the common ownership by son and daughter of both the corporate businesses of farming and grain production may lead to family discord, particularly because the son did not get along with the daughter’s husband. It was proposed that the corporation spin-off a new corporation conducting the livestock business 50% to the son, in exchange for his interest in the distributing corporation, and 50% to the parents. Thereafter, the distributing corporation engaged in the grain business would be owned 50% by the daughter and 50% by the parents. The IRS concluded that there was an adequate business purpose of elimination of disagreement of the siblings over development of the businesses and to allow them to devote their undivided attention to their respective business, despite the fact that there was also a non-corporate purpose of furthering the personal estate planning of the parents and promoting family harmony.
Other §355 business purposes which have historically been recognized include:
- Providing an equity interest in one of the divided corporations for key employees of that divided business;
- Fit and focus issues where common ownership of different businesses within a corporation lack a synergy or stifle the potential growth of one or both of the businesses;
- Division of separate businesses in order to facilitate corporate borrowing as to one or both of the businesses;
- Division of businesses in order to facilitate raising equity capital;
- Division of businesses to achieve overall cost savings (including savings of state taxes or other non-federal taxes);
- Division of businesses in order to address certain competition issues;
- Reduction of risk of one of the businesses; and
- Division in order to facilitate a tax-free acquisition of one of the resulting corporations.
Although these general fact patterns, among others, have provided the basis for favorable rulings on business purpose in the past, the devil is in the details in determining whether the requisite business purpose exists in a particular transaction.
Section 355 precludes tax-free treatment on a corporate division transaction used principally as a device for the distribution of earnings and profits of one or more corporations. A typical transaction to which the device prohibition applies is where a spin-off of one or more corporations is undertaken in order to permit the shareholders to sell one of the corporations at capital gains rates while retaining the other corporation.
A failure to satisfy the requirements of §355 on a corporate division can lead to a tax at the corporate level, and again at the shareholder level. Thus, obtaining a private letter ruling in advance is wise insurance against such a potentially disastrous tax result.
For any questions regarding requesting a private letter ruling or effectuating a Section 355 corporate division, please contact Tom Hineman at 214-744-3700.
21996-1 CB 696
32003-2 CB 86
42003-1 CB 960