Corporate Divisions Under Section 355

Originally published July, 2003. To read this article in full, please click on the link at bottom of page

TABLE OF CONTENTS

1. INTRODUCTION

   1. In General

   2. Historic Focus

   3. Current Importance

   4. Future of Section 355 -- Subchapter C Study

   5. Significant Developments

2. SECTION 355 -- OVERVIEW

   1. Tax-Free Division

      1. Types of tax-free divisions

      2. Division of one or more businesses -- "D" reorganization

   2. Tax Consequences of a Section 355 Transaction

      1. No shareholder-level gain

      2. No corporate-level gain

      3. Gain on the distribution of boot

      4. Basis of stock and securities

      5. Tax attributes

3. REQUIREMENTS UNDER SECTION 355

   1. In General

      1. Statutory requirements

      2. Non-statutory requirements

      3. Interrelationship between requirements

   2. Control Requirement

      1. In general

      2. Definition of control

      3. Control in a "D" reorganization

      4. Control and application of the step-transaction doctrine

   3. Device Restriction

      1. In general

      2. Evidence of a device

      3. Evidence of nondevice

      4. Transactions not ordinarily considered a device

      5. Additional factors not contained in the regulations

   4. Five-Year Active Trade or Business Requirement

      1. In general

      2. Statutory requirements for an active trade or business -- Generally

      3. Trade or business

      4. Active conduct

      5. Percentage of total assets that must be related to the active business

      6. Five-year period

      7. Acquisition of a trade or business, or of control of a corporation conducting

         a trade or business, in a transaction without any gain or loss

      8. Division of a functionally integrated business

      9. Direct vs. indirect conduct of a business

   5. Distribution of All or Substantial Ownership in the Controlled Corporation

   6. Business Purpose Requirement

      1. In general

      2. Corporate vs. shareholder purpose

      3. Business purpose for the distribution

      4. Relation to device test

      5. Ruling guidelines

      6. Specific business purposes

   7. The Continuity of Interest Requirement

      1. In general

      2. Degree of continuity

      3. Post-distribution continuity

      4. Pre-distribution continuity (i.e. historic continuity)

      5. Continuity in both the distributing and the controlled corporations

      6. Continuity issues arising from the division of a subsidiary as part of a "D" reorganization

   8. Continuity of Business Enterprise Requirement

1. Section 355(d) Issues

   1. In general

   2. Disqualified distributions

   3. Disqualified stock

   4. Stock acquired by purchase

   5. Fifty-percent test

   6. Purpose exception

      10. Section 355(e)

   1. In General

   2. Intragroup Spin-offs - Section 355(f)

   3. Temporary regulations under section 355(e)

   4. Examples

4. PLANNING TRANSACTIONS/ALTERNATIVES TO SPIN-OFFS

   1. "Synthetic" Spin-Offs

   2. Subsidiary Tracking Stock

   3. Dividend Followed by Public Offering

   4. Option to Purchase Corporate Assets

   5. Transaction to Thwart Hostile Takeovers

5. REQUESTING A PRIVATE LETTER RULING UNDER SECTION 355

   1. In General

   2. Checklist

   3. Change in Facts

6. APPENDIX A

   I. INTRODUCTION

   A. In General. Generally, corporate distributions of appreciated property are subject to tax on the amount by which the property's value exceeds the corporation's basis in the property. Under section 355 of the Internal Revenue Code of 1986, as amended (the "Code"), however, the distribution of stock of a subsidiary that is "controlled" by the distributing corporation may not be subject to tax either at the corporate level or to the recipient shareholders, provided a number of requirements are met.

   2. Historic Focus

      1. Traditionally, the focus under section 355 of the Code has been whether the transaction has been undertaken by the shareholders as a "device" in order to bail out earnings and profits at favorable capital gains rates.

      2. Even in the absence of a rate disparity, the device issue remains relevant. A dividend distribution is taxed currently while a section 355 transaction is tax free. Moreover, a dividend is generally fully taxed (without recovery of any basis) while a transaction structured under section 355 followed by a sale permits the selling shareholder to recover basis. Furthermore, section 355 enables a distributing corporation to avoid the impact of the repeal of the General Utilities doctrine by the Tax Reform Act of 1986 (the "1986 Act").

   3. Current Importance

      1. The repeal of the General Utilities doctrine resulted in most distributions of appreciated property being subject to a corporate-level tax. Section 355 transactions are one of the few exceptions to this general rule. Accordingly, section 355 remains as one of the few valuable planning tools after the 1986 Act for avoiding the imposition of corporate-level tax on a distribution of stock of a subsidiary corporation.

      2. However, this planning tool has been severely limited by several subsequently enacted provisions.

         1. Congress has given the Internal Revenue Service (the "Service") broad regulatory authority under section 337(d) of the Code to prevent the avoidance of the tax consequences of the General Utilities repeal; i.e., the imposition of a corporate-level tax upon the distribution of appreciated property. This regulatory authority may be used to thwart section 355 transactions structured to avoid the imposition of corporate-level tax.

         2. In addition, section 355(d) imposes a corporate-level tax on section 355 distributions if, immediately after the distribution, a shareholder holds a 50-percent or greater interest in the distributing or controlled corporation that is attributable to stock acquired by purchase within the preceding five-year period.

         3. Moreover, the Taxpayer Relief Act of 1997 ("TRA 1997"), which added section 355(e) and (f), essentially eliminated tax-free "Morris Trust" transactions.

            (1) Section 355(e) provides for a corporate-level tax on section 355 distributions that are part of a plan (or series of related transactions) pursuant to which one or more persons acquire directly or indirectly stock representing a 50- percent or greater interest in the distributing corporation or any controlled corporation.

            (2) Section 355(f) provides that section 355 will not apply to the distribution of stock from one member of an affiliated group to another member if such distribution is part of a plan described in section 355(e).

         4. TRA 1997 also granted the Service authority to provide adjustments (under section 358) to the adjusted basis of stock in the case of intragroup distributions to which section 355 applies, in order to appropriately reflect the proper treatment of such distributions.

      3. Regulations

         1. The current regulations, which were issued in 1989 and modified the original 1955 regulations, do not directly address the repeal of the General Utilities doctrine and its impact on section 355. However, many of the modifications that were made reflect the impact of General Utilities repeal.

         2. These regulations appeared to shift the emphasis of section 355 from the device restriction to the business purpose requirement, substantially tightening the business purpose requirement. Moreover, the regulations clarified the continuity of interest test, and made certain changes in the device and active trade or business tests.

         3. The regulations do not, however, reflect the amendments to section 355 made by the Revenue Act of 1987 (the "1987 Act") or the Technical and Miscellaneous Revenue Act of 1988 (the "1988 Technical Corrections Act").

         4. Final regulations have been issued under section 355(d), and revised temporary and proposed regulations have been issued under section 355(e). The revised temporary and proposed regulations under section 355(e) address the issue of what constitutes a plan or series of related transactions. Additional regulations under section 355(e) and regulations under section 358 are expected in the...