REIT Spinoffs: Passive REITs, Active Businesses, Part 2

3. SECTION 355 ISSUES

In addition to the many real estate investment trust issues discussed in the previous sections, REIT spinoffs implicate the provisions of section 355. Just as important as SpinCo's REIT qualification is the tax-free qualification of the distribution of SpinCo stock.222 Parent's contribution of assets to SpinCo and the distribution of SpinCo's stock must qualify as a section 368(a)(1)(D) reorganization (D reorganization). A D reorganization includes a corporation's transfer of all or part of its assets to another corporation if, immediately after the transfer, the transferor corporation or one or more of its shareholders, or any combination thereof, has control of the transferee corporation and the stock of the transferee corporation is distributed in a transaction qualifying under section 354, 355, or 356.223

1. Spinoff Policy Analysis

Congress granted tax-free treatment to spinoffs (and split-offs and split-ups) in 1924224 on the belief that they generally represent a mere change in the form of investment.225 However, Congress quickly determined that some taxpayers were using the original spinoff provision to avoid the dividend tax, as shown most prominently by Gregory v. Helvering.226 The taxpayer in Gregory owned a corporation that held appreciated stock. To avoid a taxable dividend of the appreciated stock, the taxpayer caused her corporation to transfer the appreciated stock position to a new subsidiary and distribute that subsidiary's stock to the taxpayer in a putative reorganization (that is, a spinoff). The taxpayer promptly liquidated the new corporation and paid tax on the appreciated stock position at a lower capital gains rate.227 Although the Supreme Court ultimately concluded in 1935 that the transaction was ''a mere device . . . to transfer a parcel of corporate shares to the petitioner'' and denied reorganization treatment,228 Congress had already acted the year before to preclude spinoffs from qualifying as reorganizations.229

In 1951 Congress restored tax-free treatment to spinoffs that satisfied significant new restrictions.230 A spinoff would be tax-free only if (1) the distributing and controlled corporations intended to carry on business after the separation, and (2) the transaction was not a device for distributing the earnings and profits of any party to the reorganization.231 The regulations already imposed a business purpose test.232 These core requirements, modified and supplemented by others, have formed the crux of the test for a spinoff's tax-free qualification ever since.

Initially, several policy arguments might be raised against allowing REIT spinoffs to qualify under section 355. For example, some might contend that a spinoff coupled with SpinCo's REIT conversion allows appreciated assets to leave corporate solution, in conflict with the general policy of imposing a tax in those instances, as in Gregory, and inconsistent with the repeal of the General Utilities doctrine.233 Of course, REITs can be, and indeed most are, corporations for legal purposes,234 and if a REIT transfers property out of corporate solution during the 10-year period after a conversion, the REIT generally will be subject to corporate tax on the portion of the built-in gain attributable to the period when the REIT was a C corporation.235 Although this policy does not completely foreclose the possibility of built-in gain eventually escaping entity-level taxation, it nonetheless is a lengthy restriction that represents a balanced approach by Treasury on where best to draw the line when a C corporation converts to REIT status.236 The separate fact that the REIT generally avoids corporate income tax on its future rental income occurs by design under the REIT rules and should not implicate any section 355 policies, assuming there is at least one valid business purpose for SpinCo's distribution, as is usually the case.

It might also be argued that section 355 should apply only when there is no or a minimal continuing...