Tax Free Corporate Spinoffs Under Section 355: Strategic Separation Without Immediate Tax

Internal Revenue Code Section 355 allows a corporation to separate qualifying businesses without immediately recognizing gain at either the corporate or shareholder level. When properly structured, a tax-free spinoff can improve management focus, accommodate different ownership or financing needs, and separate businesses with different strategic objectives.

The rules are highly technical, however. Failure to satisfy even one requirement can produce substantial corporate-level or shareholder-level tax.

What Is a Section 355 Corporate Separation?

In a traditional spinoff, a corporation distributes stock of a controlled subsidiary to its shareholders, generally on a pro rata basis. The shareholders continue to own stock in the distributing corporation while also receiving stock in the controlled corporation.

Section 355 can also apply to:

• A split-off, in which shareholders exchange some or all of their stock in the distributing corporation for controlled-corporation stock
• A split-up, in which the distributing corporation distributes stock of multiple controlled corporations and then liquidates

If all applicable requirements are satisfied, the shareholders generally recognize no immediate gain or loss from receiving the controlled-corporation stock. The distributing corporation also generally avoids recognizing gain on the distributed subsidiary stock.

This treatment ordinarily defers tax rather than permanently eliminating it. Shareholders generally allocate their existing stock basis between the distributing and controlled corporations based on their relative fair market values following the distribution.

Common Business Reasons for a Spinoff

Potential non-tax business reasons include:

• Separating businesses with different management or operational needs
• Resolving management or shareholder conflicts that interfere with business operations
• Complying with regulatory or licensing requirements
• Allowing one business to raise capital without exposing investors to the other business
• Creating different capital structures for businesses with different financial needs
• Allowing key employees to acquire an ownership interest in one business
• Improving management focus and accountability
• Separating businesses with different risk profiles when an actual distribution is necessary to accomplish that purpose

The business purpose must be specific, credible, and supported by contemporaneous documentation.

Preparing a business for a future investment or sale may also influence a separation, but any anticipated transaction involving new investors or buyers must be carefully evaluated under the device rules and Section 355(e).

Control Requirement

Immediately before the distribution, the distributing corporation must control the subsidiary whose stock is being distributed.

Section 368(c) generally defines control as ownership of stock possessing:

• At least 80% of the total combined voting power of all voting stock; and
• At least 80% of the total number of shares of all other classes of stock

This is not simply an 80%-of-value test.

Capitalization changes, minority investments, preferred stock, warrants, convertible instruments, and equity-compensation arrangements should be reviewed before the distribution because they may affect whether the required control exists.

The control test generally applies immediately before the distribution. The distributing corporation ordinarily relinquishes control when it distributes all of the controlled corporation’s stock to its shareholders.

Distribution Requirement

The distributing corporation generally must distribute all the controlled-corporation stock and securities it holds.

Alternatively, it may distribute an amount constituting control and retain some stock, but it must establish that the retained interest is not part of a plan having a principal purpose of avoiding federal income tax.

The property distributed must generally consist solely of stock or qualifying securities of the controlled corporation. Receipt of cash, other property, nonqualified preferred stock, or excess securities can create taxable gain under Section 356 even when other portions of the transaction qualify for nonrecognition.

The principal statutory requirements appear in Internal Revenue Code Section 355.

Active Trade or Business Requirement

Immediately after the distribution, both the distributing corporation and the controlled corporation generally must be engaged in the active conduct of a trade or business.

Each relied-upon business generally must:

• Have been actively conducted throughout the five-year period ending on the distribution date
• Include active and substantial management and operational activities
• Ordinarily involve the collection of income and payment of expenses
• Not consist merely of holding passive investments
• Not have been acquired during the five-year period in a transaction in which gain or loss was recognized, subject to important exceptions

A business does not necessarily fail the five-year test merely because it expanded, added products, increased capacity, or opened a new location. An expansion of an existing business in the same line may be treated as part of the historic business rather than as a newly acquired business.

Certain nonrecognition acquisitions and intragroup transactions also may not restart the five-year period.

A holding company is not automatically disqualified. Under the separate affiliated group rules, qualifying business activities conducted by controlled subsidiaries may be attributed to the distributing or controlled corporation. Section 355 also contains a special rule for a distributing holding company that distributes qualifying controlled corporations.

The active-business rules are explained further in Treasury Regulation Section 1.355-3.

Corporate Business Purpose Requirement

A Section 355 distribution must be motivated, in whole or substantial part, by one or more real and substantial nonfederal-tax corporate business purposes germane to the distributing corporation, the controlled corporation, or the relevant affiliated group.

A shareholder’s personal planning objective generally is not, by itself, a sufficient corporate business purpose. A shareholder objective may nevertheless support qualification when it is effectively inseparable from a legitimate corporate business need.

The distribution itself must further the stated business purpose. It is not enough for the preliminary transfer of assets to a subsidiary to accomplish the objective.

For example, transferring a risky business into a separate subsidiary might provide the desired liability protection without distributing that subsidiary to shareholders. If the purpose can be accomplished through another practical, nontaxable transaction that does not require a distribution, the distribution may not satisfy the business-purpose requirement.

Federal tax savings are not a qualifying corporate business purpose. The potential for federal tax avoidance is also relevant when determining whether the stated business purpose actually and substantially motivated the transaction.

Prohibition Against Using the Transaction as a Device

The transaction cannot be used principally as a device for distributing the earnings and profits of the distributing corporation, the controlled corporation, or both.

The device determination is based on all facts and circumstances. Evidence of a device can include:

• A pro rata distribution followed by a significant stock sale
• A sale or exchange negotiated or agreed upon before the distribution
• A large percentage of stock being sold shortly after the distribution
• Excess cash, marketable securities, or other assets unrelated to reasonable business needs
• A business that primarily serves the other corporation and can readily be sold without harming that corporation

A strong and immediate corporate business purpose is evidence that the transaction is not a device.

A later stock sale does not automatically disqualify the original distribution merely because it occurs after the spinoff. Nevertheless, the size, timing, and prior negotiation of the sale can create significant risk.

The business-purpose, continuity, and device rules are addressed in Treasury Regulation Section 1.355-2.

Continuity of Shareholder Interest

Section 355 is intended to apply to a restructuring of continuing ownership interests, not a complete cash-out of the historic owners.

One or more persons who owned the enterprise before the separation must, in the aggregate, retain sufficient continuing ownership in each resulting corporate enterprise.

This does not mean every shareholder must own stock in both corporations. For example, a properly structured split-off may result in one group of historic shareholders owning the distributing corporation and another group owning the controlled corporation.

Planned transfers to new owners must be evaluated under both the continuity rules and Section 355(e).

Post-Spinoff Acquisitions and Section 355(e)

Section 355(e) is one of the most important risks in planning a corporate separation.

Corporate-level gain generally results when the distribution is part of a plan or series of related transactions under which one or more persons directly or indirectly acquire a 50% or greater interest—measured by vote or value—in either the distributing corporation or a controlled corporation.

If a 50% acquisition occurs during the four-year period beginning two years before the distribution and ending two years afterward, the acquisition is presumed to be part of a plan unless the taxpayer establishes otherwise.

This does not mean every transaction within two years automatically causes the spinoff to become taxable. Regulations provide detailed facts-and-circumstances rules and several safe harbors. Conversely, waiting more than two years does not provide absolute protection if the distribution and acquisition were actually part of the same plan.

Potentially significant transactions include:

• A sale or merger involving either corporation
• A private-equity or strategic investment
• A substantial stock issuance
• Multiple coordinated stock acquisitions
• Certain asset acquisitions treated as stock acquisitions
• Transactions involving predecessors, successors, or related parties

Section 355(e) generally creates corporate-level gain while shareholder-level nonrecognition under Section 355 may remain available. This is different from a transaction that fails the basic Section 355 qualification requirements entirely.

Common Failure Points

Section 355 problems frequently arise from:

• Applying the wrong 80% control test
• Failing to distribute the required amount of controlled-corporation stock
• Relying on a business that has not been actively conducted for five years
• Acquiring the relied-upon business in a taxable transaction during the five-year period
• Treating passive investment or rental activity as an active business without sufficient services
• Assuming a holding-company structure automatically qualifies or automatically fails
• Using a business purpose that can be achieved without distributing the subsidiary
• Transferring excess cash or investment assets to one of the corporations
• Negotiating a sale or investment before the distribution
• Ignoring the Section 355(e) acquisition rules
• Providing shareholders with cash or other nonqualifying property
• Failing to preserve evidence supporting control, business purpose, valuation, and active operations

A failure does not always produce the same tax result.

When the transaction fails Section 355 entirely, the distributing corporation may recognize gain as though it sold appreciated controlled-corporation stock at fair market value. Shareholders may then be taxed under the applicable distribution or exchange rules, potentially resulting in dividend income, basis recovery, and capital gain.

In contrast, Section 355(e) can impose corporate-level gain even though the shareholders continue to receive nonrecognition treatment.

State and international tax treatment may also differ from the federal treatment.

Documentation and Reporting

A Section 355 transaction generally requires coordinated legal, tax, valuation, and accounting documentation.

Important records commonly include:

• Board and shareholder resolutions
• A detailed corporate business-purpose memorandum
• Five-year active-business histories
• Organizational and ownership charts
• Capitalization and control analyses
• Asset, liability, and employee allocation schedules
• Valuation reports
• Transaction agreements
• Records of communications with potential investors or purchasers
• Documentation addressing Section 355(e) and applicable safe harbors
• Shareholder stock-basis allocation information

The distributing corporation must generally include a statement required by Treasury Regulation Section 1.355-5 with its tax return. Certain significant distributees must also attach a statement to their returns. Additional reporting may apply when the transaction includes a Section 351 exchange or a divisive reorganization under Section 368(a)(1)(D).

The reporting requirements are described in Treasury Regulation Section 1.355-5.

Some taxpayers request an IRS private letter ruling on eligible issues because of the complexity and potential tax exposure. A ruling may address the overall transaction or specific significant issues, depending on current IRS ruling procedures. The IRS does not rule on every factual issue, and a ruling addressing one significant issue may not confirm that the entire transaction qualifies.

Cost-Benefit Considerations

A qualifying Section 355 separation can avoid immediate tax, but it introduces substantial legal, tax, valuation, accounting, governance, and operational costs.

• Professional fees and implementation costs
• Ongoing costs of operating separate corporations
• The risk of corporate-level and shareholder-level tax
• Restrictions on contemplated sales and investments
• Basis-allocation and shareholder-reporting requirements
• State, local, and international tax consequences

Section 355 is a strategic restructuring tool, not a routine method of dividing corporate assets.

Final Thought