On September 25, 2018, the IRS announced that it is undertaking a study regarding the application of the five-year active trade or business requirement of Section 355(b) (the “ATB Requirement”) to entrepreneurial ventures whose activities consist primarily of research and development (“R&D”) and that have not yet generated any operating income.
Spin-Off Transaction Background
Section 355 generally permits a corporation (the “Distributing Corporation”) to make a tax-free distribution of a controlled subsidiary (the “Controlled Corporation”) to its shareholders provided that various technical requirements are satisfied. One such requirement is that both the Distributing Corporation and the Controlled Corporation must be engaged in a trade or business that has been actively conducted for at least five years. Pursuant to Treasury regulations related to the ATB Requirement, the activities undertaken “ordinarily must include the collection of income and the payment of expenses.” The requirement to collect income has historically precluded tax-free spin-offs of early stage and R&D-focused businesses, as the IRS has formally and informally stated that some income must have been earned during the five-year period preceding the spin-off in order to satisfy the ATB Requirement.
Potential IRS Guidance
In the statement, the IRS announced that it is undertaking a study with the hope of issuing future guidance to address whether a business may satisfy the ATB Requirement if entrepreneurial activities are engaged in with the purpose of earning income in the future, despite no current income collection. While noting that it does not intend to issue industry-specific guidance, the IRS referenced the pharmaceutical and technology fields where there are extensive R&D efforts to develop products with the purpose of earning income in the future from sales or licenses. These entrepreneurial ventures consist of significant financial expenditures and operational and managerial functions despite the current lack of income. In these cases, all factors point to the establishment of an active trade or business, except the lack of income, and the IRS is considering guidance to potentially relax this income requirement.
Opportunity for Private Letter Rulings
Equally significant, in the statement, the IRS announced that, pending guidance, it will entertain requests for private letter rulings regarding whether such R&D businesses that have not collected income satisfy the ATB Requirement. The statement encourages taxpayers and their advisers to request pre-submission conferences to discuss requests for rulings on these matters.