Facts: Former Parent owned Parent, which owned Controlled, which owned Sub 1, which owned Distributing. At the end of the day, but before the investment in Controlled, the corporations were to be rearranged to look like this: Former Parent is separated; Parent now heads the group and owns Controlled, which owns Sub 1; and Parent also owns Distributing. In other words, somehow Controlled and Distributing must become brother-sister corporations under Parent, so that when Controlled disaffiliates, the new investor does not get an interest in Distributing.
To arrive at that structure, Sub 1 does what looks like a B reorganization with Parent, swapping all of its Distributing stock for some Parent stock. (This is not a great plan, because it puts some of Parent’s stock in the chain of which the investor in Controlled will obtain part ownership.) At this point Former Parent owns Parent, which owns Controlled and also owns Distributing. Observe that the investor now could invest in Controlled and not thereby obtain an interest in Distributing.
However, that is not exactly the way it happened. Before that, Parent created Merger Sub, and contributed Controlled to Merger Sub, and then Sub 1 pushed the stock of Distributing up to Parent, and then Merger Sub merged into Distributing. This merger step had the result of inverting Controlled under Distributing. At this point Former Parent owns Parent, which owns Distributing, which owns Controlled, which owns Sub 1. The investor could, at this point, invest in, and cause disaffiliation of Controlled, without obtaining an interest in or disaffiliating Distributing. However, evidently Parent did not want Distributing to be in the joint venture with the investor. Therefore, two final steps occurred: first Former Parent distributed Parent to the shareholders (we are not told why), and then Distributing distributed Controlled to Parent.
It is true that pushing up Distributing did not put Distributing in the position of being a distributing corporation, which necessitated putting Controlled under Distributing through the merger of Merger Sub into distributing. But that only meant that Distributing had to distribute Controlled to Parent so that they would (again) be brother sister corporations. The internal spin-off that caused the need for the ruling does not seem to have been necessary, but evidently it was, for some reason.
The taxpayer represented as to the final internal spin-off: “The Spin-Off was carried out for the following corporate business purposes: creating a more efficient capital structure and decreasing the administrative burden of complying with the State B regulations applicable to Business A. The distribution of the stock of Controlled was motivated, in whole or substantial part, by one or more of these corporate business purposes.”
The Ruling: The IRS ruled (taking 7 months to do so, an unusually long time) that the internal spin-off was a good section 355 spin-off. The described transactions had already occurred; this was not a ruling issued on a planned transaction. It is likely that the ruling had to be obtained because the investor in Controlled was nervous about the tax-free nature of the internal-spin off (maybe the investor couldn’t figure out why the Merger Sub step was used either).
What would have made the investor nervous? It would not be the effect of the prospective disaffiliation of Controlled, because that was not part of the ruling. Although unclear, it appears that the concern was Controlled’s 5 year active trade or business; the section 355(b) requirements.
The ruling states that Controlled had issued preferred stock that was redeemed within the five years preceding the internal spin-off. Even pure preferred stock is not disregarded for purposes of the DSAG and CSAG constructs in Prop. Reg. 1.355-3. Therefore, Controlled may have entered the DSAG within five years of the internal spin-off, when the preferred stock was redeemed. Distributing and Controlled shared the same trade or business. Therefore, under the proposed regulation, entering the DSAG could be treated as an expansion. See Cummings, The New Section 355(b) Active Trade or Business Proposed Regulations, JTAX (Aug. 2007). Those regulations are not yet in effect, so if you want assurance that they apply to your case, you need a ruling.
Or maybe the problem was something else.