Tax-free spinoffs have long been one of the most efficient tax methods to separate two “active businesses” that are owned by a single corporate group. Issued in the 1950s, Revenue Rulings 57-464 and 57-492 required that each business generate income to qualify as an “active business.” This interpretation has made it difficult for businesses operating in modern research-intensive industries, such as pharmaceuticals and biotechnology, to satisfy the “active business” requirement during their research and development phase before they generate income.
Recently, on March 21, 2019, the IRS issued Revenue Ruling 2019-9 suspending Revenue Rulings 57-464 and 57-492 pending a completion of an IRS study to determine whether a business can qualify as an “active business” while entrepreneurial activities take place with the purpose of earning income in the future before any income is collected. Taxpayers are awaiting definitive guidance with cautious optimism that the parameters of tax-free spinoffs may be expanded in the future for the benefit of research-intensive industries.
Making good on their promise to conduct a study of the importance of income in active businesses, the IRS issued a detailed information request this month in support of its pending study. The information request confirmed that the Treasury Department and the IRS have given serious consideration to the types of business operations that might be candidates for active business status in the absence of sustained income. As the IRS notes, Treasury regulations provide that an active business “ordinarily must include the collection of income.” Historically the government has required the active business to continuously collect income for at least five years, with occasional exceptions for extraordinary circumstances such as economic factors, seasonality of the business, or natural disasters outside the control of the company. As entrepreneurial ventures increasingly obtain third-party funding to extend their research and development (R&D) cycles and so retain their non-income producing status longer, the government has begun to refocus on the necessity of income.
The government appears to be sketching the contours of an exception to the income requirement, based on the type of information being requested. More specifically, the IRS is preliminarily focused on four buckets of information:
First, the IRS asks whether only certain industries (or segments of industries) have unusually long R&D cycles and whether any non-R&D based entrepreneurial businesses have a long ramp-up to income collection. With respect to all non-income producing businesses, the IRS asks for detail as to how ventures in those industries are customarily formed and operated, e.g., whether it is possible to predict the length of the pre-income cycle, what level and scope of activities are required to complete each stage of the cycle, whether the cycle is dependent upon regulatory approval(s), and finally, whether it is possible to collect income in advance of product sales, based on the achievement of regulatory milestones or otherwise.
Second, the IRS seeks to understand the extent of the ventures’ actual operational and managerial activities and whether those activities are performed by direct employees or outsourced to independent contractors. The IRS is requesting information regarding the proportion of direct and outsourced activities and, even more specifically, the number of people, hours worked, and amounts paid with respect to direct and outsourced activities.
Third, the IRS is collecting information as to how the early stage expenses are funded and by whom, e.g., by grants, third-party debt, or third-party equity raises. The IRS is also interested in the likelihood that the pre-income activities of either company could be interrupted or terminated due to insufficient capital or other reasons and whether there is a point in the R&D cycle that a go-forward decision is likely to be made. In addition, the IRS seeks to understand the situations in which an R&D venture might benefit from separating its various activities.
Fourth, the IRS asks how likely it is that either the distributing or distributed company would provide services to, or have continuing business relationships with, the other company after the distribution. This request for information indicates that the IRS is also considering whether a lack of income would signal an inability to satisfy other requirements for a spinoff. This concern may arise because each company involved in a distribution must be able to operate independently in order for the distribution to qualify as tax-free; this requirement could pose an additional challenge, for example, to an R&D company that has minimal back-office capacity and might lack the funding to build that capacity after a distribution.
Taken together, these questions indicate that the IRS may be willing to rule that some non-income producing businesses constitute active businesses. A good candidate for a ruling would be a business that is managed and operated by at least some of its own employees, has reached a point in its development cycle and secured sufficient third-party funding to give the IRS comfort that the company is likely to reach the end of its R&D cycle, and has the ability to operate as a standalone business after the distribution.