The IRS recently issued a pair of Private Letter Rulings that provide additional insight regarding taxpayers’ ability to have transactions qualify for tax-free treatment under Section 355 of the Internal Revenue Code (the “Code”). These letter rulings are two more in a series of rulings issued under the IRS Chief Office Counsel's pilot program for “no gain or loss” rulings on spin-offs, split-ups, and split-offs that was introduced in 2017 under Rev. Proc 2017-52, 2017-41 I.R.B. 283. This program expanded the scope of letter rulings available for distributions intended to qualify as tax-free under Section 355, a scope which had been limited since 2013 in order to conserve resources pursuant to Rev. Proc. 2013-32, 2013-28 I.R.B. 55.
Under this program the IRS will issue letter rulings on the general federal income tax consequences of a covered transaction, including whether a transaction qualifies as a Section 368 reorganization or meet the requirements of Section 355. The IRS will not, however, rule on certain Section 355 requirements, including whether a transaction is not a device for the distribution of earnings and profits, or if it is carried out for a corporate business purposes.
This pilot program expires on March 21, 2019, at which time the IRS will evaluate its effectiveness and sustainability.
In PLR 201851005, the IRS addressed the tax consequences of separating two businesses within a single publicly traded corporation into two publicly held groups. The IRS held that an internal distribution of assets to a newly formed controlled entity followed by a spin-off would not result in gain for the shareholders of either the parent entity or the spun-off subsidiary. Most importantly, the IRS ruled that a series of post-distribution acquisitions of the parent entity's shares and securities would not be treated as having been acquired in a Section 355(e) acquisition.
Summary of Facts
The taxpayer was a publicly traded corporation and the domestic parent (“Parent”) to a distributing entity (“Distributing”) and an affiliated group of corporations that filed a US consolidated federal income tax return. Parent proposed a series of transactions and sought a ruling on whether they would pass the control test under Section 355.
Distributing directly and indirectly owned all of the outstanding equity interests in numerous corporations, partnerships, and entities that were disregarded for federal income tax purposes (“DRE”s). Prior to the proposed transactions, Distributing was engaged in Business A and Business B, both of which had been operated as an active trade or business for the prior 5 years.
Distributing asserted it had a valid business purpose for wanting to separate the two businesses. To accomplish this purpose it proposed a series of transactions via which it would transfer the Business B assets (the “Internal Distribution”) to a newly created and wholly owned subsidiary (“Controlled”). Distributing would then distribute a percentage of Controlled stock on a pro-rata basis to certain holders of Parent’s stock (the “External Distribution”), while keeping some shares of Controlled (the “Retained Stock”) to facilitate the implementation of appropriate capital structures while preserving the financial strength and liquidity both Parent and Controlled needed to pay debt and fund other obligations.
Once all transactions had taken place, Controlled would be a publicly traded corporation and the parent of an affiliated group of includible corporations for which it would file a consolidated federal income tax return.
With respect to the Retained Stock, Distributing proposed exchanging some or all of these shares for existing debt instruments of Parent (the “Exchange Debt”) either directly with the debt holders or through a financial intermediary (the “Debt-for-Equity Exchange”). Should Distributing use a financial intermediary to implement the Debt-for-Equity Exchange, it would engage one or more investment banks to acquire debt in tender offers to existing debt holders. The tender offers would take place at some point in the future but after the due date for the SEC filings related to the first full quarter after the date of the External Distribution.
Parent also had a share repurchase authorization pursuant to which it had repurchased its shares from the public prior to the External Distribution and could continue to repurchase shares following said distribution in order to achieve an appropriate capital structure and deliver attractive cash returns to Parent's shareholders. It was anticipated that the board of directors of Controlled would also authorize share repurchases. Share repurchases by either the Parent or Controlled are referred to as the “Share Repurchase”.
Section 355 “Control” and Section 355(e)
The transaction proposed by Parent is a divisive “Type D” reorganization followed by a spin-off, which is a type of division in which a corporation makes a pro-rata distribution of a subsidiary’s shares to existing shareholders. The proposed transaction would have to comply with the requirements of both Section 368(a)(1)(D) and Section 355, as well as any judicial requirements, in order to be executed on a tax-free basis. A transaction that meets said requirements will not trigger taxable gain at either the corporate or the shareholder level, but will instead limit gain to any assets distributed other than stock or securities.
After the distribution, either the distributing entity or its shareholders must control the subsidiary immediately after the transfer. Section 355(e) causes a tax-free distribution to be taxable to the distributing corporation if the distribution is part of a plan pursuant to which one or more persons acquire 50% or more of the distributing corporation or any other controlled corporation. Section 355(e) does not cause gain recognition at the shareholder level.
While Section 355(e)(2)(B) establishes a rebuttable presumption that any shares acquired during the two years before or after a distribution are part of a plan, Treas. Reg. §1.355-7(b)(1) indicates that the existence of a plan is based on facts and circumstances. Treas. Reg. §1.355-7(b)(4) further indicates that if the distribution was motivated by a corporate business purposes other than to facilitate the acquisition of shares and would have occurred at approximately the same time and in similar form regardless of whether the acquisition had taken place, the taxpayer might establish that the distribution was not part of a plan.
The IRS ruled that neither any Retained Stock acquired in the Debt-for-Equity Exchange by any investment bank for exchange debt that constitutes Parent Securities nor the Retained Stock acquired by a holder of Parent Securities in exchange for such securities would be taken into account under Section 355(e)(2)(A)(ii) when determining whether a person acquires a 50% or more interest, because these acquisitions were excluded from such count under Section 355(e)(3)(A)(ii).
Pursuant to the facts in this private letter ruling, Distributing represented that the Share Repurchase would be motivated by a business purpose, that the stock to be repurchased would be widely held, and that the Share Repurchase was not motivated by a desire to increase the ownership percentage of any particular shareholder. Distributing also indicated that no shares would be acquired other than the shares acquired pursuant to the programs that had already been established. Any stock purchase or repurchase pursuant to the programs described above could have ostensibly caused a person to acquire a 50% or more interest. However, Distributing also represented that (a) the share repurchase authorization existed both prior to and separate from the proposed transaction, and (b) no share repurchases would represent a 50% or greater interest.
The IRS ruling seems to rely heavily on Distributing’s representations and the fact that Distributing expected to repurchase shares before, after, and regardless of whether the proposed transactions took place. After seemingly taking into account these representations, the IRS ruled that any retained stock acquired in the Debt-for-Equity Exchange by any investment bank for exchange debt that constitutes parent securities would not be counted when determining if a person acquires a 50% or more interest thanks to Section 355(e)(3)(A)(ii). The IRS also ruled that none of the Retained Stock acquired by a holder of Parent Securities in exchange for such securities pursuant to the Debt-for-Equity Exchange nor any portion of the Retained Stock would be treated as having been acquired in a Section 355(e) acquisition.
While this particular ruling does not specifically indicate why the IRS ruled the way it did regarding the Share Repurchase, there are prior IRS rulings that also stand for the proposition that the acquisition of stock in a distributing corporation or any controlled corporation by reason of holding stock or securities in such distributing or controlled corporation pursuant to a previously established program that has a separate business purpose will not count for purposes of Section 355(e). In PLR 201211008, the IRS ruled that an increase in stock ownership in connection with an open market share repurchase authorization that was in effect prior to a Section 355 spin-off would not count against shareholders for Section 355(e) purposes.
This ruling and prior IRS private letter rulings, when combined with the taxpayer’s representations in these rulings, seem to indicate that pre- and post-distribution acquisitions that occur pursuant to an established program that is separate from the proposed transaction and have their own business purpose will not count towards applying Section 355(e) as long as the taxpayer indicates, among other things, that no share purchases will represent a greater than 50% interest.
Summary of Facts
The facts as described in the ruling indicate that an S-corp with both voting and non-voting shares of stock outstanding held by US citizens or US entities was engaged in Business B (“Distributing”). A controlled entity (“Controlled”) was contributed to Distributing as a contribution to capital. Controlled, a subsidiary of Distributing which was engaged in a different business (“Business A”), elected to be treated as a qualified subchapter S subsidiary (“QSub”) disregarded as separate from its owner for Federal income tax purposes under Treas. Reg. § 1.1361-4(a)(i). Both Business A and Business B constituted an active trade or business.
Distributing proposed a transaction in which Controlled would be split-off in order to resolve certain disputes between the shareholders of Distributing, remove certain regulatory restrictions, and allow Distributing and certain of its subsidiaries to focus on Business B.
Prior to the transaction taking place, certain securities and assets would be reallocated amongst the entities so that the fair market value of the shares of Controlled stock that would be distributed to shareholders of Distributing would be approximately equal to the fair market value of the stock of Distributing that they would give up. Certain shareholders of Controlled would then surrender all of their stock in Distributing and would receive new Controlled stock of equal fair market value.
After the proposed distribution, Controlled would be owned only by the recipients of the new stock of Controlled, while Distributing would be owned by the remaining original shareholders. Prospectively the separate entities would have no ongoing relationship, would be in charge of their own administrative functions, and have no overlapping leadership or ownership.
Section 368(a)(1)(D) and Section 355
In a split-off transaction, a subsidiary is distributed to some of its parent’s shareholders in exchange for their shares in the parent/distributing corporation. If the requirements in Section 355 are met, a split-off is tax free to both the distributing and the distributed entities. If the split-off fails to qualify under Section 355, the parent/distributing corporation would be taxed based on the fair market value of the subsidiary stock distributed in redemption of the shareholders’ stock in the parent. In addition, the shareholders receiving the subsidiary stock would be taxed on the redemption of their stock in the parent.
The IRS held that the contribution of Controlled shares, followed by the distribution of the new Controlled shares to that entity’s shareholders, qualified as a tax-free reorganization under Section 368(a)(1)(D). For federal income tax purposes, Controlled would be treated as a new corporation that acquired all of its assets and assumed all of its liabilities from Distributing in exchange for the stock of Controlled.
In addition, no gain or loss would be recognized by any shareholder of Distributing upon receipt of Controlled stock under Section 355(a)(1). The IRS also held that while the distribution of shares of Controlled would terminate its QSub election because it would cease to be a wholly owned subsidiary of Distributing, the momentary ownership by Distributing of the stock of Controlled would not cause Controlled to be ineligible to elect S-corp status for its first taxable year.
As expected, the Ruling indicated that no opinion was expressed regarding business purpose, whether Distributing was a valid S-corp, or whether Controlled was otherwise eligible to be an S-corp, among other things.