RSM Resources

Key points and opportunities
Recently proposed regulations for determining whether acorporate distribution of a controlled subsidiary meets the active trade orbusiness requirement of IRC § 355 provide clarification, surprising results,and opportunities.  If finalized, theregulations would change the long standing IRS position on business expansionsthough stock acquisitions and could expand taxpayers’ ability to utilize IRC §355.  In addition, the proposedregulations address another historically contentious issue; the attribution ofan active trade or business to a corporation.   

Background
IRC § 355 provides for the tax-free distribution of acontrolled subsidiary’s stock (C) to a shareholder of the distributingcorporation (D).  There are a number ofrequirements for qualifying such a distribution for tax-free treatment.  One of those requirements is that both D andC are engaged in an active trade or business (ATB).  IRC § 355(a)(1)(C). 

The ATB requirement is met if both D and C are engaged in anactive trade or business immediately after the distribution.  IRC § 355(b)(1).  In general, the business being relied upon tosatisfy the ATB requirement must have been operated by the taxpayer immediatelyprior to the distribution, and the ATB must not have been acquired within thefive year period prior to the distribution in a transaction in which gain orloss was recognized.

The Tax Increase Prevention and Reconciliation Act of 2005(TIPRA) created IRC § 355(b)(3), and significantly changed how the ATBrequirement is determined for D and C.  UnderIRC § 355(b)(3), the ATB requirement is met if both the distributing andcontrolled separate affiliated groups (DSAG or CSAG) are engaged in an ATB.  A separate affiliated group is defined as agroup of affiliated corporations as defined in IRC § 1504(a) if either D or C wasthe common parent.  The change was intendedto eliminate the need for taxpayers to restructure an existing corporationsolely for the purpose of meeting the ATB requirement.

Recent Guidance
On May 4, 2007 the IRS issued proposed regulations(REG-123365-03) under Reg. § 1.355-3. The proposed rules are intended to operate within the intent of IRC §355(b)(3), while admittedly perhaps not within the literal statutorylanguage.  Under the proposedregulations, a “corporation will not be treated as engaged in the activeconduct of a trade or business unless it (or its SAG, or a partnership fromwhich the trade or business assets and activities are attributed) is theprincipal owner of the goodwill and significant assets of the trade or businessfor Federal income tax purposes.”  Prop.Reg. § 1.355-3(b)(2)(iii).  In line withthe statute, all corporations included in the DSAG and CSAG respectively arelooked at as a single corporation for purposes of satisfying the ATBrequirement within the SAG. 

Expansion through Stock Acquisition
In general, a corporation is considered to expand anexisting ATB rather than acquire a new ATB by an asset acquisition when thefacts clearly establish that the acquired assets are in the same line ofbusiness as the existing ATB.  Asignificant clarification or perhaps even change in the IRS position is theproposition that the acquisition of control, as defined in IRC § 1504(a), of asubsidiary can represent an expansion of an existing business.  The proposed rules treat the acquisition ofcontrol of a subsidiary as the acquisition of the underlying assets of thesubsidiary, and as such, a mere expansion of the existing business.  This is the case whether or not the stock wasacquired in a transaction in which gain or loss was recognized. 

Consider the following example in which D is a holdingcompany that wholly owns S1, which has operated a hardware store for >5years.  D acquires C, which has operated ahardware store for >5 years, in a taxable acquisition.  Assuming the activities are virtually thesame, the acquisition represents an expansion of the DSAG business.  In Year 2 D distributes C to X (a Dshareholder) in exchange for all of X’s D shares.  Assuming all other requirements are met, thedistribution of C qualifies as an IRC § 355 split up despite the fact that Cwas acquired in a taxable transaction within the previous 5 years.

The result seems too good to be true; however, questionsremain.  First, economic substancesurrounding the acquisition of C must be considered for potential taxavoidance, and second, the distribution may run afoul of IRC § 355(a)(3)(B),which treats stock of controlled acquired within 5 years in a taxabletransaction (hot stock) as taxable boot to the shareholder.  The application of IRC § 355(a)(3)(B) couldcause the seemingly absurd result of a fully tax-free distribution to D and C,and fully taxable to distribution to X. The IRS and Treasury do not have a position on how the proposedregulations affect the application of hot stock in an expansion transaction andhave requested comments. 

However, it would seem reasonable to conclude that the stockshould be ignored in the application of IRC § 355(a)(3)(B) in the same manneras it is for IRC §§ 355(b); however, without further guidance such a conclusionwould seem contrary to the statutory guidance, and therefore not a strongposition.  A better approach for ataxpayer would likely be to request a private letter ruling on the issue fromthe IRS.  

Attribution of Activities
In addition to the separate affiliated group rules, the proposedregulations address the attribution of ATB activities to the DSAG andCSAG.  In general the corporation mustconduct the ATB; however, there are circumstances where the ATB activities areattributed to the corporation even though it is not directly operating theATB.  Attribution generally occurs in twoareas: 1) attribution from partnerships and 2) attribution of activity fromrelated entities. 

With a partnership, the ATB is attributed to a partner only duringthe period the partner owns a significant interest or a meaningful interest.  In defining a significant interest, thepreamble cites an example within Reg. § 1.368-1(d)(4)(iii)(B)(1), whichprovides that a one-third interest is significant (relating to the IRC § 368COBE requirement).  With respect todetermining if an interest is meaningful, the proposed rules look to whetherthe partner performs active and substantial management functions of the ATB andowns less than a significant interest. In addition, an ATB of a lower tier partnership can be attributedthrough the upper tier partnership; however, an ATB of a corporation whose stockis owned by a partnership is not attributed to the partners.