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IRS rules on implications for the active trade or business requirements of Section 355

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Tax Hot Topics: Active trade or business requirements of Section 355The IRS recently ruled in a private letter ruling (PLR 201551009) on the implications of gain recognition under Section 751 in the context of a Section 355 spinoff.  

Under the PLR, a parent corporation (Distributing) and its wholly owned subsidiary corporation (Subsidiary) owned collectively all of the outstanding interests in an entity treated as a partnership (LP). LP owned Business A, which was housed in several limited liability companies (LLCs) that were disregarded as separate from LP. Distributing and LP engaged in the following steps:

First, LP contributed various assets (including disregarded entities) that comprised Business A to a newly formed C corporation (Controlled) in a transaction intended to qualify as tax-free under Section 351. Second, LP distributed the stock of Controlled to Distributing in a distribution in partial redemption of Distributing’s interest in LP, in which gain may have been recognized under Section 751. Third, Distributing, in turn, distributed Controlled’s stock to Distributing’s shareholders in a transaction intended to qualify as a tax-free spinoff under Section 355.

Section 355(a) generally provides that a distributing corporation can distribute stock and securities of a controlled corporation to its shareholders tax-free. Section 355(a)(1)(B), however, limits the general rule when the distribution is used principally as a device for the distribution of earnings and profits of the distributing corporation or the controlled corporation. The active trade or business requirements of Section 355(b) further enforce the prohibition of a distribution principally used as this type of device.  

Section 355(b)(2)(B) provides that an active trade or business must be actively conducted by both the distributing corporation and the controlled corporation throughout the five-year period ending on the date of the distribution. Section 355(b)(2)(C) provides that such active trade or business cannot be acquired within the five-year period in a transaction in which gain or loss was recognized in whole or in part.

Distributing acquired Controlled, which owned Business A, in a taxable distribution in which gain may have been recognized under Section 751. Though the PLR didn’t provide a detailed analysis, the IRS nevertheless concluded that the gain recognition from the Section 751 distribution wouldn’t prevent the distribution of Controlled by Distributing to its shareholders from satisfying the active trade or business requirements of Section 355(b).

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