The Spin on Corporate Spin Offs

Albert and Bertram have been business partners for decades. Their S Corporation, Celestial Builders, Inc., constructs homes and small commercial properties for its owner-user clients. Over a period of years, the corporation purchased several parcels of real property and built its own commercial properties to hold for rental income.

At present, Celestial Builders continues to build for clients with its staff supervised by Albert, and Bertram oversees a staff that manages and leases the commercial properties. The value of the construction component of the corporation is approximately equal to its equity in its real properties.

More recently, Albert and Bertram have disagreed on the proper management of the two disparate components of Celestial Builders. Albert is not pleased with Bertram’s management of the commercial property, because he believes rents should be higher and management expenses lower. Bertram disagrees with Albert’s cost estimates on new construction jobs and believes the workers are not managed properly. Both want to apply Celestial Builders’ resources to their own areas of the business and phase out the area of the other owner. Each seeks a simple way to pass his share of the corporate assets to his next generation without involving the other’s family.

If one owner buys out the interest of the other in one of the businesses, he will incur substantial capital gains. The Internal Revenue Code¹ may help their situation. IRC §368 provides for tax-free treatment of various corporation changes, such as a merger or consolidation of corporate entities,² the acquisition of stock of one corporation by another in exchange for its stock,³ or a change in only the form (C or S Corporation), name or place of organization of a single corporation.⁴ So long as the corporate changes are not veiled efforts to distribute corporate earnings to shareholders, the IRC permits many tax-free corporate reorganizations.

A divisive corporate reorganization under IRC §368(a)(1)(D) involves a transfer by one corporation (the “transferring corporation”) of all or part of its assets to another corporation (the “acquiring corporation”), also known as a “D” reorganization or a “spin-off.” A corporate spin-off qualifies for non-tax treatment if:

1. Distribution of stock. A corporation distributes stock in a corporation it controls to its shareholders.⁵
2. Active conduct of a trade or business. Both the transferring and acquiring corporations are engaged, immediately after the distribution, in the active conduct of a trade or business that was actively conducted by the transferring corporation throughout the 5-year period ending on the date of distribution.⁶ If one line of business was acquired during the 5-year period in a taxable transaction, it will not qualify for non-recognition treatment.⁷ The ownership, operation and leasing of real property is not considered the active conduct of a trade or business, unless the owner performs significant services in the management of the property.⁸ If the owner secures tenants and manages the properties with its own employees, it is deemed engaged in the active conduct of a trade or business.⁹ If however it engages a management company to locate tenants, collect rents, manage repairs, and pay expenses, while the owner only collects its allocated portion of the rents, it likely is not deemed engaged in the active conduct of a trade or business.¹⁰
3. Not a disqualified investment corporation. Neither the transferring corporation nor the acquiring corporation can be a disqualified investment corporation with the fair market value of its investment assets being two-thirds or more of the value of all its assets.¹¹
4. Not a device to distribute earnings and profits. If (a) substantial cash is distributed from one of the corporations to the shareholders on a pro-rata basis, or (b) assets are utilized that were not used in the trade or business, or (c) one of the shareholders sells his corporation soon after the transfer, the transaction likely will not qualify as a tax-free spin-off.¹² Adjustments to the values of the respective corporate assets may be made through the assumption of loans.¹³
5. Business-purpose requirement. The spin-off must be carried out for one or more corporate business purposes.¹⁴ The purpose must be a real and substantial purpose that is relevant to the business of one of the corporations, such as: (a) separating a baby foods business from a pesticides manufacturing business because customers would not purchase baby foods from a pesticides company,¹⁵ (b) dividing a pharmaceuticals business from a cosmetic business to facilitate financing for both companies,¹⁶ or (c) dividing a company with a software business and a paper products business to allocate management resources between the companies in a more efficient manner.¹⁷ A shareholder purpose, such as personal estate planning, is not a corporate business purpose.¹⁸ The reduction of federal income taxes also is not a corporate business purpose.¹⁹
6. Continuity-of-interest requirement. One or more persons who were, directly or indirectly, the owners of the distributing corporation prior to the transaction must own, in the aggregate, an amount of stock that continues their interest in the corporations²⁰ after the division.²¹

A corporate spin-off may be a tax-free solution for Albert and Bertram. Celestial Builders would form a subsidiary corporation, Diablo Holdings, Inc. that would also elect S Corporation status. All parcels of real property and the property management component of the company would be transferred to Diablo Holdings as a separate corporate entity, and real property loans would be assigned to it. Bertram would then exchange his one-half share in Celestial Builders for all the stock of Diablo Holdings. At the end of the transactions, Albert would be the sole owner of Celestial Builders with its construction business, and Bertram would be the sole owner of Diablo Holdings managing its commercial rental properties.

Although we typically expect the IRC to tax every transaction, it includes numerous provisions that allow tax-free treatment when there is a mere change in the form of conducting business. Each transaction should be examined to determine whether there is a tax-free method to accomplish a corporate change.

[1] All references to the Internal Revenue Code or IRC are to the Internal Revenue Code of 1986, as amended.
[2] IRC §368(a)(1)(A), also known as an “A” reorganization.
[3] IRC §368(a)(1)(B), also known as a “B” reorganization.
[4] IRC §368(a)(1)(F), also known as an “F” reorganization.
[5] IRC §355(a).
[6] IRC §355(b).
[7] IRC §355(b)(2)(C), (D); Athanasios v. Comm’r of Internal Revenue, T.C. Memo. 1995-72 (2/15/1995).
[8] Internal Revenue Regulations (hereinafter “Reg.”) §1.355-3(b)(2)(iv)(B).
[9] King v. Comm’r of Internal Revenue, 458 F.2d 245 (6th Cir. 1972)
[10] Rev. Rul. 1986-125; Rafferty v. Comm’r of Internal Revenue, 452 F.2d 767 (1st Cir. 1971).
[11] IRC §355(g).
[12] Reg. §1.355-2(d)(2).
[13] Athanasios, supra.
[14] Reg. §1.355-2(b)(1).
[15] Rev. Rul. 2003-110.
[16] Rev. Rul. 2003-75; Rev. Rul. 2005-65.
[17] Rev. Rul. 2003-74.
[18] Rafferty, supra.
[19] Reg. §1.355-2(b)(2).
[20] An S Corporation’s momentary ownership of all the single class of stock in another corporation in connection with a divisive reorganization does not terminate its S corporation election. Revenue Ruling (hereinafter “Rev. Rul.”) 72-320; Private Letter Ruling (hereinafter “PLR”) 200943019 (7/20/2009); PLR 9713020 (12/30/1996).
[21] Reg. §1.355-2(c).