In Rev. Rul. 2017-9 the IRS ruled on two different transactions involving three related corporations, one of which gives the IRS position on “North-South” spinoff transactions that the IRS had placed on its no rule list in 2013.
The first situation, and the one which proves to be the most taxpayer friendly, involved three related corporations involved in a North-South spinoff. P, the parent corporation, owns 100% of D, what will eventually be the distributing corporation in this arrangement. D owns 100% of C, a corporation whose stock the taxpayer wishes to transfer upstream to P.
P has an operating business (Business A) which P has been engaged in for more than five years and qualify under the active conduct of a trade or business rule of IRC §355(b). C also has an operating business (Business B) which C has also been engaged in for than 5 years and which also qualifies under IRC §355(b). D, however, does not have any operating trade or business.
That’s a problem because the taxpayer wishes to transfer stock in C to P in a tax-free manner. Section 355 would fit the bill but D must distribute stock of a company with an active trade or business and retain a qualified active trade or business. D is missing the latter.
The fair value of Business A is $100X, while the fair value of the C stock is $25X.
P attempts to solve the Section 355 active business problem for D by transferring the assets and activities of Business A to D. P believes this transaction qualifies for tax free treatment under IRC §351 and D would inherit P’s activities in conducting the business. Following that transfer, D, which now has an active business to retain, transfers the stock of C to P in a transaction that the group believes qualifies for Section 355 nonrecognition treatment.
The potential issue would be if the IRS used the step transaction doctrine to treat those transaction as a single transaction where P exchanged its operating business, receiving C stock in payment from D. In that case, the group has a taxable exchange and, potentially, a lot of tax due.
The IRS notes this as the agency begins its discussion of this transaction:
The federal income tax consequences to P and D in Situation 1 will depend on whether the Date 1 and Date 2 transfers are treated as separate transactions. Because they are undertaken pursuant to the same overall plan, a question arises as to whether the two transactions are part of a single reciprocal transfer of property — an exchange.
The IRS also outlines the disastrous consequences to the parties if this is treated as a single transaction:
If the Date 1 and Date 2 transfers are integrated into a single exchange for federal income tax purposes, P would be treated as transferring its Business A property to D in exchange for a portion of the C stock in an exchange to which § 1001 applies. In such an exchange, gain or loss would be recognized to P on the transfer of its property to D; gain or loss would be recognized to D, under § 1001(a), upon its transfer of 25 percent of the C stock to P in exchange for the property transferred to it. In addition, § 355 would not apply to any part of the distribution of C stock because D would not have distributed stock constituting § 368(c) control of C. Gain would be recognized to D, under § 311(b), upon the distribution of the remaining 75 percent of the C stock with respect to P’s stock in D to which § 301 would apply.
Realistically, with that result it is highly unlikely anyone would enter into a transaction like this except out of ignorance. But is that the proper result?
Interestingly, rather than using standard analyses to determine if the step transaction doctrine should apply (such as the “but-for” test which this transaction would appear to fail—the transfer from P would not have taken place but for the need to get an operating business into D to allow for a 355 distribution), the IRS analyzed the matter differently:
The determination of whether steps of a transaction should be integrated requires review of the scope and intent underlying each of the implicated provisions of the Code. The tax treatment of a transaction generally follows the taxpayer’s chosen form unless: (1) there is a compelling alternative policy; (2) the effect of all or part of the steps of the transaction is to avoid a particular result intended by otherwise-applicable Code provisions; or (3) the effect of all or part of the steps of the transaction is inconsistent with the underlying intent of the applicable Code provisions. See H.B. Zachry Co. v. Comm’r, 49 T.C. 73 (1967); Makover v. Comm’r, T.C. Memo 1967-53; Rev. Rul. 78-330, 1978-2 C.B. 147. Sections 351, 355, and 368 generally allow continued ownership of property in modified corporate form without recognition of gain. See American Compress & Warehouse Co. v. Bender, 70 F.2d 655 (5th Cir. 1934), cert. denied, 293 U.S. 607 (1934); § 1.1002-1(c); Rev. Rul. 2003-51.
The IRS did not find that the steps taken were contrary to the intent of Sections 351 or 355, and thus the IRS granted that the transfer of stock from D to P would be a valid Section 355 transfer.
The IRS also clarified that the operating business could also have come from a subsidiary of P, noting:
The federal income tax consequences would be the same (qualification under § 355) if, instead of acquiring an active trade or business in a § 351 transfer from P to D, D acquired an active trade or business from a subsidiary of P in a cross-chain reorganization under § 368(a)(1). See Rev. Rul. 74-79.