IRS Notice of Partial Withdrawal of Notice of Proposed Rulemaking, Guidance Under Section 355 Concerning Device and Active Trade or Business, REG-134016-15, RIN 1545-BN47, 91 Fed. Reg. 68420 (scheduled publication Oct. 21, 2026) (partially withdrawing REG-134016-15, 81 Fed. Reg. 46004 (July 15, 2016); codified at 26 C.F.R. pt. 1).

Under the general rules of Subchapter C of the Internal Revenue Code, corporate distributions of appreciated property trigger gain recognition at the corporate level under Section 311(b), while distributee shareholders are taxed on the receipt of property as dividend income under Section 301(c)(1), basis recovery under Section 301(c)(2), or capital gain under Section 301(c)(3). Section 355 provides a vital exception to these general dividend and recognition rules, permitting a distributing corporation (Distributing) to distribute stock and securities of a controlled corporation (Controlled) to its shareholders and security holders without triggering corporate-level gain or shareholder-level income recognition.

To prevent tax-free corporate separations from being converted into mechanisms for avoiding dividend taxation on corporate earnings and profits (E&P), Section 355 imposes stringent statutory requirements. Principally, Section 355(a)(1)(B) mandates that the transaction must not be used “principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both.” Concurrently, Section 355(a)(1)(C) and Section 355(b) require that both Distributing and Controlled be engaged, immediately after the distribution, in the active conduct of a five-year active trade or business (Active Business) that was not acquired in a taxable transaction within the preceding five-year period under Section 355(b)(2)(B)-(D).

The statutory device prohibition and active business requirement have evolved through decades of judicial interpretation, legislative amendments, and administrative guidance. Following early abuses where corporations transferred cash and liquid surplus into new subsidiaries prior to spin-offs—prompting the Supreme Court’s seminal decision in Gregory v. Helvering, 293 U.S. 465 (1935)—Congress re-authorized spin-offs in Section 317(a) of the Revenue Act of 1951 (65 Stat. 452, 493) with strict device and active business safeguards. As noted in the congressional record during debate on the 1951 Act, Senator Hubert Humphrey emphasized that “[u]nless strictly safeguarded, [a spin-off provision] can result in a loophole that will enable a corporation to distribute earnings and profits to stockholders without payment of the usual income taxes.”

Judicial Doctrines and Legislative Purpose

Courts interpreting Section 355 and its predecessors have consistently placed substance over form to ensure compliance with the overarching legislative purpose of the statute. In Gregory v. Helvering, the Supreme Court established that statutory compliance in form alone cannot grant tax-free treatment if the transaction lacks genuine business purpose, characterizing the transaction as “an operation having no business or corporate purpose–a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character.”

Subsequent judicial rulings reinforced that Section 355(b) functions to limit nonrecognition treatment strictly to genuine separations of operating corporate enterprises. In Coady v. Commissioner, 33 T.C. 771 (1960), aff’d, 289 F.2d 490 (6th Cir. 1961), the Tax Court articulated that a primary function of Section 355(b) is “to prevent the tax-free separation of active and inactive assets into active and inactive corporate entities.” Similarly, in Commissioner v. Gordon, 382 F.2d 499 (2d Cir. 1967), rev’d on other grounds, 391 U.S. 83 (1968), the Second Circuit examined the acquisition limitations of Section 355(b)(2)(C) and observed: “We think that the draftsmen of Section 355 intended these subsections to apply only to the bringing of new assets within the combined corporate shells of the distributing and the controlled corporations.”

Treasury Regulations promulgated in 1955 (T.D. 6152, 20 Fed. Reg. 8875) and significantly expanded in 1989 (T.D. 8238, 54 Fed. Reg. 283; Treas. Reg. § 1.355-2(d)) established a facts-and-circumstances balancing test to evaluate device potential. Under Treas. Reg. § 1.355-2(d)(1), a tax-free distribution presents device potential because it “facilitat[es] the avoidance of the dividend provisions of the Code through the subsequent sale or exchange of stock of one corporation and the retention of the stock of another corporation,” noting that a device can exist even if shareholder-level tax rates on capital gains and qualified dividends are identical due to basis recovery.

Overview of the 2016 Proposed Regulations

On July 15, 2016, the Treasury Department and the IRS published a Notice of Proposed Rulemaking (REG-134016-15, 81 Fed. Reg. 46004) to address concerns regarding corporate separations that segregated large volumes of liquid, investment, or nonbusiness assets from active trades or businesses—often in connection with tax-free real estate investment trust (REIT) or regulated investment company (RIC) conversions, as highlighted in Notice 2015-59 (2015-40 I.R.B. 459) and Rev. Proc. 2015-43 (2015-40 I.R.B. 467). The Treasury Department expressed grave concern that such transactions circumvented the repeal of the General Utilities doctrine by facilitating the tax-free separation of built-in gain investment assets from corporate operations.

The 2016 Proposed Regulations sought to modernize Treas. Reg. § 1.355-2(d) and Treas. Reg. § 1.355-3 by introducing objective mathematical thresholds and bright-line rules:

First, Proposed Treas. Reg. § 1.355-2(d)(2)(iv)(B) introduced the concepts of “Business Assets” (gross assets used in an active trade or business without regard to the five-year or income-collection requirements, including reasonable working capital and regulatory reserves) and “Nonbusiness Assets” (gross assets other than Business Assets). The ratio of Nonbusiness Assets to Total Assets was defined as the “Nonbusiness Asset Percentage” (NBAP). Under Proposed Treas. Reg. § 1.355-2(d)(2)(iv)(C), an NBAP of 20 percent or more for either corporation, or an NBAP difference of 10 percentage points or more between Distributing and Controlled, constituted evidence of device.
Second, Proposed Treas. Reg. § 1.355-9(b) established a new statutory requirement under Section 355(b), mandating that both Distributing and Controlled maintain a “Five-Year-Active-Business Asset Percentage” (fair market value of Five-Year-Active-Business Assets divided by Total Assets) of at least 5 percent.
Third, the 2016 Proposed Regulations established three mechanical provisions that drew severe criticism from the tax bar: an irrebuttable “per se” device test under Proposed Treas. Reg. § 1.355-2(d)(5), a device anti-abuse rule under Proposed Treas. Reg. § 1.355-2(d)(2)(iv)(E), and a minimum active business anti-abuse rule under Proposed Treas. Reg. § 1.355-9(d).

Detailed Analysis of Withdrawn Provisions

In response to extensive public comments and stakeholder feedback criticizing the administrative rigidity and uncertainty generated by these provisions, the Treasury Department and the IRS issued a Notice of Partial Withdrawal (REG-134016-15, RIN 1545-BN47), formally withdrawing three specific portions of the 2016 Proposed Regulations.

Irrebuttable Per Se Device Rule Under Proposed Regulation Section 1.355-2(d)(5)

The most controversial element of the 2016 Proposed Regulations was the per se device test set forth in Proposed Treas. Reg. § 1.355-2(d)(5). Under this proposed rule, if a distribution met a two-pronged mathematical asset test, the transaction was conclusively deemed to be a device, “notwithstanding the presence of nondevice factors described in paragraph (d)(3) of this section [such as a valid corporate business purpose or widely held public stock] or other facts and circumstances.”

The first prong of the per se test required that either Distributing or Controlled possess an NBAP of 66 2/3 percent (two-thirds) or more. The second prong compared the relative NBAPs of Distributing and Controlled using three designated mathematical comparison bands:

Band One: If one corporation’s NBAP was 66 2/3 percent or more but less than 80 percent, the test was met if the other corporation’s NBAP was less than 30 percent.
Band Two: If one corporation’s NBAP was 80 percent or more but less than 90 percent, the test was met if the other corporation’s NBAP was less than 40 percent.
Band Three: If one corporation’s NBAP was 90 percent or more, the test was met if the other corporation’s NBAP was less than 50 percent.

If both prongs were satisfied, the distribution was classified as a per se device unless it qualified for narrow exceptions under Proposed Treas. Reg. § 1.355-2(d)(5)(i) (distributions where distributee corporations would be entitled to a dividends received deduction under Section 243(a) or Section 245(b), or transactions ordinarily not considered a device under Treas. Reg. § 1.355-2(d)(6)). By removing the ability of taxpayers to establish that compelling nondevice factors—such as an urgent, non-tax corporate business purpose—overcame high nonbusiness asset ratios, the per se test created an inflexible rule that penalized legitimate corporate separations.

Device Anti-Abuse Rule Under Proposed Regulation Section 1.355-2(d)(2)(iv)(E)

To prevent taxpayers from manipulating asset balances to circumvent the general nonbusiness asset device factors or the per se device test, the IRS proposed an expansive anti-abuse rule in Proposed Treas. Reg. § 1.355-2(d)(2)(iv)(E) (and incorporated into per se device rules via Proposed Treas. Reg. § 1.355-2(d)(5)(iv)).

Under this provision, any “transaction or series of transactions (such as a change in the form of ownership of an asset; an issuance, assumption, or repayment of indebtedness or other obligations; or an issuance or redemption of stock) ... undertaken with a principal purpose of affecting the Nonbusiness Asset Percentage of any corporation” would be disregarded for purposes of evaluating device. Although the rule excluded non-transitory asset acquisitions or transfers between Distributing and Controlled, its subjective “principal purpose” standard created substantial execution risk and tax uncertainty for routine pre-spin restructuring steps, intra-group debt settlements, and capital contributions.

Minimum Active Trade or Business Anti-Abuse Rule Under Proposed Regulation Section 1.355-9(d)

Corresponding to the 5 percent minimum active business asset threshold under Proposed Treas. Reg. § 1.355-9(b), Proposed Treas. Reg. § 1.355-9(d) established a targeted anti-abuse rule governing Section 355(b) compliance.

Under Proposed Treas. Reg. § 1.355-9(d), any transaction or series of transactions (including changes in asset ownership form, debt transactions, or stock issuances/redemptions) undertaken with a principal purpose of affecting the Five-Year-Active-Business Asset Percentage of Distributing or Controlled to avoid failing the 5 percent threshold was disregarded. Similar to the device anti-abuse rule, this provision introduced subjective intent analysis into Section 355(b) active trade or business determinations, complicating internal group restructurings necessary to align active operations prior to spin-offs.

Treasury and IRS Rationale for Partial Withdrawal

As stated in the official Notice of Partial Withdrawal, the Treasury Department and the IRS determined that withdrawal was warranted following critical stakeholder feedback regarding the administrative burden, overbreadth, and uncertainty imposed by these three provisions:

“The Treasury Department and the IRS received feedback from stakeholders that generally was critical of the proposed ‘per se’ device rule and the two anti-abuse rules. In response to the feedback received, the Treasury Department and the IRS are withdrawing proposed §§ 1.355-2(d)(2)(iv)(E) and (d)(5) and 1.355-9(d).”

Tax practitioners and industry groups argued that the per se device test fundamentally subverted the statutory balancing mandate of Section 355(a)(1)(B) by ignoring valid corporate business purposes. Furthermore, commentators pointed out that subjective, intent-based anti-abuse rules undermined commercial predictability and trapped non-abusive transactions.

The IRS explicitly noted in the withdrawal notice that the elimination of these proposed rules does not leave the government without enforcement tools against abusive tax-free spin-offs:

“The withdrawal of these proposed rules does not affect the potential application of other rules or judicial doctrines, such as the substance-over-form or step-transaction doctrines. The Treasury Department and the IRS continue to study the issues addressed in the 2016 proposed regulations.”

Practical Implications for Tax Practitioners

For CPAs, EAs, and corporate tax specialists, the partial withdrawal of the 2016 Proposed Regulations carries immediate procedural and strategic implications for structuring corporate distributions under Section 355:

Restoration of Facts-and-Circumstances Balancing: The irrebuttable per se device presumption is eliminated. High concentrations of cash, marketable securities, or nonbusiness assets remain evidence of device under Treas. Reg. § 1.355-2(d)(2)(iv), but tax advisers can once again overcome device evidence by establishing a strong, non-tax corporate business purpose under Treas. Reg. § 1.355-2(d)(3)(ii).
Retention of Core 2016 Proposed Provisions under Study: The partial withdrawal applies strictly to Proposed §§ 1.355-2(d)(2)(iv)(E), 1.355-2(d)(5), and 1.355-9(d). The remaining portions of the 2016 Proposed Regulations—including the general Nonbusiness Asset device factors under Proposed Treas. Reg. § 1.355-2(d)(2)(iv)(C) (20 percent NBAP threshold and 10 percentage point ratio difference) and the 5 percent minimum active business asset requirement under Proposed Treas. Reg. § 1.355-9(b)—have not been withdrawn and remain under Treasury study.
Continued Primacy of Common Law Doctrines: Tax professionals must recognize that pre-distribution asset reallocations, capital contributions, and debt recapitalizations remain subject to scrutiny under established judicial standards. The IRS will continue to utilize the substance-over-form, step-transaction, and business purpose doctrines (Gregory v. Helvering) to challenge transactions designed to segregate passive corporate wealth tax-free.

Prepared with assistance from Gemini Notebook.