How to Document a Tax-Free D Reorganization With a Split-Off

By Steve Drucker, CPA, MST

 PHOTO BY HARMPETI/ISTOCK
PHOTO BY HARMPETI/ISTOCK
 

EXECUTIVE
SUMMARY

 
  • For several years, the IRS has not provided private letter rulings on whether a split-off reorganization transaction meets the requirements to be a tax-free D reorganization under Sec. 368(a)(1)(D) or qualifies for nonrecognition treatment under Sec. 355.
  • Taxpayers, however, must be able to document that they met those requirements if the IRS challenges the tax-free treatment of the reorganization transaction.
  • The sample memorandum presented here can be adapted by taxpayers for use as part of the documentation of how a split-off reorganization meets the requirements under Secs. 368(a)(1)(D) and 355.

In the past, a taxpayer could request an IRS private letter ruling on whether a transaction qualifies for nonrecognition treatment under Sec. 355 or whether a transaction constitutes a reorganization under Sec. 368. To conserve IRS resources, Rev. Proc. 2013-32 restricted the scope of letter rulings that address issues arising from Sec. 355 transactions and Sec. 368 reorganizations. Effective Aug. 23, 2013, the IRS no longer rules on an entire transaction under Sec. 355 or a reorganization under Sec. 368.

Rev. Proc. 2016-3 contains the revised guidance for 2016 on IRS no-rule areas. Section 3.01(50) of Rev. Proc. 2016-3 provides that the IRS will still not issue a letter ruling about whether a transaction qualifies under Sec. 355 for nonrecognition treatment or whether it constitutes a corporate reorganization within the meaning of Sec. 368. In addition, Section 3.01(53) of Rev. Proc. 2016-3 continued the IRS's even longer-standing prohibition on rulings on the individual issues of whether a distribution has a corporate business purpose and that the transaction is not a device for purposes of Sec. 355. In August, in Rev. Proc. 2016-45, the IRS modified Rev. Proc. 2016-3, Section 3.01(53), to remove the corporate business purpose and device issues from the no-rule list. However, the IRS did not modify Section 3.01(50) of Rev. Proc. 2016-3 and will still not rule on whether the entire transaction qualifies for nonrecognition treatment under Sec. 355.

With Rev. Proc. 2016-3 in effect, taxpayers are unable to obtain a ruling on whether a Type D tax-free split-off reorganizations under Sec. 368(a)(1)(D) will receive nonrecognition treatment. Instead, if a transaction is challenged by the IRS, a taxpayer must document in detail how it meets all the requirements of a split-off reorganization, including the control requirement, establishing that the transaction is not a device to distribute earnings and profits, and the active trade or business requirement, among others. To aid practitioners in documenting the requirements, following is an example of a Type D reorganization memorandum that includes a statement of facts, the reason for the memorandum, a statement of law, an analysis, a conclusion, and procedural matters exhibits. The memorandum is the backbone of the documentation, supplemented by supporting exhibits, for how a transaction qualifies for nonrecognition treatment.

Split-Off Type D Reorganization Memorandum

This memorandum is being completed on behalf of Corporation A. The memorandum details that its reorganization to split off part of the business meets all the requirements of a Type D tax-free reorganization under Sec. 368(a)(1)(D).

A. STATEMENT OF FACTS

1. Taxpayer Information

The Corporation's legal name is [legal name of corporation].

The Corporation's address is [corporation's address] and its phone number is [phone number].

The Corporation's taxpayer identification number is [corporation's TIN].

The Corporation's tax year begins Jan. 1 and ends on Dec. 31.

The Corporation is owned 50% by [owner 1] and 50% by [owner 2].

The Corporation's method of accounting for maintaining the accounting books and filing its federal income tax return is cash.

2. Description of Taxpayer's Business Operations

Corporation A is a closely held corporation that was incorporated in the State of Iowa on Jan. 1, 1994. The business activity code number for Corporation A is 112210. The business activity of Corporation A is farming, and the product or service is hogs.

3. Facts Relating to Transaction

[Owner 1] and [owner 2] each own 50% of Corporation

A. [Owner 1] and [owner 2] are brothers who have developed a difference in opinion on how the hog operation should be conducted. [Owner 2] is going to split off from Corporation A and start a new company, Corporation B Inc. ("Corporation B"). Both [owner 1] and [owner 2] believe the business would be more profitable and run more efficiently if the business were split off with each brother managing and operating his own company. This is the business purpose of the transaction. Corporation B will be in the same hog confinement business as Corporation A. The split of assets and liabilities between Corporation A and Corporation B is as follows as of closing on Dec. 31, 2015:

CorporationA

1. Hog Confinement Building at [address 1]: Fair market value (FMV) of $500,000

2. Tractor: FMV of $10,000

3. Cash: FMV of $40,000

4. Loan from [owner 2]: Loan Balance of $100,000

Total Value Received: $650,000

CorporationB

1. Hog Confinement Building at [address 2]: FMV of $650,000

Total Value Received: $650,000

The net value of assets and liabilities that Corporation B received is larger than the net value of assets and liabilities Corporation A received in the split off. A loan from Corporation B to Corporation A has been executed in the amount of $100,000 for the difference in values that Corporation B received compared to CorporationA.

The split-off took place on Dec. 31, 2015, and is effective starting Jan. 1, 2016.

 

B. REASON FOR MEMORANDUM

The memorandum is being completed for the following reason:

1. Corporation A's business reorganization meets all the requirements of a Type D tax-free split-off reorganization under Sec. 368(a)(1)(D), and related tax authorities, including Treasury regulations, IRS rulings, and court cases.

C. STATEMENT OF LAW

This memorandum is based on the law and analysis set forth below. To the best of the taxpayer's knowledge, there is no pending legislation that may affect the issues and transactions discussed in this memorandum. Corporation A is not under a current or pending IRS examination.

Tax-Free Reorganization Under Sec. 368(a)(1)(D)

1.Sec. 368(a)(1)(D) provides as follows:

The term reorganization means—

A transfer by a corporation of all or part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction that qualifies under Code Sec. 354, 355, or 356.

The definition of "control" in Sec. 368(a)(1)(D) is provided in Sec. 368(c) and stated as follows:

For purposes of part I (other than Sec. 304), part II, this part, and part V, the term "control" means the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.

2. For a split-off reorganization to qualify under Sec. 355 (and require no gain or loss recognition to a shareholder or security holder on the receipt of stock or securities), it must meet the following requirements:

a. Sec. 355(a)(1)(B): The transaction was not used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both.

i. Sec. 355(a)(1)(B)

The transaction must not be used principally as a device for the distribution of earnings and profits of either the transferee or transferor corporation. Regs. Sec. 1.355-2(d) provides a facts-and-circumstances test for determining whether the purpose of the transaction was to provide a device to distribute earnings and profits.

(1) A pro rata (or substantially pro rata) distribution of stock is evidence of a device.

(2) A sale or exchange of the stock in either corporation after the distribution is evidence of a device. If the sale or exchange is made under an arrangement negotiated or agreed on before the distribution, there is substantial evidence of a device.

(3) There is evidence of a device if the distributing or controlled corporation holds assets that are not used in a qualifying business (as defined in Sec. 355(b)).

(4) There is evidence of a device if either of the corporations' principal functions is to serve the activities of the other corporation for a significant period of time after the separation and that business can be sold without adversely affecting the primary business.

Regs. Sec. 1.355-2(d)(3) also contains examples of factors that will be considered evidence of the lack of a device, the most important of which is a corporate business purpose.

b. Sec. 355(a)(1)(C): The requirements relating to active businesses are satisfied.

i. Sec. 355(a)(1)(C)

Immediately after the distribution, the distributing corporation and the controlled corporation(s) must meet a five-year active business test, which is met if:

(1) Under Sec. 355(b)(2)(B), the trade or business has been actively conducted throughout the five-year period ending on the date of distribution.

(2) Under Sec. 355(b)(2)(C), the trade or business was not acquired within the five-year period in a transaction in which gain or loss was recognized in whole or in part.

(3) Under Sec. 355(b)(2)(D), the trade or business was not conducted by a corporation, control of which the distributee or distributing corporation acquired, directly or indirectly, in a taxable transaction during the five-year period.

c. Sec. 355(a)(1)(D): As part of the distribution, the distributing corporation distributes all of the stock and securities in the controlled corporation held by it immediately before the distribution, or an amount of stock in the controlled corporation constituting control within the meaning of Sec. 368(c), and it is established to the satisfaction of the Secretary that the retention by the distributing corporation of stock in the controlled corporation was not in pursuance of a plan having as one of its principal purposes the avoidance of federal income tax.

i. Sec. 355(a)(1)(D)

Distributions and acquisitions pursuant to a plan may disqualify a transaction from tax-free reorganization status. Sec. 355(e) and Regs. Sec. 1.355-7 say in part that:

(1) If one or more persons directly or indirectly acquire stock,

(2) Representing a 50% or greater interest in the distributing corporation or any controlled corporation,

(3) During the four-year period beginning two years before the date of the distribution, then

(4) Such acquisition is a taxable transaction unless it is established that the distribution and the acquisition are not pursuant to a plan or series of related transactions.

d. Sec. 355(g): This section does not apply to any distribution that is part of a transaction if either the distributing corporation or controlled corporation is, immediately after the transaction, a disqualified investment corporation, and any person holds, immediately after the transaction, a 50% or greater interest in any disqualified investment corporation, but only if that person did not hold the interest in the corporation immediately before the transaction.

i. Sec. 355(g) denies tax-free treatment for distributions involving a disqualified investment corporation in which a person holds a 50% or greater interest after the transaction, but only if that person did not hold an interest in the corporation before the transaction.

A corporation is a disqualified investment corporation if the FMV of its investment assets is two-thirds or more of the FMV of all assets. Investment assets include cash, securities, certain partnership interests, etc. However, this rule only applies if the reorganization transaction results in any person owning (directly or indirectly) 50% or more of the disqualified investment corporation, and if that person did not hold that interest immediately before the transaction.

3. In addition to the statutory requirements in Sec. 368(a)(1)(D), there are the recordkeeping and filing requirements in Regs. Sec. 1.368-3(a) and the three nonstatutory requirements that have been incorporated in the regulations under Secs. 355 and 368.

a.Regs. Sec. 1.368-3(a): The plan of reorganization must be adopted by each of the corporations that are parties. Each corporation must include a statement titled, "STATEMENT PURSUANT TO REGS. SEC. 1.368-3(a) BY [INSERT NAME AND EMPLOYER IDENTIFICATION NUMBER (IF ANY) OF TAXPAYER], A CORPORATION A PARTY TO A REORGANIZATION," on or with its return for the tax year of the exchange.

i. Regs. Sec. 1.368-3(a)

Regs. Sec. 1.368-3(a) states the plan of reorganization must be adopted by each of the corporations that are parties to the transaction and each must include a statement with its return for the tax year of exchange. The statement must include:

(1) The names and employer identification numbers (if any) of all those parties.

(2) The date of reorganization.

(3) The aggregate FMV and basis, determined immediately before the exchange, of the assets, stock, or securities of the target corporation transferred in the transaction; and

(4) The date and control number of any private letter ruling(s) issued by the IRS in connection with the reorganization.

b .Regs. Sec. 1.368-1(d)(1): There must be continuity of business enterprise (COBE) of the acquired corporation after the reorganization. The issuing corporation (P) must either continue the target corporation's (T's) historic business or use a significant portion of T's historic business assets in the business.

i. Regs. Sec. 1.368-1(d)(1) requires the existence of continuity of business enterprise of the acquired corporation after the reorganization. Continuity of business enterprise is satisfied if:

(1) The issuing corporation continues the target corporation's historic business. The fact that the issuing corporation is in the same line of business as the target corporation tends to establish the requisite continuity, but is not alone sufficient.

(2) If the target corporation has more than one line of business, continuity of business enterprise requires only that the issuing corporation continue a significant line of business.

(3) In general, a corporation's historic business is the business it has conducted most recently. However, a corporation's historic business is not one the corporation enters into as part of a plan of reorganization.

(4) All facts and circumstances are considered in determining the time when the plan comes into existence and in determining whether a line of business is "significant."

(5) The COBE requirement is satisfied if the issuing corporation uses a significant portion of the target corporation's historic business assets in a business.

(6) A corporation's historic business assets are the assets used in its historic business. Business assets may include stock and securities and intangible operating assets such as goodwill, patents, and trademarks, whether or not they have a tax basis.

(7) In general, the determination of the portion of a corporation's assets considered "significant" is based on the relative importance of the assets to the operation of the business. However, all other facts and circumstances, such as the net FMV of those assets, will be considered.

c. Regs. Sec. 1.368-1(e): There must be a continuity of shareholder interest (COSI) of the acquired corporation in the acquiring corporation. COSI requires that in substance a substantial part of the value of the proprietary interest in the target corporation be preserved in the reorganization. A proprietary interest in the target corporation is preserved if, in a potential reorganization, it is exchanged for a proprietary interest in the issuing corporation, it is exchanged by the acquiring corporation for a direct interest in the target corporation enterprise, or it otherwise continues as a proprietary interest in the target corporation.

i. Regs. Sec. 1.368-1(e) requires the existence of COSI of the acquired corporation in the acquiring corporation. At least one preorganization shareholder must continue to hold an equity interest in any new or surviving corporation. All parties to the separation need not have a continuing interest in each of the entities. Instead, each corporation must be owned by one or more persons who (directly or indirectly) owned the enterprise before the reorganization.

d. Regs. Sec. 1.355-2(b): Corporate Business Purpose.

i. Under Regs. Sec. 1.355-2(b), Sec. 355 applies to a transaction only if it is carried out for one or more corporate business purposes. A transaction is carried out for a corporate business purpose if it is motivated, in whole or substantial part, by one or more corporate business purposes. Generally, a shareholder's purpose will not qualify.

In Letter Ruling 200038034, a split-off was used to resolve disputes between two groups of shareholders in a corporation owned by members of an extended family. The two groups could not agree on how the company's business matters should be handled, which was having a detrimental impact on the day-to day operations of the corporation's business. Assets from the original corporation were transferred to a newly formed corporation for all of its voting stock and the assumption of liabilities associated with the transferred assets. The stock of the newly formed corporation was then transferred to one of the shareholder groups in exchange for its stock of the original corporation. The IRS ruled that the transaction constituted a valid Type D reorganization, and no gain was recognized by the original corporation or the family shareholders under Sec. 355(a)(1).

D. ANALYSIS

1. The reorganization of Corporation A meets the definition of "control" in Sec. 368(a)(1)(D)

For a reorganization to be treated as tax-free under Sec. 368(a)(1)(D), one or more of the transferor corporation's shareholders must be in control of the corporation to which the assets were transferred. The term "control" means the ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.

[Owner 1] and [owner 2] are 50/50 shareholders of Corporation A. When Corporation A is split off, [owner 2] is going to be the 100% shareholder of the new corporation, Corporation B. Since [owner 2] was a shareholder of the transferor corporation and will be a 100% shareholder (owning 100% of all classes of stock) of the new corporation that the assets are transferred to, the reorganization will meet the definition of "control" in Sec. 368(a)(1)(D).

2. The reorganization transaction qualifies under Sec. 355

For a split-off transaction to qualify under Sec. 355 (and require no recognition of gain or loss by a shareholder), it must meet four requirements:

a. The first requirement under Sec. 355(a)(1)(B) is that the transaction is not used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both. Factors listed in Regs. Sec. 1.355-2(d) as possible evidence of a device include (i) a pro rata distribution of the stock to the shareholders of the distributing corporation, (ii) a distribution followed by a sale or exchange of the stock of either corporation, or (iii) the existence of cash or liquid assets of the distributing corporation not used in a qualifying business.

The transaction is not principally a device to bail out the corporation's earnings and profits. The stock of the new corporation will be distributed to [owner 2], and so will not be distributed pro rata to the two shareholders. Furthermore, the shareholders do not intend to sell their stock within the foreseeable future, and all the cash or liquid assets from the distributing corporation will be used in the new corporation.

b. The second requirement under Sec. 355(a)(1)(C) is that the requirements relating to active businesses are satisfied. Sec. 355(b)(2) states that both corporations must be engaged in the active conduct of business, with the trade or business having been conducted throughout the five-year period ending on the date of distribution.

Following the reorganization, both corporations will be engaged in the active conduct of a business. Furthermore, both businesses have been operating for more than five years. We have attached "pro forma" tax-related schedules to support this required criteria.

c. The third requirement under Sec. 355(a)(1)(D) is that either all of the stock and securities of the transferee corporation is distributed or at least 80% is distributed in a plan not having a principal tax avoidance purpose.

All of the stock is being distributed. The reorganization is intended to resolve business-related conflicts between the two shareholders, [owner 1] and [owner 2]. The reorganization does not have a principal tax avoidance purpose.

d. The fourth requirement under Sec. 355(g) is that neither the distributing corporation nor the controlled corporation is, immediately after the transaction, a disqualified investment corporation nor does any person hold immediately after the transaction a 50% or greater interest in any disqualified investment corporation, but only if that person did not hold such an interest in such corporation immediately before the transaction.

Neither corporation is a disqualified investment corporation under Sec. 355(g). Thus, neither [owner 1] nor [owner 2] has a 50% or greater interest in a disqualified investment corporation prior to the transaction and immediately after the transaction.

3. The reorganization transaction meets the nonstatutory requirements under Regs. Sec. 1.368 and Rev. Proc. 96-30

a. The first requirement under Regs. Sec. 1.368-3(a) is that each of the corporations that are parties to the reorganization must adopt the plan of reorganization. Each corporation must also include a statement about the reorganization on or with its return for the tax year of the exchange.

Shareholders [owner 1] and [owner 2] have adopted in writing a plan of reorganization for both corporations. Both corporations will include in their respective tax returns for the tax year of the exchange a statement about the reorganization that includes all items listed in Regs. Sec. 1.368-3(a).

b. The second requirement under Regs. Sec. 1.368-1(d)(1) is that there must be a continuity of business enterprise of the acquired corporation after the reorganization. To satisfy the COBE requirement, the new corporation must continue the historic business of the old corporation or use a significant portion of the old corporation's business assets in the business.

The new corporation that is split off will continue the historic business of hog confinement, which is the corporation's business. The new corporation will use a significant portion of the historic assets of Corporation A for its hog confinement business that is being split off.

c. The third requirement under Regs. Sec. 1.368-1(e) is that there must be a continuity of shareholder interest of the acquired corporation in the acquiring corporation. At least one preorganization shareholder must continue to hold an equity interest in any new or surviving corporations. [Owner 2], who owned 50% of Corporation A, will be the 100% owner of the new corporation. Therefore, the COSI requirement is met.

d. Regs. Sec. 1.355-2(b) requires a stated business purpose (other than tax reasons) for the reorganization. A bona fide corporate business purpose for separating ownership of the corporation's operating activities must exist. Letter Ruling 200038034 allowed for a split-off to be used to resolve disputes between two shareholder groups of a family-owned corporation that were interfering with the operations of the corporation and receive tax-free treatment under a Sec. 368(a)(1)(D) and Sec. 355(a)(1).

There is a bona fide business purpose for the split-off reorganization. The two shareholders, [owner 1] and [owner 2], disagree about the business and want to divide the business based on their interests. They believe the business will run better if they are both running two separate entities and businesses. Thus the business purpose is analogous to the business purpose approved by the IRS in Letter Ruling 200038034.

 

E. CONCLUSION

The reorganization by Corporation A meets the definition of a reorganization under Sec. 368(a)(1)(D). The reorganization meets all the requirements under Sec. 355. The reorganization also meets all the requirements under Regs. Sec. 1.368-3(a) and Rev. Proc. 96-30. Therefore, the split-off business reorganization by Corporation A meets all of the requirements of a tax-free reorganization under Sec. 368(a)(1)(D).

F. PROCEDURAL MATTERS: EXHIBITS

Exhibit A: Five-Year Pro Forma Financials

Exhibit B: Reorganization FMV Asset & Liability Split Off

Exhibit C: Articles of Incorporation of CorporationA

Exhibit D: Bylaws of CorporationA

Exhibit E: Annual Board Minutes of Corporation A, 2010—2014

Exhibit F: Appraisal of Hog Confinement Buildings

Exhibit G: Reorganization Legal Documents

 

Contributor

Steve Drucker is with Williams & Co. PC in Spencer, Iowa. For more information about this article, contact thetaxadviser@aicpa.org.

 

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