IRS Issues Helpful Regs. on the Interplay of Active Trade and Hot Stock

In response to changes made to the active trade or business requirement in the Tax Increase Prevention and Reconciliation Act of 2005, P.L. 109-222 (TIPRA), the Service recently issued temporary and proposed regulations harmonizing the Sec. 355 “hot stock” rule with the TIPRA changes (T.D. 9435, REG-150670-07).

Background

Under Sec. 355(a), a distributing corporation (D) may distribute the stock of a controlled corporation (C) to its shareholders without causing either D or its shareholders to recognize income, gain, or loss. However, Sec. 355(a)(3)(B) provides that C stock acquired by D by reason of any taxable transaction that occurs within five years of the stock distribution will not be treated as C stock but as other property (hot stock). As a result, the distribution of hot stock results in potential gain recognition to both the shareholders and D.

There are a number of requirements for qualifying a distribution under Sec. 355(a). One such requirement is the active trade or business (ATB) requirement found in Sec. 355(a)(1)(C). To satisfy the ATB requirement, both D and C must engage in an ATB immediately after the distribution (Sec. 355(b)(1)(A)). In addition, Sec. 355(b)(1)(B) provides that a corporation meets the ATB requirement if, immediately after the distribution, substantially all of its assets consist of stock and securities of a corporation controlled by it that is so engaged. However, as discussed below, the enactment of Sec. 355(b)(3) overrides the application of Sec. 355(b) (1)(B). In addition, each ATB must have been conducted throughout the five-year predistribution period and must not have been acquired within the predistribution period in a transaction in which gain or loss was recognized, in whole or in part (Secs. 355(b)(2)(B) through (D)).

TIPRA amended the statute by adding the Sec. 355(b)(3) affiliated group rules for determining satisfaction of the ATB requirement. Sec. 355(b)(3)(A) provides that for purposes of determining whether a corporation is engaged in an ATB, all members of the corporation’s separate affiliated group (SAG) are treated as one corporation. Sec. 355(b)(3)(B) provides that for purposes of Sec. 355(b)(3), with respect to any corporation, the term “SAG” refers to the affiliated group that would be determined under Sec. 1504(a) if the corporation were the common parent and Sec. 1504(b) did not apply. Sec. 355(b)(3)(C) provides that if a corporation becomes a SAG member as a result of one or more taxable transactions, any trade or business conducted by the corporation (at the time the corporation became a member) will be treated for purposes of Sec. 355(b)(2) as acquired in a taxable transaction.

Expansion Through Stock Acquisition

In general, a corporation is considered to expand an existing ATB rather than acquire a new ATB through an asset acquisition when the facts clearly establish that the acquired assets are in the same line of business as the existing ATB (Regs. Sec. 1.355-3(b)(3)(ii)). However, it was previously unclear whether a stock acquisition could represent an expansion.

The changes made in TIPRA seem to answer that question affirmatively. As a result, in certain circumstances, the acquisition of stock could represent an expansion of an existing trade or business. This conclusion is confirmed by the legislative history, which provides that “such an acquisition is subject to the provisions of section 355(b)(2)(C), and may qualify as an expansion of an existing active trade or business conducted by the distributing corporation or the controlled corporation, as the case may be” (Joint Committee on Taxation, Description of the Tax Technical Corrections Act of 2007 as Passed by the House of Representatives 5 (JCX-119-07) (December 18, 2007)). The proposed ATB regulations further confirm this result by treating the acquisition of control of a subsidiary as the acquisition of the subsidiary’s underlying assets and, as such, potentially an expansion of the existing business (see Prop. Regs. Sec. 1.355-3(b)(3)(ii)).

The statutory changes provide for an interesting result whereby D could distribute the stock of a recently acquired C in a qualifying Sec. 355 transaction if the acquisition of C represented an expansion of the D business (Prop. Regs. Sec. 1.355-3(d)(2), Examples (20) and (21)).

However, this result would appear to conflict with the hot stock rule discussed above, which would cause the seemingly absurd result of a qualifying tax-free distribution that is taxable to the shareholder and potentially taxable to the distributing corporation. Congress realized this and added Sec. 355(b)(3)(D), which provides regulatory authority for the modification of the hot stock rule, in the Tax Technical Corrections Act of 2007.

Temp. Regs. Modify Application of the Hot Stock Rule

Acting upon this regulatory authority, Treasury issued temporary regulations modifying the application of the hot stock rule to the SAG. The regulations provide that C stock purchased within the five-year predistribution period is not treated as hot stock if C is a member of the distributing corporation’s separate affiliated group (DSAG) at any time after the acquisition but before the distribution of C (Temp. Regs. Sec. 1.355-2T(g) (2)(i)). In essence, these regulations reflect the congressional intent that the hot stock rule should not apply to any acquisition of C stock where C is a DSAG member at any time after the acquisition. This is the case whether D owned C stock prior to the predistribution period, acquired stock representing Sec. 1504(a) control in a single transaction, or acquired stock in multiple transactions (Temp. Regs. Sec. 1.355-2T(g)(5), Example (2)). The following examples show how the temporary regulations apply in various situations.

Example 1: D is a bank holding company that wholly owns S, which has operated a bank for more than five years. In year 6, D acquires C, which has operated a bank for more than five years, in a taxable acquisition. Assuming the activities are virtually the same, the acquisition represents an expansion of the DSAG business. In year 8, D distributes C to X in exchange for X’s D shares. Assuming all other requirements are met, the distribution of C qualifies as a Sec. 355 split-up despite the fact that C was acquired in a taxable transaction within the prior five years.

Example 2: The facts are the same as in Example 1, except that D acquired 50% of C in year 2 in a taxable transaction and acquired the remaining 50% in year 6 in a separate taxable transaction. Assuming all other requirements are met, the distribution of C qualifies as a Sec. 355 split-up despite the fact that 50% of C was acquired in a taxable transaction within the prior five years.

Example 3: The facts are the same as in Example 1, except that D acquired Sec. 368(c) control of C in year 4 in a taxable transaction and acquired the remaining ownership in year 6. Assuming all other requirements are met, the distribution of C qualifies as a Sec. 355 split-up.

In addition, and consistent with the SAG rule that treats the DSAG as a single corporation, transfers of C stock owned by DSAG members immediately before and immediately after the transfer are disregarded and not treated as acquisitions for purposes of the hot stock rule. Finally, the temporary regulations retain the affiliate acquisitions exception under Regs. Sec. 1.355-2(g), which provides that the hot stock rule does not apply for acquisitions of controlled corporation stock from another member of the affiliated group.

Conclusion

The recently issued temporary regulations provide welcome confirmation to taxpayers on their ability not only to expand a business through a stock acquisition, but also to distribute the acquired stock without fear of the stock being considered hot stock.

EditorNotes

Mindy Cozewith is director, National Tax, at RSM McGladrey, Inc., in New York City.

Unless otherwise noted, contributors are members of or associated with RSM McGladrey, Inc.

For additional information about these items, contact Ms. Cozewith at (908) 233-2577 or mindy.cozewith@rsmi.com.