Arguably one of the most restrictive and limiting rules imposed on a corporation by the federal income tax system is the corporate-level tax on the sale of business assets or subsidiaries that hold business assets. This inability to sell business assets without a corporate-level tax severely impedes a corporation from monetizing appreciated assets and reinvesting the sale proceeds to expand its retained businesses. Not surprisingly, with limitation comes the inevitable challenge to find a solution. Unfortunately, in this case businesses and their tax advisers often find themselves with an empty toolbox and are unable to overcome the challenge. Nonetheless, the search for tax-efficient exit structures often leads to creative planning and use of the current tax rules to produce economic results otherwise reserved for a tax-free sale of assets.
Sec. 355 allows a corporation (Distributing) to distribute to its shareholders or its security holders the stock or securities of one or more corporations that it controls (Controlled) without triggering income or gain to itself or its shareholders. Following the repeal of the General Utilities doctrine (see General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935)), Sec. 355 remains the only reliable way to distribute appreciated assets from a corporation to its noncorporate shareholders without paying a corporate-level tax on the distributed assets.
It should be no surprise that Sec. 355 is a useful tool for mitigating the corporate-level tax on the disposition of business assets. However, in order for a transaction to be governed by Sec. 355, a long list of requirements must be met, some of which specifically target a sale of either Distributing or Controlled (e.g., the device prohibition, continuity of interest, continuity of business enterprise, Sec. 355(d), and Sec. 355(e)). The latter two requirements are generally the most restrictive and require careful planning to produce tax-free results. One transaction that can successfully navigate all the requirements of Sec. 355, yet economically results in a tax-free monetization of appreciated business assets, is known as the “sponsored spin.”
Sec. 355(d) causes a spin-off to be taxable at the corporate level if the distribution of a controlled corporation is to any person holding “disqualified stock” constituting a 50% or greater interest (by vote or value) of either Distributing or Controlled. Generally, disqualified stock is any stock of the distributing or controlled corporation acquired by purchase within the five-year period ending on the date of the distribution. Under Sec. 355(e), a spin-off is taxable at the corporate level if it is “part of a plan or a series of related transactions” involving an acquisition of 50% or more of the stock of either Distributing or Controlled. Accordingly, a sponsored spin transaction generally limits the acquisition of either Distributing or Controlled to less than a 50% interest.
The best way to illustrate the mechanics and benefits of a sponsored spin is by walking through a very basic example.
Example: Corporation X is a publicly held corporation engaged in two separate lines of businesses. The first business, A, is X’s primary business and accounts for two-thirds of its revenue, cashflow, and fair market value (FMV). Business B accounts for the remaining one-third of X’s revenue, cashflow, and FMV. X conducts each business through a separate LLC subsidiary treated as a disregarded entity for U.S. income tax purposes (collectively, the LLCs). A has an FMV of $800 and B has an FMV of $400. X has a zero basis in its A and B assets. X has $400 of outstanding thirdparty debt and has no assets other than its interests in the LLCs.
Despite the smaller size of B relative to A, X’s management devotes the majority of its time to running B and believes that the lack of resources devoted to A is severely limiting A’s growth. Further, a disposition of B would result in cash proceeds available either to satisfy a portion of X’s outstanding debt or to fund the growth and expansion of A. Clearly, the most straightforward method to dispose of B is a cash sale of either the B assets or the LLC interest that holds the assets. However, both of these sales would result in a significant tax bill to X.
First, consider the economics and taxation of a straight sale of B to a third party. If X sells B for its FMV, X will recognize a $400 gain on the sale ($400 FMV less $0 basis). Assuming that a combined federal and state tax rate of 40% is applied to this gain, X will pay $160 of tax on the sale and realize aftertax cash proceeds of $240. Following the sale, X will have an FMV of $640 (assuming that X uses the cash proceeds either to pay down existing debt or to invest in capital assets).
Next, contrast the alternative transaction, which uses Sec. 355 to provide a greater economic benefit to X and its shareholders. (See Exhibit 1.) First, a thirdparty investor (New Investor) purchases $49 of X stock on the open market. (New Investor is the “sponsor” in the sponsored spin.) Next, X forms a new controlled corporation (Controlled) and contributes B in exchange for Controlled stock and a $300 debt instrument from Controlled that qualifies as a security for U.S. tax purposes. As part of a reorganization plan, X then distributes the Controlled security to its third-party debt holders in exchange for a portion of X’s outstanding debt, and it distributes the Controlled stock to its shareholders in a transaction intended to meet all the requirements of Sec. 355. In the stock distribution, X will transfer a portion of the Controlled stock (having an FMV of $49) to New Investor in redemption of the X stock held by New Investor, and it will distribute the remainder of Controlled stock pro rata to its public shareholders.
The result of this sponsored spin is that X receives $300 of value from Controlled free from tax because Controlled has effectively assumed $300 of X’s third-party debt. In addition, X’s public shareholders receive $51 of value in the form of Controlled stock. Following the transaction, X will have an FMV of $700, and Controlled will have an FMV of $100. Exhibit 2 compares each alternative.
Practitioners should note that the rules applicable to sponsored spin transactions are very specific and require careful planning and that there are numerous variations on the sponsored spin transaction described above (see, e.g., Letter Ruling 200708016, which involves a “sponsored reverse spin”). As with all transactions, the precise form of transaction the taxpayer uses must be determined based on all the facts and circumstances as well as the taxpayer’s short- and long-term goals.
Sec. 355 and IRS Private Letter Rulings
355, the often-ambiguous application of the statutory and nonstatutory requirements for tax-free treatment, and the potential tax cost involved in running afoul of these requirements, taxpayers often wish to confirm the tax treatment of a Sec. 355 distribution before its execution. The highest level of confirmation comes in the form of a private letter ruling from the IRS and provides the taxpayer with assurance that the Service will uphold any ruled-upon positions taken on its tax return. In addition, an IRS ruling can reduce the chance that the Service will challenge or analyze aspects of a transaction in future audits. Generally, a taxpayer may file a request for a ruling before executing a transaction or, for a completed transaction, any time before filing its tax return for the year of the transaction. A taxpayer may also submit a request after the return is filed, provided that the relevant IRS field office waives jurisdiction over the transaction (see generally Rev. Proc. 2008-1).
Jeff Kummer is director of tax policy at Deloitte Tax LLP in Washington, DC.
Unless otherwise noted, contributors are members of or associated with Deloitte Tax LLP.
For additional information about these items, contact Mr. Kummer at (202) 220-2148 or email@example.com.