In Letter Ruling 201528016, the IRS ruled that a distributing corporation's acquisition of an interest in a partnership was not an acquisition of a new or different business. It was an expansion of the distributing corporation's business under Regs. Sec. 1.355-3(b)(3)(ii).
Parent is the common parent of an affiliated group of corporations that file a consolidated federal income tax return (the Parent Group). Parent owns all of the membership interests in Disregarded Entity, a limited liability company (LLC) that is disregarded as separate from Parent for federal income tax purposes. Disregarded Entity owns all of the stock of Distributing 2, which owns all of the stock of Distributing 1. Distributing 1 and Distributing 2 are members of the Parent Group.
Distributing 1 owns a "significant" economic interest and voting interest (subject to special majority provisions relating to certain significant actions) in Partnership, an LLC that is treated as a partnership for federal income tax purposes. Distributing 1 also owns several subsidiaries (the Distributing 1 Subsidiaries), all of which are members of the Parent Group. Distributing 1, directly and through the Distributing 1 Subsidiaries, has been engaged in the active conduct of Business 1 for more than five years.
On date 1, Partner A and Partner B (the Founders) formed Partnership and contributed to it the assets used in the conduct of Segment A (a segment of Business 1) since year 1 in exchange for all of the membership interests (then composed of Classes A-1, A-2, and B) in Partnership.
On date 2, the Founders sold all of their Class B membership interests in Partnership to Distributing 1 in a taxable transaction. At the time, Class B membership interests represented a significant economic interest and voting interest in Partnership.
The management of Partnership is vested exclusively in Partnership's Board of Managers (the Board). The Founders have been delegated certain responsibilities with respect to the conduct of Segment A, subject to the general oversight of the Board. Notwithstanding the delegation, the Board generally has the authority to make management decisions and control the day-to-day conduct of SegmentA.
To enable the long-term growth and expansion of Segment A as an independent business, the Parent Group intends to raise capital through an initial public offering (IPO) of stock of a newly formed corporation that will be directly engaged in Segment A. To facilitate this IPO, the following transactions have been proposed (the Proposed Transactions):
- Partnership will acquire a portion of the Founders' interest in Partnership, after which Partnership will either make an election under Regs. Sec. 301.7701-3 to be classified as a corporation (Controlled) for federal tax purposes, or a new corporation (Controlled) will be formed, into which Distributing 1 and the Founders will contribute all of their Partnership interests;
- Distributing 1 will distribute all of its stock of Controlled to Distributing 2;
- Distributing 2 will distribute all of its stock of Controlled to Disregarded Entity;
- Disregarded Entity will distribute all of its stock of Controlled to Parent; and
- Parent will distribute all of its stock of Controlled to its shareholder.
The Parent Group represents that (1) Distributing 1 owns, and has owned since its acquisition of Partnership on date 2, a significant interest (within the meaning of Rev. Rul. 2007-42) in Partnership; and (2) Partnership has been engaged in the active conduct of Segment A throughout the period following Distributing 1's acquisition of its interest in Partnership on date 2.
Laws and Analysis
Sec. 355(a) provides that, under certain circumstances, a corporation may distribute stock or securities in a controlled corporation to its shareholders or security holders in a transaction that is tax-free to those shareholders or security holders. Secs. 355(a)(1)(C) and 355(b) require that both the distributing and controlled corporations be engaged, immediately after the distribution, in the active conduct of a trade or business that has been actively conducted throughout the five-year period ending on the date of distribution.
Under Regs. Sec. 1.355-3(b)(3)(ii), the fact that a trade or business underwent change during the five-year period preceding the distribution (e.g., by adding new or dropping old products, making changes in production capacity, and the like) shall be disregarded, provided that the changes are not of such a character as to constitute the acquisition of a new or different business. In particular, if a corporation engaged in the active conduct of a trade or business during that five-year period purchased, created, or otherwise acquired another trade or business in the same line of business, then the acquisition of that other business is ordinarily treated as an expansion of the original business, all of which is treated as having been actively conducted during that five-year period, unless that purchase, creation, or other acquisition effects a change of such a character as to constitute the acquisition of a new or different business.
In Rev. Rul. 2007-42, the IRS ruled that a corporation that owns a membership interest in an LLC classified as a partnership for federal tax purposes would be considered to be engaged in the active conduct of a trade or business for purposes of Sec. 355(b) if the corporation (1) owns a "significant" interest (e.g., at least a one-third interest) in the LLC, or (2) performs active and substantial management functions for the LLC.
Conclusion
Distributing 1, directly and through the Distributing 1 Subsidiaries, has been engaged in the active conduct of Business 1 for more than five years. Distributing 1 owns a "significant interest" in Partnership, which has been engaged in the conduct of Segment A, a segment of Business 1. Based on the facts and information provided, the IRS privately ruled that Distributing 1's acquisition of business Segment A through its acquisition of an interest in Partnership constituted an expansion of Distributing 1's Business 1 under Regs. Sec. 1.355-3(b)(3)(ii), and not an acquisition of a new or different business.
EditorNotes
Mark Cook is a partner with SingerLewak LLP in Irvine, Calif.
For additional information about these items, contact Mr. Cook at 949-261-8600 or mcook@singerlewak.com.
Unless otherwise noted, contributors are members of or associated with SingerLewak LLP.
