Proposed ‘hot dog stand’ regulations for spinoffs

Editors: Mindy Tyson Weber, CPA, and Trina Pinneau, J.D., LL.M.

Completing a tax-free spinoff provides significant tax advantages. In a spinoff, a parent corporation (Distributing) distributes stock of a subsidiary (Controlled) to its shareholders. To qualify for tax-free treatment, Distributing and Controlled must both conduct an active trade or business (ATB) (Sec. 355(b); Regs. Sec. 1.355-3). In addition, the spinoff must not be used principally as a device for the distribution of earnings and profits (Sec. 355(a)(1)(B); Regs. Sec. 1.355-2(d)). Numerous other requirements must also be met.

To address the ATB and device requirements, the Treasury Department and the IRS issued proposed regulations in July 2016 (REG-134016-15). The proposed regulations, generally, are intended to further limit a corporation’s ability to separate business assets from nonbusiness assets in a tax-free manner.

Whether the business assets involved in a spinoff must be valuable in relation to the other assets has long been an open question. Because the question can be well-illustrated by a hypothetical “hot dog stand” spinoff, the proposed regulations are popularly known as the hot dog stand proposed regulations. Consider this hot dog stand example: What if Controlled operates a hot dog stand business worth $20,000 and has nonbusiness assets worth $2 million? Prior government guidance did not necessarily deny tax-free treatment to this hot dog stand spinoff. The proposed regulations would.

Under the proposed regulations, spinoffs would not qualify for tax-free treatment where the nonbusiness assets of either Distributing or Controlled have a fair market value (FMV) that is too high in relation to the FMV of the corporation’s business assets. In the example above, the hot dog stand worth $20,000 would not support a tax-free spinoff when coupled with $2 million of nonbusiness assets.

Minimum ATB test

To qualify for a tax-free spinoff, both corporations must operate an ATB immediately after the distribution and, generally, must have operated the ATB for the five years prior to the distribution (see Regs. Sec. 1.355-3). Under current law, there is no requirement that the ATB comprise a specific percentage of the corporate assets (Rev. Rul. 73-44).

For issuance of a favorable spinoff private letter ruling, the IRS formerly required that an ATB have an FMV that was at least 5% of the FMV of the total assets of the relevant corporation (Rev. Proc. 96-43). Later, the IRS reduced the availability of private letter rulings, and the 5% test was withdrawn, along with the IRS’s willingness to rule on these ATB issues (Rev. Proc. 2003-48).

The proposed regulations would apply a 5% ATB size test to all spinoffs. Under this minimum ATB test, if either Distributing or Controlled had a five-year ATB asset percentage of less than 5%, the spinoff would not qualify for tax-free treatment (Prop. Regs. Sec. 1.355-9(b)). The five-year ATB asset percentage would be determined by dividing the FMV of the relevant corporation’s five-year ATB assets by the FMV of its total assets (Prop. Regs. Sec. 1.355-9(a)(6)).

Proposed framework for analyzing business and nonbusiness assets

The proposed regulations include rules for classifying assets as business or nonbusiness assets in spinoff contexts(see, generally, Prop. Regs. Sec. 1.355-2(d)(2)(iv)(B)). Distributing and Controlled would each characterize the assets they hold immediately after the spinoff as business or nonbusiness assets. Then, they would be required to determine in a consistent manner their assets’ FMV on one of the alternative dates specified in the proposed regulations (Prop. Regs. Sec. 1.355-2(d)(2)(iv)(D)(4)).

The proposed regulations also set out tests for determining whether stock of subsidiaries and interests in partnerships are considered business or nonbusiness assets (Prop. Regs. Secs. 1.355-2(d)(2)(iv)(D)(2), -2(d)(2)(iv)(D)(6), and -2(d)(2)(iv)(D)(7)). Cash and cash equivalents would be considered business assets if they are held as a reasonable amount of working capital, for regulatory purposes, or to provide for exigencies (Prop. Regs. Sec. 1.355-2(d)(2)(iv)(B)(2)).

Device test

As noted above, if a spinoff is a device for the distribution of earnings and profits, it does not qualify for tax-free treatment and instead generally triggers tax at both the corporate level and the shareholder level. Whether a spinoff is a device is a facts-and-circumstances-based determination involving examination of all relevant factors (the device test) (Regs. Sec. 1.355-2(d)(1)). The regulations governing the device test list “device factors” that are considered evidence of a device, such as a sale of stock after a distribution, and some “nondevice factors” that are considered evidence of “nondevice,” such as a corporate business purpose (Regs. Secs. 1.355-2(d)(2) and -2(d)(3)).

Another relevant factor for the device test is the nature and use of Controlled’s assets (Regs. Sec. 1.355-2(d)(2)(iv)). The proposed regulations would heighten the specificity and impact of this nature-and-use factor under the device test. They propose detailed rules that would require examinations of the business and nonbusiness assets of both Distributing and Controlled.

The proposed regulations look to both (1) the ownership of nonbusiness assets by Distributing or Controlled, and (2) the difference between the nonbusiness asset percentages of Distributing and Controlled. Ownership of nonbusiness assets by either would be some evidence of a device (Prop. Regs. Sec. 1.355-2(d)(2)(iv)(C)(1)). The strength of the evidence of a device generally would increase if there is a difference between the nonbusiness asset percentages of Distributing and Controlled, and the strength of the evidence of a device would increase as this difference increases (Prop. Regs. Sec. 1.355-2(d)(2)(iv)(C)(2)). However, business asset percentage differences would ordinarily not be evidence of a device if (1) the difference is less than 10%, or (2) the difference is attributable to a need to equalize the values of Distributing and Controlled stock that would be held by different groups of shareholders after the spinoff (Prop. Regs. Secs. 1.355-2(d)(2)(iv)(C)(2)(i) and -2(d)(2)(iv)(C)(2)(ii)).

Per se device rule

The proposed regulations also would create a new per se device rule. A spinoff would be a per se device if at least two-thirds of the assets of either corporation were nonbusiness assets and the nonbusiness assets of the other corporation were disproportionately small in comparison (Prop. Regs. Sec. 1.355-2(d)(5)(iii)).

A spinoff that is a per se device generally would not qualify for tax-free treatment regardless of whether nondevice factors, such as a strong corporate business purpose, were present (Prop. Regs. Sec. 1.355-2(d)(5)(i)). Some exceptions are provided, however. The per se device rule ordinarily would not apply to spinoffs (1) within certain affiliated corporate groups, (2) that are distributions wholly qualifying for treatment as redemptions under Sec. 302(a) or 303(a), or (3) where neither Distributing nor Controlled has earnings and profits and no distribution of property by Distributing or Controlled before the separation would produce current earnings and profits (Prop. Regs. Sec. 1.355-2(d)(5)(i)).

Anti-abuse rules

The proposed regulations contain broad anti-abuse rules aimed at transactions undertaken with a principal purpose of affecting either (1) device test outcomes under the proposed nonbusiness asset percentage rules (Prop. Regs. Sec. 1.355-2(d)(2)(iv)(E)), or (2) the minimum ATB test outcomes under the proposed five-year ATB asset percentage rules (Prop. Regs. Sec. 1.355-9(d)).

The proposed anti-abuse rules appear overbroad and are a potential cause for taxpayer concern. They would prohibit various pre-spinoff structuring transactions among related companies that are permitted under current law. The preamble to the proposed regulations did not set out reasons for restricting pre-spinoff transactions so severely.

Prospective effective date

The proposed regulations would generally be effective for transactions occurring on or after the date final regulations are published. However, they generally would not apply to spinoffs for which one or more of the following events occur prior to publication of final regulations: (1) A binding agreement is in place; (2) a private letter ruling request was submitted to the IRS on or before July 15, 2016; or (3) an SEC filing or public announcement describing the spinoff has been made (Prop. Regs. Sec. 1.355-2(i)(1)).

Analyze assets before spinning off

The proposed regulations would require companies undergoing spinoffs to focus on the ratios of business and nonbusiness assets for each corporation involved. They would establish a new minimum relative value of the business being relied upon to satisfy the ATB requirement and provide additional detailed rules surrounding whether a distribution represents a device. Companies considering a spinoff should consider the relative values of business and nonbusiness assets involved in light of the proposed rules.

EditorNotes

Mindy Tyson Weber is a senior director, Washington National Tax for RSM US LLP. Trina Pinneau is a manager, Washington National Tax for RSM US LLP.

For additional information about this item, contact the author at Stefan.Gottschalk@rsmus.com.

Unless otherwise noted, contributors are members of or associated with RSM US LLP.