Structuring divisive reorganizations

A Type D reorganization involves a transfer of assets between corporations. Immediately after the transfer, the transferor corporation or its shareholders must be in control of the corporation to which the assets are transferred (Sec. 368(a)(1)(D)). For divisive D reorganizations, control means ownership of at least 80% of the total voting stock and at least 80% of the total number of shares of all other classes of stock (Sec. 368(c)). Under Sec. 368(a)(1)(D), stock or securities of the corporation to which the assets are transferred must be distributed to the transferor's shareholders in a transaction that qualifies under Sec. 354, 355, or 356.

Type D reorganizations can be either acquisitive or divisive. However, the most common uses of D reorganizations involve the splitting of one corporation into two or more corporations in transactions commonly described as split-ups, split-offs, and spinoffs. Such transactions occur because the two businesses are perceived to be worth more individually than together, or because the shareholders want to split, with some owning one business (via owning the stock of one of the corporations) and others owning another (via owning the stock of the other corporation).

Type D divisive reorganizations can take the form of a split-up, a split-off, or a spinoff, whereby a corporation transfers part of its assets to one or more controlled corporations, which then distribute their stock in one of the following ways:

• In a split-up, assets are transferred from one corporation to two or more controlled corporations. The stock of the controlled corporations is then distributed to the transferor corporation's shareholders, and the transferor corporation is liquidated. The distribution of the controlled corporations' stock can be made on a pro rata or non—pro rata basis.
• In a split-off, certain assets of a corporation are transferred to a newly created corporation in exchange for all of the new corporation's stock. The transferor corporation then distributes the new corporation's stock to one (or one group of) shareholder(s), who are required to give up their stock in the transferor corporation in exchange.
• In a spinoff, certain assets of a corporation are transferred to a newly created corporation in exchange for all of the new corporation's stock. The transferor corporation then distributes the new corporation's stock to its shareholders, who are not required to give up any part of their stock in the transferor corporation.

In the following examples, assume that A Corp. operates a trucking business and a hazardous waste disposal business. Because of insurance concerns, the board of directors decides to operate the two businesses separately:

• In a split-up, B Corp. is formed, and the hazardous waste disposal business is transferred to it in exchange for all of its stock. In addition, C Corp. is formed, and the trucking business is transferred to it in exchange for all of its stock. The B and C stock is distributed to the A Corp. shareholders on either a pro rata or non—pro rata basis, and A is liquidated.
• In a split-off, B Corp. is formed, and the hazardous waste disposal business is transferred to it in exchange for all of its stock. A Corp. then transfers the B stock on a pro rata or non—pro rata basis to some or all of its shareholders in exchange for part or all of their A stock.
• In a spinoff, B Corp. is formed, and the hazardous waste disposal business is transferred to it in exchange for all of its stock. A Corp. then transfers the B stock pro rata to its shareholders.

Observation: When deciding the form of corporate division to undertake, its purpose should be considered. For example, a spinoff should not be used when there is corporate discord, because it will result in pro rata ownership of the distributing and new corporations by the existing shareholders. In contrast, a split-off does not require a pro rata distribution of stock and, thus, can result in one shareholder owning most or all of the original corporation, and the other shareholder(s) owning most or all of the newly formed company.

A split-up can be used in a variety of circumstances, including separating groups of shareholders whose disagreements on how a business should be run could have a detrimental impact on the business.

Example 1. Splitting up a C corporation to facilitate business operations and avoid double taxation: R Inc. is a family-owned C corporation that owns ranching property in Western Texas. The corporation was founded by the family many years ago, and the current shareholders acquired their stock by inheritance. Exploratory drilling activity in surrounding areas shows that oil and gas can be profitably produced in certain areas of R's land. Most of the family members want to develop the oil-and-gas property. However, some would prefer to remain in the ranching business. If R develops the property, the oil-and-gas income will be taxed on the corporation's Form 1120, U.S. Corporation Income Tax Return. Furthermore, R's shareholders will be taxed if they receive dividends. If R elects S status, all of its assets become subject to the built-in gains (BIG) tax. Can R develop its natural resource properties in a way that avoids double taxation on the income it derives from its mineral interests and minimizes its liability for the BIG tax?

The practitioner recommends that R use a Type D reorganization to split up its ranching and oil-and-gas activities. R forms two subsidiaries: F Inc. and P Inc. R transfers the assets and liabilities of its ranching operations to F in exchange for all the stock in F. R transfers its mineral interests to P in exchange for all the stock in P. R immediately distributes the F stock to those shareholders wanting to continue ranching and P stock to the remaining shareholders in exchange for their R stock. R then goes out of existence. P immediately elects S status.

The reorganization appears to meet the requirements (continuity-of-business-enterprise, continuity-of-shareholder-interest, and business-purpose tests) for a reorganization. Corporate business reasons for the reorganization include minimizing the risks involved in the development and production of oil-and-gas properties and the desire to separate the new business activity of developing the natural resources from the unrelated ranching activity.

A split-up permits the disproportionate distribution of F and P stock to the R shareholders in exchange for their R stock. This allows R to distribute only F stock to the shareholders who prefer ranching activities and not the development of the natural resources. The reorganization also appears to meet the additional requirements (the device restriction, five-year history, etc.) for divisive reorganizations.

R does not recognize any gain or loss on the transfer of the assets and liabilities of its ranching operation to F (Sec. 361(a)). Similarly, it recognizes no gain or loss on the transfer of its mineral interests to P. In addition, R does not recognize any gain or loss on the distribution of the F and P stock to its shareholders in exchange for their R stock (Sec. 361(c)).

F and P recognize no gain or loss on the issuance of their stock in exchange for the assets and liabilities they receive from R (Sec. 1032). The acquiring corporations take a transferred adjusted basis in the assets and liabilities they receive equal to the adjusted basis they have in R's hands (Sec. 362(b)). The holding period (of R) tacks on to the holding period of the assets in the acquiring corporations' hands (Sec. 1223(1)).

Observation: Sec. 362(e) may limit the basis in transferred assets to their fair market value if the assets have a built-in loss.

The shareholders do not recognize gain or loss on the exchange of their R stock for stock in F and P (Sec. 355(a)(1)). Since this reorganization is for valid business reasons (oil-and-gas production is a risky business), it is probably not a device for the distribution of earnings and profits (E&P). Furthermore, the shareholders receive no boot. Each shareholder's adjusted basis in the F and P stock they receive is the same as the adjusted basis in the R stock they surrender. More specifically, they allocate their basis in R stock to the stock they receive in F and P (Sec. 358(a)).

To summarize, the disproportionate distribution of F and P stock in exchange for R allows the family members to adjust their ownership interests in the ranching and natural resource production activities. The assets of F remain in a C corporation and are not subject to the BIG tax. P's assets on hand at the date the S election becomes effective are subject to the BIG tax if they are sold within the recognition period.

In a split-off, the parent transfers assets constituting an active trade or business to a subsidiary. The subsidiary's stock is then distributed to one or more shareholders who surrender their stock in the parent corporation. When the division is completed, the parent and the subsidiary are owned by different members of the original ownership group.

Example 2. Splitting off corporate assets to a shareholder's active children: J is the founder and majority shareholder of FDI Inc. The corporation has two separate and distinct business activities — a flower shop and a wedding consulting activity — both of which have been conducted by FDI since its inception over five years ago. J has two daughters who are active in the business. H manages the flower shop, and A manages the wedding business. J owns 60 shares, which equal 60% of FDI's outstanding stock. Her daughters each own 20 shares (20%) of the corporation's stock. J would eventually like to retire and transfer control in FDI to her daughters. Unfortunately, she is constantly settling turf disputes between the two daughters and feels their family relationship would deteriorate if she transferred her ownership in FDI equally to each daughter, which would make each daughter a 50% owner. J is also not willing to transfer a majority interest in FDI at this time to either daughter.

J could use a split-off to transfer the assets of the wedding business to a newly created subsidiary (W Co.). Assuming the two separate businesses were of roughly equal value, J would receive 60% of W's stock in exchange for half of her 60% interest in FDI. A would receive the remaining 40% of W's stock in exchange for her 20% interest in FDI. H would not be involved in the transaction.

After the split-off, FDI would be owned 60% by J (60 - 30 shares = 30 shares) and 40% by H (prior 20 shares). W would be owned 60% by J and 40% by A. Therefore, each daughter would own 40% of the company that operates her respective business and could operate that business without interference from her sister. J could eventually transfer her stock in W to A, and her FDI stock to H, when each daughter demonstrates she is ready to assume full ownership and management responsibility.

Observation: Spinoffs and split-ups are less frequently used in business succession planning because both result in the parent corporation's shareholders owning shares of the subsidiary in the same proportion as their ownership of the parent. In a split-off, control of the subsidiary can be transferred to one or more existing shareholders in exchange for their interest in the parent, while other shareholders of the parent retain their stock in that corporation.

In IRS Letter Ruling 200425033, a split-off was used to resolve disputes between two families of shareholders. The families could not agree on how the company's business matters should be handled, and this was having a detrimental impact on the business. An asset from the business was transferred to a newly formed corporation for all of its voting stock along with the assumption of liabilities associated with the transferred asset. The stock of the newly formed corporation was then transferred to one of the families in exchange for their stock in the original business. The transaction constituted a Type D reorganization, and no gain was recognized by the original corporation or the family shareholders.

In IRS Letter Ruling 200425041, the Service ruled that a spinoff of a line of business that was done to reduce risk would qualify as a Type D reorganization. An S corporation with two shareholders was engaged in two businesses (Business A and Business B). The shareholders were seeking to reduce risk between the businesses by separating them. A new corporation was formed, and the assets of Business B were contributed to the new corporation. The stock of the new corporation was then distributed to each shareholder equally. The IRS ruled that no gain or loss would be recognized by either the distributing corporation or the shareholders upon receipt of the new corporation's stock.   

This case study has been adapted from PPC's Tax Planning Guide — Closely Held Corporations, 32d Edition (March 2019), by Albert L. Grasso, R. Barry Johnson, and Lewis A. Siegel. Published by Thomson Reuters/Tax & Accounting, Carrollton, Texas, 2019 (800-431-9025; tax.thomsonreuters.com).