Using a divisive D reorganization to shift ownership by creating a new S corporation

A divisive Type D reorganization occurs with the transfer of assets to a controlled subsidiary in connection with a distribution of the stock and securities of the subsidiary to the transferor’s shareholders, except only part of the parent’s assets are transferred (Sec. 368(a)(1)(D)). Whether or not the parent is liquidated, the reorganization has divided the corporation into two or more corporations.

A divisive Type D reorganization can take the form of a spinoff (distribution of stock of a controlled corporation to the shareholders of the controlling corporation), a split-off (the same as a spinoff, except the shareholders of the controlling corporation surrender stock in exchange for the stock of the controlled corporation), or a split-up (the distribution of the stock of two or more controlled corporations as part of the complete liquidation of the controlling corporation).

Defining control: For purposes of a divisive Type D reorganization, “control” is defined as ownership of at least 80% (by vote and value) of the subsidiary. In a divisive Type D reorganization, Sec. 355 applies to the distribution of the controlled subsidiary’s stock (see Sec. 354(b)(2)). Thus, control (80%) is determined under the general rule provided in Sec. 368(c).

The examples and discussion in this column illustrate the use of a divisive Type D reorganization to divide an existing corporation. In the illustrated transaction, a new corporation is created and spun off. The new corporation will be eligible to elect S status.

Example 1. Using a divisive Type D reorganization to split an existing corporation: Gold Clothiers Inc., an S corporation from inception, operates a clothing business in two locations. The stock of Gold Clothiers is owned 50% by Mary Gold and 50% by her sister, Susan. Its main retail store is a long-standing enterprise that has been operated for more than 10 years in the heart of the community’s central business district. The second location is a retail sporting goods outlet that has been open for six years in a nearby lakeshore resort community. The outlet is open the entire year, but the business is highly seasonal, with substantial sales in June and July.

A divisive Type D reorganization is being considered that would allow Gold Clothiers to split into two corporations. The primary purpose for dividing the business into two corporations is to allow a shifting of ownership between the two sisters. Mary operates the older store, and Susan is primarily involved with the sporting goods outlet. The two sisters have had conflicting opinions about the management of the two stores. Further, a major renovation of the sporting goods store will require substantial capital input, but only Susan is financially able and willing to inject these funds. As part of the divisive reorganization, Mary would primarily take stock in the main retail store, and Susan would assume majority control of the resort retail sporting goods store. Both stores have more than a five-year continuous business history.

Gold Clothiers can use a divisive reorganization to split into two successor S corporations.

Meeting the requirements for a divisive Type D reorganization

Generally, in a divisive reorganization, a corporation transfers part of its assets to another corporation and, immediately after the transfer, the transferor corporation controls the transferee. Thereafter, the transferor distributes the transferee corporation’s stock to one or more of its stockholders (but not necessarily in a pro rata manner) (Secs. 368(a)(1)(D) and 355(a)(2)).

To accomplish such a reorganization under the facts of Example 1, Gold Clothiers would form a new subsidiary corporation and transfer the assets of the sporting goods store into that new corporation. Gold Clothiers would then distribute the stock of the new corporation primarily to Susan in exchange for her stock in the existing corporation. Mary might also exchange a portion of her stock, although the intent of the sisters indicates that Susan would receive the majority of the new corporation’s stock.

Additional requirements: The planner should verify that, in addition to conforming to the statutory structure for tax-deferred exchange treatment under Sec. 368(a)(1)(D), the reorganization meets additional requirements that apply to all types of reorganizations, i.e., continuity of business enterprise, continuity of shareholder interest, and business purpose.

The Gold Clothiers reorganization described in Example 1 satisfies all three tests:

• Each store will continue to conduct its same business activity;
• The former shareholders will continue as shareholders of the two remaining corporations (although in different proportionate ownership); and
• The primary purpose of the reorganization is to provide separate ownership of the two stores between the sisters to resolve management conflicts and to facilitate Susan’s injection of capital into the sporting goods outlet.

Further requirements for divisive reorganizations

Additional restrictions apply only to divisive reorganizations. Under the facts of Example 1, the Gold Clothiers divisive reorganization meets the further requirements for divisive reorganizations:

• The transaction is not principally a device to bail out the earnings and profits (E&P) of Gold Clothiers. The stock of the new transferee corporation will be distributed primarily (or exclusively) to Susan and thus will not be distributed pro rata to the two shareholders. Furthermore, neither shareholder intends to sell her stock within the foreseeable future.
• Following the reorganization, both the clothing store and sporting goods outlet will be engaged in the active conduct of a business. Furthermore, both outlets have been open for more than five years.
• All of the stock of the transferee corporation will be distributed to Susan and Mary. The plan is intended to solve management conflicts and to enable Susan to inject additional capital into the sporting goods outlet, and so it does not have a principal tax-avoidance purpose.
• The distribution of the subsidiary stock would not cause the corporation to recognize gain under Sec. 355(d). If a distribution is disqualified, the distributing corporation may have to recognize gain as if the controlled stock were sold for its fair market value (FMV), to the extent the FMV exceeds its basis. A distribution is disqualified if any person holds disqualified stock that is a 50% or greater interest in the distributing corporation or the controlled corporation (or, if stock of more than one controlled corporation is distributed, in any controlled corporation).

For stock to be disqualified, a person must have acquired it in the distributing corporation or the new subsidiary by purchase (which may include by attribution or deemed purchase) within the five years ending on the date of the distribution. Stock acquired before Oct. 10, 1990, is excluded (Regs. Secs. 1.355-6(a)(2) and (b)(2)). Since Mary and Susan acquired their stock more than five years ago, the distribution will not be disqualified and the corporation should not be required to recognize gain, if any, from the distribution of the new subsidiary’s stock.

S status

After a divisive reorganization, if the transferor corporation was previously an S corporation and had terminated its election within the prior four-year period, the spun-off corporation generally cannot elect S status until the fifth year following the former termination year (Sec. 1362(g)). If the spun-off corporation is treated as a successor corporation, it cannot make an S election (without IRS permission) until the fifth year after the transferor’s prior S termination (IRS Letter Ruling 8243198). If the transferor corporation was always a C corporation or has been for at least four years, the statutes do not prevent the spun-off corporation from electing S status, assuming the new corporation meets all other qualifications necessary to elect S status.

In Example 1, since the transferor corporation (Gold Clothiers) is an S corporation that has not previously terminated its S election, the spun-off (sporting goods outlet) corporation can elect S status. Although the spun-off corporation technically must meet all S corporation eligibility requirements on each day of its first tax year to elect S status, the IRS has privately ruled that the fact a spun-off corporation had a corporate shareholder for at least the first day of its tax year did not prevent it from electing S status. Assuming S status is elected within two months and 15 days of its incorporation, the S election of the spun-off corporation will be effective as of the first day of its existence, and it will not be necessary to obtain the consent of the transferor corporation (IRS Letter Rulings 9011044 and 8922004).

In Letter Ruling 201128025, an existing C corporation (Distributing) formed a new corporation (Controlled), elected to treat Controlled as a qualified Subchapter S subsidiary (QSub), and transferred the stock of an existing QSub (QSub 1) to Controlled. Distributing then distributed all the stock of Controlled to existing holders of Distributing’s stock in exchange for all of Distributing’s stock. After this stock distribution, Controlled elected to be treated as an S corporation and elected to treat QSub 1 as a QSub. The IRS ruled that the transaction would be treated as a Sec. 368(a)(1)(D) reorganization, with Controlled treated as if it received a contribution of all assets and liabilities from Distributing immediately before a distribution in exchange for stock in Distributing. Therefore, no gain or loss would be recognized on the transaction.

Recognition of built-in gain

Although not a factor under the facts of Example 1 (since Gold Clothiers has always been an S corporation), the IRS has ruled that the transfer of net unrealized built-in gain (BIG) assets (as defined in Sec. 1374(d)(1)) from the transferor corporation to the spun-off corporation will not constitute a recognized BIG transaction under Sec. 1374 (Letter Ruling 9036034). Thus, the reorganization will not cause the transferor corporation to be liable for the BIG tax. The spun-off (transferee) corporation also will not be liable for the tax unless the assets are disposed of within the remainder of the recognition period (Announcement 86-128).

Allocation of AAA

In a Type D divisive reorganization, the S corporation’s accumulated adjustments account (AAA) will be allocated in a manner similar to the allocation of a regular C corporation’s E&P under Sec. 312(h) and the regulations thereunder (Regs. Sec. 1.1368-2(d)(3)). Pursuant to the Sec. 312 rules, a C corporation’s E&P generally is allocated based on the FMV of assets retained and transferred, although in appropriate cases the allocation can be made on a “net basis” (i.e., assets less liabilities).

Therefore, under the facts of Example 1, the AAA of Gold Clothiers (the transferor corporation) will be allocated based on the FMV of the assets retained and transferred to the spun-off corporation.

Using a Type D reorganization to qualify for S status

The regulations require a corporate business purpose other than reduction of federal taxes for the reorganization. By way of example, the regulations state that the business-purpose requirement for a divisive reorganization is not met if the objective is to elect S status and the reduction in federal taxes is greater than the reduction in state taxes as a result of the S election (Regs. Sec. 1.355-2(b)(5), Example (7)). However, another valid business purpose may qualify the reorganization, even if a subsequent S election is also made (Regs. Sec. 1.355-2(b)(5), Examples (1), (2), and (5)).

Example 2. Spinoff solely for the purpose of electing S status is not a valid business purpose: Assume that Gold Clothiers from Example 1 is already organized as two regular C corporations in a parent-subsidiary relationship. Gold Clothiers Inc., the parent corporation, operates the main retail store, while its subsidiary, Gold Sports Inc., operates the resort sporting goods store.

Assume further that both shareholders are involved in each store, and there is no management conflict providing a corporate business reason for separating the ownership. Rather, the shareholders desire to accomplish a spinoff of Gold Sports Inc. so that Mary and Susan each own 50% of each corporation (i.e., the two corporations would then be owned in a brother-sister relationship rather than parent-subsidiary). The sisters seek this arrangement to allow an election of S status for each corporation.

Unfortunately, the business-purpose requirement for a divisive reorganization is not met if the sole objective is to elect S status (Regs. Sec. 1.355-2(b)(5), Example (6)).

Example 3. Spinoff for the purpose of transferring stock to a key employee and coincidentally qualifying to elect S status is a valid business purpose: Assume the same facts as in Example 2, except that the distribution of the subsidiary stock of Gold Sports Inc. is made to enable a key employee of the sporting goods store, Steve Silver, to acquire stock of Gold Sports without investing in the parent corporation. Silver is critical to the success of Gold Sports, and there is the risk he will leave the company if he is not admitted to an equity position.

If the facts and circumstances establish that the reorganization was substantially motivated by the need to issue stock to an employee, it will meet the corporate business-purpose requirement, notwithstanding that the filing of an
S election was also a relevant factor (Regs. Sec. 1.355-2(b)(5), Example (8)).

Contributor

Shaun M. Hunley, J.D., LL.M., is an executive editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org. This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s S Corporations topic. Published by Thomson Reuters, Frisco, Texas, 2026 (800-431-9025; tax.thomsonreuters.com).