Sibling Rivalry

You have probably encountered family-owned corporations in which the founder’s offspring are involved in the business to varying degrees. They may even own some equity, typically having received such equity as gifts from their parents.[i] These situations often evolve in a way that they present challenging succession planning issues for the family and its business.

Let’s assume that two siblings are active participants in the family-owned business. Each aspires to lead the corporation after their parents have retired. At some point, their competing goals, divergent management styles, or different personalities may generate enough friction between the siblings, and within the corporation, so as to jeopardize the continued well-being of the business.[ii]

Alternatively, the siblings may be interested in different parts of the corporation’s business. Each sibling may be responsible for a different line of business – for example, a different product or service – or for a different geographic region. Their differing interests may lead to disagreements as to the allocation of resources and the prioritization of goals.

The dispute between the siblings will sometimes fester to the point where costly litigation and the disruption of the business seem inevitable.

Dividing the Business?

In that case, it may still be possible to de-escalate the situation if it can be demonstrated to the feuding siblings that the business may be divided between them on a tax-efficient basis, especially where they may have already incurred significant legal costs in trying to divorce themselves from one another.

Of course, it would be preferable (and less expensive) if the siblings could separate without first resorting to litigation, although it is often the case that such litigation provides the impetus for a more constructive approach toward the settlement of their disputes.[iii]

There are two basic forms of corporate division by which two or more shareholders may go their separate ways. In the “split-off” form of division, the parent corporation distributes all of its shares in a subsidiary corporation[iv] to one or more of its shareholders in a complete redemption of their shares in the parent corporation, leaving the parent corporation in the hands of its remaining shareholders. In the “split-up” form of division, the parent corporation distributes all its shares in at least two subsidiary corporations to at least two different sets of shareholders in a complete liquidation of the parent corporation.[v]

“Tax-Free” Divisions

Whatever form of division is selected, there are numerous requirements that must be satisfied in order for the division to receive favorable tax treatment. In general:

1. the distributing parent corporation must distribute to some or all of its shareholders all of the stock of a subsidiary corporation controlled by the parent;
2. the distributing corporation and the subsidiary corporation must each be engaged in the “active conduct of a trade or business” immediately after the distribution;[vi]
3. neither of the active trades or businesses was acquired in a taxable transaction during the five-year period preceding the distribution;
4. there is a real and substantial business purpose for the distribution that cannot be accomplished by another nontaxable alternative which is neither impractical, nor unduly expensive;[vii]
5. the transaction must not be used principally as a “device” for the distribution of the earnings and profits of either the distributing corporation or the subsidiary corporation;[viii]
6. the distributee shareholder(s) did not acquire their shares in the distributing parent corporation by “purchase” during the five-year period ending on the date of the distribution;[ix] and
7. the distribution is not made pursuant to a plan by which at least 50% of parent or of the former subsidiary is acquired by third parties.[x]

Consequences

In general, if these requirements are satisfied, (1) the shareholders will not recognize gain or loss upon the receipt of the subsidiary stock, (2) the distributing corporation will not recognize gain or loss upon the distribution of the subsidiary stock to the shareholders, (3) the aggregate basis of the subsidiary stock received by each shareholder immediately after the distribution will equal the shareholder’s aggregate basis in the distributing corporation stock surrendered in the distribution, and (4) the holding period of the subsidiary stock received by each shareholder will include the holding period of the stock in the distributing corporation with respect to which the distribution of the subsidiary stock is made.[xi]

Failed Split-Off

If these criteria are not met, then the distributing corporation will be treated as having sold the distributed property – the stock of the controlled subsidiary corporation – for an amount equal to the property’s fair market value, it will have to recognize the gain realized on deemed sale of the property, and it will be taxed thereon.

The shareholders will be taxed on their receipt of the property distributed by the corporation, either as a dividend of an amount equal to the fair market value of such property,[xii] or as a payment of the same amount in exchange for their shares of stock in the distributing corporation.[xiii]

In order to avoid the adverse tax consequences described immediately above, it is imperative that each of the requirements for a “tax-free” division of the distributing corporation be satisfied.[xiv]

Business Purpose

In the context of a family-owned corporation, the requirement that the distribution be carried out for a real and substantial corporate business purpose may present a unique challenge, at least where the ostensible business purpose for the division of the corporation is to enable competing siblings – who would otherwise succeed to the ownership and management of the corporation – to go their separate ways.

Specifically, it may be difficult in that case, depending upon the facts and circumstances, to distinguish between a corporate business purpose, on the one hand, and a personal non-business purpose of the shareholders, on the other.

That being said, it should be noted that one of the most commonly relied upon corporate business purposes[xv] for the distribution of a subsidiary as part of a corporate division is that it will enhance the success of each corporation’s business by enabling a significant shareholder or shareholder group to concentrate on a particular line of business, and to thereby resolve management or other problems that arise, or that are exacerbated, by the operation of different businesses within a single corporation.[xvi]

The IRS has also conceded that a vertical division of a corporate-owned business[xvii] may be undertaken to resolve management disputes between shareholders that threaten to have an adverse effect upon the business.[xviii]

However, the IRS has long recognized the potential, in the context of a family-owned corporation, for such a distribution to also facilitate the personal planning (such as estate planning or gifts) of a shareholder.

In order to better understand how to prepare for an IRS challenge on such grounds, the parties and their advisers will need to familiarize themselves, in the first instance, with the published guidance[xix] provided by the IRS itself.[xx]

It would also behoove them to determine whether the IRS has issued private letter rulings[xxi] to taxpayers under circumstances that were comparable to those confronting their clients.

The IRS recently released one such private letter ruling that involved the separation of two branches of a family.[xxii]

Pruning a Branch from the Corporate Tree

Distributing was a closely held corporation that operated Business A. Distributing had elected to be treated as an S corporation for tax purposes.

All of Distributing’s issued and outstanding stock was owned, directly and indirectly, by members of Family Branch A and Family Branch B. Family Branch A owned “X” percent of the issued and outstanding stock of Distributing, while Family Branch B owned “Y” percent.

Distributing was engaged in the conduct of Business A. Based upon financial information submitted by Distributing to the IRS,[xxiii] it appeared that Business A had gross receipts and operating expenses representing the active conduct of a trade or business for each of the past five years.

The Problem

Family Branch A and Family Branch B had differences of opinion as to the management and operation of Business A.

To address these differences, the two Branches of the Family decided to split Distributing’s assets and operate separate portions of Business A independently of each other.

But how to do so without incurring significant tax liabilities?

The Solution

Accordingly, Distributing proposed the following transactions (the “Proposed Transaction”):

1. Distributing would incorporate Controlled as a State Z corporation and would timely elect to treat Controlled as a qualified subchapter S subsidiary[xxiv] as of the date of its incorporation.
2. Distributing would contribute certain Business A assets to Controlled in exchange for: (i) all the stock of Controlled; and (ii) potentially the assumption of certain Business A liabilities to the extent necessary to equalize the values of Distributing and Controlled (the “Contribution”).
3. Distributing would distribute all the stock of Controlled to Family Branch B in complete redemption of all of Family Branch B’s Distributing stock (the “Distribution”), following which Family Branch A would own all of Distributing and Family Branch B would own all of Controlled – a so-called “split-off.”
4. Controlled would timely elect[xxv] to be treated as a subchapter S corporation for U.S. federal income tax purposes, effective immediately after the Distribution.

After the Distribution, Family Branch B would have no involvement in the management of Distributing, and Family Branch A would have no involvement in the management of Controlled.

However, it was expected that Distributing and Controlled would continue to engage in certain transactions – implicitly with one another – the nature, extent and duration of which were not identified or described in the ruling (the “Continuing Transactions”).

Following the Distribution, and except with respect to the Continuing Transactions, Distributing and Controlled each would continue, independently and with its separate employees, the active conduct of its share of all the integrated activities of Business A – a “vertical” division of the business – the business relied on by each of Distributing and Controlled to meet the active trade or business requirement, as conducted by Distributing prior to the consummation of the transaction.

The Continuing Transactions would be subject to arm’s-length terms between Distributing and Controlled.[xxvi]

No intercorporate debt would exist between Distributing and Controlled at the time of the Distribution, and no intercorporate debt would exist between the corporations subsequent to the Distribution except with respect to the Continuing Transactions.

IRS Ruling

Distributing demonstrated or represented to the IRS that the proposed split-off would satisfy the criteria for a “tax-free” division, described earlier.[xxvii]

Based upon such information and representations, the IRS ruled that:

(1) The Contribution and the Distribution, together, would constitute a “D reorganization”[xxviii] to which Distributing and Controlled would each be “a party.”[xxix]

(2) Distributing would not recognize gain or loss on the Contribution.[xxx]

(3) Controlled would not recognize gain or loss on the Contribution.[xxxi]

(4) Controlled’s basis in each asset received in the Contribution would be the same as the basis of such asset in the hands of Distributing immediately before the Contribution (thereby preserving the gain in such assets).[xxxii]

(5) Controlled’s holding period in each asset received in the Contribution would include the period during which Distributing held the asset.[xxxiii]

(6) No gain or loss would be recognized by Distributing on the Distribution.[xxxiv]

(7) No gain or loss would be recognized by (and no amount would otherwise be included in the income of) Family Branch B upon its receipt of stock of Controlled in the Distribution in exchange for all their stock of Distributing.[xxxv]

(8) Each participating shareholder’s aggregate basis in its Controlled stock immediately after the Distribution would equal such shareholder’s aggregate basis in the Distributing stock surrendered in the Distribution and would be allocated among the shares received.[xxxvi]

(9) Each participating Family Branch B shareholder’s holding period in its Controlled stock received in the Distribution would include the holding period of the Distributing stock received in exchange therefor, provided that such Distributing stock was held as a capital asset on the date of the Distribution.[xxxvii]

(10) The Distribution would cause a termination of Controlled’s QSub election because Controlled would cease to be a wholly owned subsidiary of a subchapter S corporation. For U.S. federal income tax purposes, Controlled would be treated as a new corporation acquiring all of its assets and assuming all of its liabilities from Distributing immediately before the termination of Controlled’s QSub election in exchange for the stock of Controlled.[xxxviii]

(11) Distributing’s accumulated adjustment account immediately before the transaction would be allocated between Distributing and Controlled.[xxxix]

(12) Distributing’s momentary ownership of the stock of Controlled, as part of the reorganization, would not cause Controlled to have an ineligible shareholder[xl] for any portion of its first taxable year, and would not, by itself, render Controlled ineligible to elect to be a subchapter S corporation for its first taxable year. If Controlled otherwise satisfied the requirements of a “small business corporation,” Controlled would be permitted to make an S election for its first taxable year, provided the election was made effective immediately following the termination of the QSub election.[xli]

The above split-off transaction seems to have been fairly straightforward, though there are two items worth noting.

Non-Business Planning?

The first is the business purpose for the separation. It was not clearly stated in the ruling, but it’s likely that the reference to “Branches” indicated the individual shareholder who was the “head” of each family; these were the insiders whose management of and/or vision for the business clashed to the point of jeopardizing the well-being of the business.

Absent such specificity, the goal of separating “branches” may easily be interpreted as allowing each family to go its separate way so as to facilitate gift and estate planning within each family.

In the end, if the post-split-off activities of the two Branches are consistent with the ostensible business purpose for dividing the corporation, the “tax-free” treatment of the division should be respected.

The “Continuing Transaction”?

Which brings us to the second item of interest, the unidentified Continuing Transaction.

By the nature of the above split-off – with Distributing contributing a vertical slice of its business assets to newly formed Controlled – the transaction in question probably involves the sharing of one or more key employees[xlii] or other staff by the two corporations, perhaps the use by one corporation of certain property (office space, warehouse, other facilities) leased or owned by the other corporation, or maybe even the “joint” participation of both corporations in some arrangement with a third party.[xliii]

If the business purpose for the split-off was as stated – to allow the separate management and operation of each Branch’s share of the Business – then any continuing business relationship between the two corporations has to be considered closely to ensure it is carried on at arm’s length and, just as importantly, that it not remain in place beyond a stated transitional period.

Looking Ahead?

It is clear that the division of a family-owned corporation may be effectuated for the purpose of resolving or eliminating management disputes among sibling-shareholders.

Moreover, the division may be accomplished on a tax-efficient basis, provided the criteria set forth above are satisfied, including the requirement that the distribution by the family-owned corporation of the stock in its subsidiary be motivated, at least in substantial part, by a business purpose as distinguished from a nonbusiness purpose. Specifically, can the parties to the transaction demonstrate that there is an immediate business reason for the divisive distribution?

In the ruling discussed in today’s post, it appears that the differences between the two branches of the family eventually would have resulted in significant harm to the corporation’s business. Indeed, it’s probably fair to surmise that the difficulties anticipated were not remote, and the resulting harm to the business was not conjectural.

However, one can imagine a situation in which the immediacy of the stated business purpose may not be obvious to an outsider, or where the severity of the consequences to be avoided is not easily determinable.

In the context of a family-owned corporation, the presence of these factors – a remote risk or an ill-defined harm – may call into question whether the distribution is motivated in substantial part by a bona fide business purpose; the failure to establish such a purpose may cause the corporation’s distribution of its subsidiary to be taxable.

For that reason, if a divisive transaction is to withstand IRS scrutiny, the closely held corporations and the shareholders that are parties to the transaction must be prepared to substantiate the corporate business purposes which they claim motivated the transaction.[xliv] They must be ready to present documented factual support for the stated business purpose, that describes in detail the problems associated with the current corporate structure, and that demonstrates why the distribution will eliminate those problems.

The opinions expressed herein are solely those of the author(s) and do not necessarily represent the views of the Firm.

[i] Or as partial gifts (as in the case of a bargain sale); rarely in exchange for capital contributions, or as compensation.

[ii] Of course, such clashes are not limited to the world of business. The Old Testament, for example, is full of references to the consequences of sibling rivalry: Cain and Abel, Isaac and Ismael, Esau and Jacob, then down to the sons of Solomon (ironic that the kingdom of the man who rendered the Judgment of Solomon should be split in two after his death).

[iii] Indeed, if the parents could reasonably foresee the risk of serious disagreement among their successors in the business, they may decide to explore with their tax and corporate advisers whether the business can be divided among the kids while the parents are still alive and before the business suffers the adverse consequences that typically accompany such infighting. Too often, the parents don’t want to deal with the obviously gestating issues within their family. They tell themselves that the kids will learn to work together, or they will deny the problem altogether, leaving it for the kids to resolve it after the parents are gone.

[iv] The subsidiary may be formed just prior to the distribution; for example, the parent corporation may contribute one line of business to a newly formed subsidiary as a prelude to the distribution of the stock of the subsidiary, as described above; or it may be an existing entity that is engaged in a trade or business that is related to, or completely different from, the business conducted by the distributing corporation (or by its remaining subsidiary).

[v] There is also a third form of division – a “spin-off” – by which a parent corporation may distribute the stock of its subsidiary corporation to at least some of its shareholders by way of a “dividend,” thereby changing the form of the relationship to that of brother-sister corporations with some degree of common ownership. This is likely the form of division that parents would undertake in preparation for transferring different parts of their business to different children.

[vi] I.e., a “trade or business” that has been “actively conducted” throughout the 5-year period ending on the date of the distribution. IRC Sec. 355(b); Reg. Sec. 1.355-3.

[vii] Reg. Sec. 1.355-2(b).

[viii] IRC Sec. 355(a)(1)(B).

[ix] IRC Sec. 355(d).

[x] IRC Sec. 355(e); Reg. Reg. 1.355-7.

Underlying the divisive reorganization provisions of the Code is the principle that it would be inappropriate to tax a transaction as a result of which the participating taxpayers – the corporations and their shareholders – have not sufficiently changed the nature of their investment in the corporation’s assets or business, provided the transaction is motivated by a substantial non-tax business purpose.

[xi] IRC Sec. 355, IRC Sec. 368(a)(1)(D).

[xii] Generally, in the case of a spin-off.

[xiii] In the case of a split-off or split-up.

[xiv] The parties may be well-advised to ask the IRS for a letter ruling.

[xv] See Rev. Proc. 96-30, Appendix A, which provides guidelines that the IRS will use, for ruling purposes, in evaluating whether a distribution satisfies the corporate business purpose requirement in certain situations, including “fit and focus.”

[xvi] For example, in Example (2) of Reg. Sec. 1.355-2(b)(5), Corporation X is engaged in two businesses: the manufacture and sale of furniture and the sale of jewelry. The businesses are of equal value. The outstanding stock of X is owned equally by unrelated individuals A and B. A is more interested in the furniture business, while B is more interested in the jewelry business. A and B decide to split up the businesses and go their separate ways. A and B expect that the operations of each business will be enhanced by the separation because each shareholder will be able to devote his undivided attention to the business in which he is more interested and more proficient. Accordingly, X transfers the jewelry business to new corporation Y and distributes the stock of Y to B in exchange for all of B’s stock in X. The example concludes that the distribution is carried out for a corporate business purpose, notwithstanding that it is also carried out in part for shareholder purposes.

[xvii] Following which there would be two separate corporations, each with its own vertically integrated business.

[xviii] Reg. Sec. 1.355-3(c), Examples, 6, 7 and 8.

[xix] Such guidance often takes the form of a revenue ruling, which is an official interpretation by the IRS of the Code and regulations. It is the conclusion of the IRS on how the law is applied to a specific set of facts.

[xx] The IRS once considered the case of a corporation (“Corp”) the stock of which was owned equally by Parents, Son, and Daughter. Although Parents participated in some major management decisions, most of the management, and all of the operational activities, were performed by Son and Daughter.

Son and Daughter disagreed over the future direction of Corp’s business. Son wished to expand one line of business, but Daughter was opposed because this would require substantial borrowing by Corp. Daughter preferred to sell that line of business and concentrate on Corp’s other business. Despite the disagreement, the two siblings cooperated on the operation of the business in its historical manner without disruption. Nevertheless, it prevented each sibling from developing, as he or she saw fit, the business in which he or she was most interested.

Parents remained neutral on the disagreement between their children. However, because of the disagreement, Parents preferred to bequeath separate interests in the business to their children.

To enable Son and Daughter each to devote their undivided attention, and apply a consistent business strategy, to the line of business in which he or she was most interested, and to further Parents’ estate planning goals, Corp contributed one of its lines of business to a newly-formed and wholly-owned subsidiary corporation (“Sub”), and distributed 50% of Sub’s stock to Son in exchange for all of his stock in Corp. Corp then distributed the remaining Sub stock to Parents in exchange for half of their Corp stock.

Going forward, Daughter would manage and operate Corp and have no stock interest in Sub, and Son would manage and operate Sub and have no stock interest in Corp. Parents would also amend their wills to provide that Son and Daughter would inherit stock only in Sub and Corp, respectively. After the distribution, Parents would still own 50% of the outstanding stock of Corp and of Sub and would continue to participate in certain management decisions related to the business of each corporation.

The IRS determined that the distribution would eliminate the disagreement between Son and Daughter over the future direction of Corp’s business and would allow each sibling to devote their undivided attention to the line of business in which they were most interested, with the expectation that each business would benefit. Therefore, although the distribution was intended, in part, to further the personal estate planning of Parents and to promote family harmony, it was motivated in substantial part by a real and substantial non-tax purpose that was germane to the business of Corp. Thus, the business purpose requirement was satisfied. Rev. Rul. 2003-52.

[xxi] A “letter ruling” is a written determination issued to a taxpayer by an associate chief counsel office in response to the taxpayer’s written inquiry, filed prior to the filing of returns required by the tax laws, about the tax effects of its acts or transactions.

Although the ruling applies only to the taxpayer to which it was issued, other taxpayers may consider the facts and holdings of the letter ruling when considering the likely outcome of their own transaction.

[xxii] PLR 202235002.

The IRS stated clearly that it made no determination regarding whether the Distribution in each case: (i) satisfied the business purpose requirement of Reg. Sec. 1.355-2(b); (ii) was used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both (see section 355(a)(1)(B) and Reg. Sec. 1.355-2(d)); or (iii) was part of a plan (or series of related transactions) pursuant to which one or more persons would acquire directly or indirectly stock representing a 50-percent or greater interest in the distributing corporation or the controlled corporation, or any predecessor or successor of the distributing corporation or the controlled corporation, within the meaning of Reg. Sec. 1.355-8 (see IRC Sec. 355(e)(2)(A)(ii) and Reg. Sec. 1.355-7).

[xxiii] In accordance with Rev. Proc. 2017-52.

[xxiv] Within the meaning of IRC Sec. 1361(b)(3) (a “QSub”).

[xxv] Under IRC Sec. 1362(a).

[xxvi] With the exception of (i) the Continuing Transactions, (ii) certain receivables that were disproportionately allocated between the two corporations to equalize values, and (iii) income and deductions taken in connection with Activity that occurred after the Distribution, the transaction would not involve and would not result in a situation in which one party owned Property, but another party recognized the income associated with such Property.

[xxvii] Rev. Proc. 2017-52.

[xxviii] Within the meaning of IRC Sec. 368(a)(1)(D).

[xxix] Within the meaning of IRC Sec. 368(b).

[xxx] IRC Sec. 361(a) and Sec. 357(a).

[xxxi] IRC Sec. 1032(a).

[xxxii] IRC Sec. 362(b).

[xxxiii] IRC Sec. 1223(2). Consistent with the carryover basis.

[xxxiv] IRC Sec. 361(c).

[xxxv] IRC Sec. 355(a)(1).

[xxxvi] Such basis would be allocated in the manner described in Reg. Sec. 1.358- 2(a). IRC Sec. 358(a)(1) and (b)(1).

[xxxvii] IRC Sec. 1223(1). Certainly the case here.

[xxxviii] Pursuant to Reg. Sec. 1.1361-5(b)(1)(i). IRC Sec. 1361(b)(3)(B) and (C).

[xxxix] In a manner similar to the manner in which Distributing’s earnings and profits would be allocated under IRC Sec. 312(h) in accordance with Reg. Sec. 1.1368- 2(d)(3). Reg. Sec. 1.312-10(a) and Sec. 1.1368-2(d)(3).

[xl] Under IRC Sec. 1361(b)(1)(B).

[xli] IRC Sec. 1361 and Sec. 1362.

[xlii] See PLR 201949012, which involved the division of one corporation into three corporations, each of which, after the distribution, operated a vertical slice of the business previously operated entirely by the distributing corporation.

What’s more, each corporation had only one full-time employee – the individual who also happened to be such corporation’s sole shareholder. The three corporations shared a “second employee” – Employee – who performed services for each of them. The IRS ruled favorably.

[xliii] Rev. Proc. 96-30, Sec. 4.08(4) and App. A, Sec. 2.05(5).

[xliv] See the reporting requirements in Reg. Sec. 1.355-5 and Sec. 1.368-3.