On February 28, 2020, the Internal Revenue Service (IRS) released private letter ruling 202009002 (the PLR), which concluded that an absence of income does not, under the facts of the PLR, prevent a line of business from being treated as a “trade or business” for purposes of determining whether a transaction qualifies as a tax-free spin-off under Section 355^[1] (although the line of business was believed to have “the ability to generate income”).^[2] The issuance of a favorable ruling despite a lack of income may be a positive indication of the IRS’s willingness to relax the application of the Income Collection Requirement (described below) to entrepreneurial businesses. The ruling may be particularly relevant to businesses that alternatively may opt to enter into licensing or other income-generating agreements early in their development or defer commercialization (and income collection) until they are more mature, e.g., biotech or pharmaceutical companies. However, the extent of such relaxation is not clear, particularly where the business relied on to meet the ATB Test (described below) could not realistically have generated income to any extent prior to the distribution.

Background. Historically, the U.S. Department of the Treasury’s and the IRS’s position has been that the “active trade or business” test for tax-free spin-offs under Section 355 (the ATB Test) required, except in extraordinary circumstances, both the distributing corporation and controlled corporation to collect income throughout the five-year period preceding the spin-off, as well as immediately after the spin-off (the Income Collection Requirement). 

However, on September 25, 2018, the IRS announced a study of the ATB Test as applied to entrepreneurial ventures that would not satisfy the Income Collection Requirement. The IRS indicated that it would consider requests for private letter rulings regarding satisfaction of the ATB Test by corporations that have not generated income.^[3] On May 17, 2019, the IRS released private letter ruling 201920008, which concluded that a transaction qualifies as a tax-free spin-off under Section 355 despite the fact that the distributed corporation “may not generate revenue” in the future (although it would “continue to seek to generate future revenue”).^[4] 

The PLR. The PLR relates to a distributing corporation (distributing) that is engaged in the development of certain products. For products of this type to be commercialized, they generally undergo a multi-step process of research, development, testing, and modification, which if successful ultimately culminates with commercialization. Historically, distributing developed products only to a particular step in this process and derived revenue by entering into research-oriented contracts and licensing with other industry participants (under what the PLR refers to as Collaborator Agreements), who then undertook to complete the commercialization process in collaboration with distributing (Business 1). 

However, with respect to one product (Item 1), distributing undertook to develop the product itself to a later stage of the commercialization process. The incremental development of Item 1 beyond the stage to which distributing historically developed its other products is referred to as Business 2. While distributing does not anticipate completing the entire commercialization process itself for Item 1, the expectation is that Business 2 will complete steps of the commercialization process beyond what distributing historically completed with respect to other products in Business 1.

In addition, it is expected that once Business 2 successfully develops Item 1 to a further step of the commercialization process, Business 2 will be able to collect income (through receipts of royalties, milestone payments, or profit-splits) by entering into a Collaborator Agreement that significantly exceeds the income that could have been earned if it had entered into a Collaborator Agreement at an earlier step of the process. As a result, however, distributing has foregone the collection of any income with respect to Business 2. Importantly, however, distributing believes it could have entered into a Collaborator Agreement with respect to Item 1 at an earlier step of the commercialization process, if it had been willing to forego the potential for greater income later.

At the time of the distribution intended to qualify as a tax-free spin-off under Section 355, it appears that Business 2 will not have progressed the development of Item 1 to the step of the process at which it intends to enter into a Collaborator Agreement, so following the distribution, further development will be necessary before Business 2 derives income.

The PLR states that the absence of income collection does not itself prevent distributing’s Business 2 from constituting a “trade or business” for purposes of determining whether the distribution satisfies the ATB Test. The PLR does not otherwise rule on the treatment of the proposed transaction. 

[1] All section references herein are to the Internal Revenue Code of 1986, as amended.

[2] While PLRs generally apply only to the taxpayer to whom they are written, they often are viewed as an indication of the IRS’s current position on issues.

[3] For prior coverage of the September 2018 release, please see https://www.wsgr.com/en/insights/irs-may-relax-collection-of-income-prong-of-section-355-active-trade-or-business-test-for-r-d-companies.html.

[4] For prior coverage of private letter ruling 201920008, please see https://www.wsgr.com/en/insights/irs-ruling-may-signal-relaxation-of-collection-of-income-prong-of-section-355-active-trade-or-business-test.html.