On November 18, 2022, the Internal Revenue Service (IRS) published private letter ruling 202246008 (the PLR),1 which concluded that a transaction qualifies as a tax-free spin-off under Section 3552 despite the fact that the distributing corporation “has not yet collected income,” based on the distributing corporation’s demonstration that it had “incurred substantial, continuing operating expenses representing the active conduct of a trade or business” in accordance with Revenue Procedure 2017-52. This PLR demonstrates that the IRS is willing to permit certain entrepreneurial, pre-revenue companies to engage in tax-free spin-offs.
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 it applies to entrepreneurial ventures whose activities consist of lengthy phases of research and development without the generation of income. Since the issuance of that announcement, the IRS has issued PLRs that show relaxation of the Income Collection Requirement for at least one (but not all) of the businesses of the distributing corporation.3
The PLR
The PLR relates to a distributing corporation (distributing) that is engaged in research and development for the production of two products, Product X and Product Y. Both Product X and Product Y must go through a number of steps to receive regulatory approval before being marketed or sold to the public. Employees of distributing have engaged in “regular, continuing operational and managerial activities” with respect to each of Product X and Product Y for more than five years. Although distributing had received grants in the past, it has not received such grants in the past five years, nor has it ever collected any income associated with either Product X or Product Y.
In order to raise capital to transition Product X to the next stage of development, distributing proposes to contribute assets and liabilities associated with Product Y to a newly formed, wholly owned corporation (controlled) and distribute stock of controlled to distributing’s shareholders on a pro rata basis (together, the transaction). The IRS ruled that Section 355 applies to the transaction.4
The issuance of the PLR demonstrates that the IRS is willing to permit a tax-free spin-off for a venture that demonstrates activities consistent with the active conduct of a trade or business for more than five years notwithstanding the absence of income collection during that time. The fact that the products in the PLR generally require a lengthy regulatory approval process prior to commercialization appears to have been a significant consideration.
[1] 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.
[2] All section references herein are to the Internal Revenue Code of 1986, as amended.
[3] See, e.g., PLR 202009002; PLR 201920008. For prior coverage of PLR 201920008, 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.
[4] The IRS expressly did not rule on whether the transaction satisfies the business purpose requirement of Section 355.
