The “five-year active trade or business” or “ATB” requirement of section 355 is notorious for defeating many otherwise promising tax-free spin-off transactions. Consider the following common scenarios: 

• TechCo has developed two business lines using its core technology, only one of which is producing revenue. The shareholders are planning a stock sale, but prospective buyers place no value on the non-revenue producing business. TechCo therefore proposes to drop the unwanted business line into a subsidiary and distribute the subsidiary to the shareholders before a sale of TechCo. 

• PlatformCo has developed core technology potentially useful in many distinct applications. PlatformCo plans to create an LLC holding company above PlatformCo, drop the assets associated with each application into separate subsidiaries of PlatformCo and distribute the subsidiaries to the LLC. The LLC could then sell the stock of the subsidiaries to different buyers over time with only one level of tax on each transaction. 

For these spin-offs to be tax-free, they must run the gauntlet of section 355’s many technical requirements (e.g., “control,” “distribution,” “business purpose,” “non-device” and “continuity of interest”). What usually nips a spin-off in the bud, however, is the ATB requirement. Specifically, both the distributing corporation and the controlled corporation must have conducted an ATB for at least five years at the time of the distribution.[1]

The regulations under section 355 provide that an ATB is a group of activities that includes every operation that forms a part of the process of earning income, including “ordinarily the collection of income.” [2] In the scenarios described above, the businesses being spun-off have not yet produced any revenue. Some advisors may nevertheless be willing to bless these distributions by relying on the regulation’s use of the word “ordinarily.” This is risky, however, given the potential for tax at both the distributing corporation and shareholder levels if the IRS takes a different view. Another alternative is to treat the distribution as taxable but rely on a nominal valuation of the distributed assets. This is risky too, given the possibility of a post-distribution sale at a high valuation – which, after all, is what the shareholders typically expect. 

On September 25, the IRS announced that it is rethinking the ATB test, specifically to address scenarios like those described above.[3] In its statement, the IRS solicited comments regarding the collection-of-income aspect of the ATB requirement and stated that it will entertain requests for private letter rulings for corporations that have not yet collected income. 

In October, IRS officials informally indicated that forthcoming guidance may permit corporations without revenue to satisfy the ATB test based on factors such as: 

• Regular, continuing research and related activities by a significant number of full-time management and operational employees,
• Regular, continuing research and related expenses,
• Significant progress toward developing an income-producing product, or
• The likelihood that the business may be able to enter into income-producing arrangements. 

Navigating section 355 remains challenging, but the IRS’s willingness to rethink the ATB test should encourage many taxpayers and their advisors to at least consider tax-free spin-offs again. 

Reprinted with permission from the North Carolina Association of CPAs.

[1] See IRC §355(b).

[2] See Treas. Reg. §1.355-3(b)(2)(ii).

[3] See IRS statement regarding the active trade or business requirement for section 355 distributions (September 25, 2018)