Category: Corporations Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com The taxpayer, XYZ , Inc., is a C corporation and has been engaged since its inception in 1989 in the business of gear grinding. XYZ has never been an S corporation. XYZ has only two shareholders, Messrs. A and B, both of whom are active in the business. There is considerable friction between the shareholders which is adversely affecting the business. The parties have decided to split the business into two pieces, each operating separately and in competition with one another. XYZ's assets consist principally of equipment and accounts receivable. XYZ owns no stock in any other company. The shareholders propose that the various assets be divided into two groups of approximately equal value, one intended for Mr. A and the other intended for Mr. B. The assets would then be contributed to two newly-formed subsidiaries of XYZ in exchange for the stock of the new subsidiaries. The assets intended for Mr. A would be contributed to one subsidiary (Subsidiary A), and the assets intended for Mr. B would be contributed to the other (Subsidiary B). XYZ would then distribute the stock of Subsidiary A to Mr. A in exchange for all his XYZ stock and the stock of Subsidiary B to Mr. B in exchange for all Mr. B's XYZ stock. XYZ would then dissolve. XYZ's customers will be notified of the split-up and choose which new company to use in the future. XYZ's relationship with its customers is strictly at-will. There are no long-term commitments with respect to customer relationships. The issue is how to effect the split-up on a tax-free basis. The above fact pattern potentially seems to fit nicely under the D-reorganization provisions. If so, the transaction would generally have the following effects. XYZ's contribution of assets to the new subsidiaries would not trigger any gain or loss to XYZ. XYZ's basis in the contributed assets would carry over to the new subsidiaries. The stock of the newly-formed subsidiaries would have the same basis as the assets contributed. The exchange of Mr. A's XYZ stock for the stock of Subsidiary A would not trigger any gain or loss to Mr. A. The basis of the stock of Subsidiary A in Mr. A's hands would be the same as the basis of Mr. A's old XYZ stock. Mr. B's transaction would be treated identically. The tax attributes of XYZ--unused net operating losses, unused capital losses, unused tax credits, earnings and profits, accounting methods, and various other items set forth at IRC Section 381(c)(1) through (c)(26)--do not carry over to the new subsidiaries. The new subsidiaries are free to make their own tax elections and to select their own accounting period independent of the choices made by XYZ. Stated another way, the new subsidiaries must affirmatively make any desired election as to accounting periods or methods. Nothing of that sort carries over from XYZ. In order to qualify for D-reorganization status, the following requirements must be met. XYZ must control the newly-formed subsidiaries immediately after the contribution. Control for this purpose means ownership of at least 80% of the stock of the new subsidiaries. Only the stock of the new subsidiaries can be distributed to Messrs. A and B with respect to their XYZ stock. Indirectly, this rule requires that everything in XYZ must be put into one subsidiary or the other such that only subsidiary stock is distributed in dissolution of XYZ. The transaction cannot be a device for distributing earnings and profits (E&P) of XYZ. The active business requirement of Section 355(b) must be met. It is necessary to have a corporate business purpose (as opposed to a shareholder purpose) for the transaction. I will now comment on the requirements that are not self-explanatory. Device for Distributing E&P One factor is subsequent disposition of stock distributed in a D-reorganization. I assume that both the shareholders plan to hold the stock distributed in this transaction for the foreseeable future. Have them make that representation to you. Also, have them affirmatively represent to you that there is no prearranged plan to dispose of any of the shares. Another factor is discontinuance of one of the distributed business after the transaction. Have the shareholders represent that they intend to continue operation of the split-up businesses for the foreseeable future. An important factor weighing against the finding of a device is the existence of a strong corporate business purpose for the transaction. Here, the case should be forcefully made (and documented in considerable detail) that friction between the shareholders is adversely (and materially) affecting the entire business. Shareholder friction as a business purpose has typically been viewed by the IRS and the courts as an acceptable reason for a tax-free split-up. Active Business Requirement Initially, the IRS took the position that a single business cannot be divided in two or more pieces in a tax-free transaction. However, after repeatedly losing in the courts, the IRS conceded the position in Rev. Rul 64-147 and finally amended its regulations in 1989 to specifically sanction the division of a single business. See Comr. v. Coady, 33 T.C. 771 (1960), aff'd, 289 F.2d 490 (6th Cir. 1961); U.S. v. Marett, 325 F.2d 28 (5th Cir. 1963); Rev. Rul 64-147, 1964-1 C.B. 136; and Regs. Section 1.355-1(b). It seems clear in this case that the business in question is active (as opposed to some kind of passive investment company) and that the business has been conducted for at least five years. Assuming that the resulting businesses are themselves active (i.e., each subsidiary is capitalized with a viable, active business which is then actively conducted) the active trade or business requirement seems to be met. ********* Rev. Proc. 96-30 provides a checklist for obtaining a ruling for a divisive D-Reorganization. Even though no ruling will be requested, I strongly suggest that you go through this checklist with your client. Because I am removed from your client's facts, the checklist could very well enable you to elicit very important information that I would not know to ask about. If you need a copy of the procedure, please let me know. Steps for Effecting the Transaction 1. Call for a meeting of the Board of Directors of XYZ. Carefully observe all relevant formalities of local corporate law. Get competent legal advice on this subject. At this meeting, resolve to split-up XYZ into two new subsidiaries and then to dissolve XYZ. Detail how the assets will be divided. It is essential that everything be done pursuant to a plan of reorganization. The minutes of this meeting are the sole formal representation of that plan. This is the most important document that will result from this entire transaction. Carefully document the events of this meeting in the corporate minutes. Make sure the minutes meet all the requirements of local law. Then, have the minutes reviewed from a tax perspective. I would like to help with this step. I have attached sample minutes. Note that these minutes are for a spin-off, not a split-up. Also, these minutes are for some state other than Michigan. 2. Document in detail the corporate business purpose of the transaction outside the context of the minutes. Prepare a narrative providing considerable detail as to how shareholder friction is adversely affecting the business. This narrative should not be part of the minutes, but rather be prepared now and set aside for future use. Please allow me to review and perhaps edit this document. 3. I assume that shareholder approval is required for such a transaction under local corporate law. Again, get legal advice and meticulously follow all the formal requirements of local law. Produce minutes of the shareholder meeting at which the plan of reorganization is approved. Again, I have attached sample minutes. Again, they relate to a spin-off in a state other than Michigan. 5. Having taken care of the formalities, the following steps are needed. a) Form two new subsidiaries pursuant to local law. b) Contribute all of XYZ's existing assets and liabilities to either of the two new corporations. Make sure that the liabilities contributed do not exceed the tax basis of the assets so contributed. c) Dissolve XYZ pursuant to local law. Distribute the stock of the respective subsidiary to the proper shareholder in exchange for his existing XYZ stock. File IRS Form 966 within 30 days of the adoption of the plan of reorganization. d) Note that the dissolution date of XYZ starts the 2-1/2 month time period for filing XYZ's final tax return. For example, if XYZ is formally dissolved on June 15, 1997, its final return would be due the 15th day of the third following month (i.e., September 15, 1997). e) File XYZ's final return. Include disclosure required by Regulation Section 1.355-5(a). The disclosure is very important and the requirements are rather extensive. I strongly suggest preparing this disclosure immediately after the transaction is consummated while the transaction is fresh in mind. I would like to be involved in this step if possible. f) Note the each shareholder's return must include disclosure of the transaction as required by Regulation Section 1.355-5(b). The same goes for this disclosure as in (e), above.
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