Category: Corporations; Nontaxable Exchanges
Subject: Reorganizations
Title: Division of Corporate Business, Spin Off
IRC Sections: 368(a)(1)(D) and 355
Filename: 1203.html
Date Produced: 02/95

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Facts
Taxpayer (TP) is an S corporation which has engaged for more than five years in two separate lines of business, a theater operation and a shopping center. A larger theater company (LARGE) wishes to acquire TP's theater operation through merger. It has been suggested that TP put the assets of the theater operation into a new subsidiary (NEWCO) and spin off the NEWCO stock to its sole shareholder. Immediately after the spin off, the shareholder would enter into a merger agreement with LARGE whereby the NEWCO stock would be exchanged for convertible preferred stock of LARGE.

Issue
Can the spin off portion of the transaction set forth above be accomplished on a tax free basis?

Answer
The spin off will not be tax free.

Discussion
The spin off portion of the transaction is intended to qualify as a D-type tax-free reorganization under the provisions of Internal Revenue Code Sections 368(a)(1)(D) and 355. Generally speaking, to qualify under those provisions, the following requirements must be met.

(1) the parent (TP) is in control of the subsidiary (NEWCO) immediately before the distribution;

(2) the distribution is not device for distributing the earnings and profits of the distributing corporation or the controlled corporation;

(3) both the distributing corporation and the controlled corporation are engaged in an active trade or business immediately after the distribution; and

(4) there is a corporate business purpose for the distribution. In addition, the distributing corporation must distribute either all of the stock or securities it owns in the controlled corporation before the distribution, or, if it can show that its retention of some stock or securities does not have tax avoidance as a principal purpose, a controlling interest in the stock of the controlled corporation.

Requirement (2), the so-called device requirement, seems to be an insurmountable problem in this case. Regulation Section 1.355-2(d)(2)(iii)(A) provides the circumstances in which the transaction will be viewed as a device for distributing earnings and profits. If the shareholder receiving the stock of the controlled corporation (NEWCO in this case) sells or exchanges the stock, that is an indication of a device. The more stock sold or exchanged, the greater the indication of the device. The shorter the time period between the distribution and the sale or exchange, the greater the indication of a device. Also, the regulations provide that a sale or exchange pursuant to a prearranged plan, which this one almost certainly would be, constitutes substantial evidence of a device for distributing earnings and profits.

Presumably the parties in this case would not enter into the spin off transaction absent a binding obligation to merge NEWCO into LARGE. Given that 100% of the stock of NEWCO will be exchanged immediately after receipt as part of a prearranged plan, it seems to me that the device rule is clearly violated. Unfortunately, that is fatal to tax free treatment under Sections 368(a)(1)(D) and 355.