Category: Corporations
Subject: Reorganization
Title: D-Reorganizations
IRC Sections: 355, 368(a)(1)(D)
Filename: 1355.html
Date Produced: 12/93

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

Taxpayer (TP) is an S corporation engaged in manufacturing. TP is very concerned about product liability claims from one of the products manufactured.

TP proposes to divide the business into three separate segments--sales, manufacturing, and a newly formed business segment. Each segment will be spun into a separate new subsidiary the stock of which will immediately be distributed to TP's sole shareholder.

It is anticipated that all the assets and liabilities of TP will be spun off such that TP will be an empty shell at the conclusion of the transaction. It is further anticipated that TP will remain in existence to provide legal insulation against potential lawsuits.

Based on the foregoing facts, you have identified the following issues.

1. Does the division of a single business into multiple new corporations qualify under the five year active business requirement of §355?

2. Can the old corporation remain in existence simply as an empty shell?

3. Is there anything to prevent the newly formed corporations from electing S corporation status?

Issue No. 1
Division of a single business into several separate new corporations does meet the five year active business requirement under §355 provided that the entire original business was actively conducted for five or more years prior to the transaction. The IRS fought this result for many years, but after losing repeatedly in the courts, finally conceded the issue. The regulations at §1.355-3(c) Example 4 through 6 specifically sanction division of a single business into two separate corporate components. More importantly, regulation §1.355-3(c) Example 10 sanctions dividing a single business into multiple components along functional lines. The other examples cited divided a single business by separating divisions or factories or customer lists. Example 10 divides a single meat processing business as between its sales and processing functions. This example more closely resembles the fact pattern set forth above.

There is considerable uncertainty if any function of the single business is less than five years old. If any function has been conducted for less than five years, it is quite possible that the IRS might successfully argue that the five year requirement is not met, particularly if the newer function is singled out by placing it separately in its own subsidiary. The existence of TP's new business segment appears to be a serious potential problem.

Issue No. 2
My research did not uncover any prohibition against leaving the original corporation in existence as shell after the transaction. IRC §368(a)(1)(D), the definition of a D-reorganization, explicitly provides that all or a part of a corporation's assets can be transferred to a controlled corporation in a D-reorganization.

Issue No. 3
There is nothing presented in the facts set forth above to prevent the new corporations from electing S corporation status. However, there is exposure that an S election by the newly formed corporations will jeopardize the tax free status of the entire reorganization.

One of the many technical requirements of a D reorganization is the necessity to have a substantial non-federal tax reason for the transaction. Election of S corporation status has been associated, at least for private ruling purposes on this issue, with tax avoidance, and D reorganizations will not pass muster if tax avoidance is an important motivating factor. There is substantial uncertainty about this issue. Accordingly, it would appear prudent to avoid an S election for the new companies unless the taxpayer can obtain a private ruling specifically sanctioning the election.

Other Important Matters
1. D reorganizations, particularly spin-offs, are very closely scrutinized by the IRS. Typically, the potential tax cost and the attendant professional liability ramifications of a disallowed D reorganization are staggering. Accordingly, knowledgeable commentators on this subject strongly urge obtaining a private ruling prior to consummating a D reorganization. The requirements for a D reorganization are extremely technical and extremely complex. Also, some of the requirements are subject to considerable and unpredictable interpretation by the IRS and the courts. Given that close IRS scrutiny is virtually guaranteed, I urge you in the strongest possible terms to convince your client to seek a private ruling on this matter.

2. As stated above, the D reorganization provisions are extremely technical and extremely complex. I have considered the issues that you have identified above narrowly. In other words, the scope of this project is strictly limited to the issues above. There are numerous critical matters which must be considered, and I have not attempted to address them. There are two reasons for my having taken this position. First, my involvement with this matter has been limited. A tax-free reorganization is a major event, the successful execution of which requires a substantial investment in professional time. My involvement does not even begin to approach the investment necessary to insure a favorable result. Second, my knowledge of your client's circumstances is extremely limited. It is absolutely essential that intimate knowledge of your client's facts be integrated with understanding of the technical provisions involved.

Of course, my services are at your disposal should you desire them.

3. There has been no consideration of state income taxes, or the state and local non-income tax ramifications, e.g., sales taxes, property tax revaluations, etc..

Addendum:
In our phone conversation today, we wondered whether leaving the new business segment in the original corporate shell would change the problem with the five year active business requirement. It does not. §355(b)(2) provides that both the distributing and the controlled corporation must each meet the five year requirement.