Peter L. Faber is a partner with McDermott Will & Emery LLP, New York.
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More and more publicly owned corporations are dividing their businesses, distributing, or spinning off one or more of their businesses to their shareholders. Spinoffs typically result from a perception by corporate management that the whole may be less than the sum of its parts. Management may conclude that shareholder values would be maximized by conducting a corporation's businesses in several separately owned corporations rather than in one corporation or in a group of related corporations. In many cases, the linkage of one business with another business in the public eye may reduce the business's attractiveness as an investment. The typical spinoff by a publicly owned company is prompted by management's perception that the stock of two separate companies would trade at a higher combined price than would the stock of one company conducting the two businesses.
Spinoffs are often done by privately held corporations to accomplish a variety of business objectives, including insulating one business from the liabilities and risks of another, providing critical employees involved in only one of the corporation's several businesses an opportunity to acquire an equity interest in that business alone, and facilitating financing. They are also a means for effecting a corporate divorce when the shareholders of a corporation are not getting along.
Federal Tax Consequences
If a corporation (Distributing) distributes the stock of a controlled corporation (Controlled) to its shareholders, the distribution will be tax free to both Distributing and the shareholders under IRC section 355 if specific requirements are met. If those requirements are not met, Distributing will recognize gain on any appreciation in the value of Controlled stock and the shareholders will generally be treated as having received a dividend of the value of the Controlled stock (to the extent of Distributing's earnings and profits). The resulting double tax is sufficiently catastrophic that taxpayers often request a ruling from the IRS that the requirements for tax-free treatment are met. The alternative is to proceed based on an opinion of counsel.
The principal requirements for tax-free treatment under the Internal Revenue Code are the following:
- Distributing must control Controlled immediately before the distribution.1 Control means the ownership of stock possessing at least 80 percent of the voting power of Controlled's outstanding stock and at least 80 percent of each class of Controlled's nonvoting stock.2
- Immediately after the distribution, Distributing and Controlled must each be engaged in a trade or business that has been actively conducted for at least five years before the distribution and that was not acquired by Distributing or Controlled in a taxable transaction during the five-year period.3 In the application of that test, each of Distributing and Controlled, together with all members of an affiliated group that it controls, is treated as a single corporation.4
- The distribution must not be used principally as a device for distributing the earnings and profits of Distributing, Controlled, or both.5
- Distributing or a distributee corporation must not have acquired control of Controlled within the preceding five years in a taxable transaction.6
- Distributing must distribute at least an amount of Controlled stock constituting control of Controlled and it must establish that any undistributed Controlled stock or securities was retained for reasons other than principally to avoid paying federal tax.7
The courts have added requirements to those imposed by the statute. The shareholders of Distributing before the distribution must retain a proprietary interest in both Controlled and Distributing after the distribution, and there must be a business purpose for the transaction. Those requirements have been incorporated in detailed Treasury regulations.8
The statutory rules are fairly clear, and, although occasionally questions arise regarding what constitutes an "active business," tax practitioners can generally determine with a reasonable degree of certainty whether the statutory tests will be met. The problems that typically arise in qualifying a spinoff as tax free have generally been caused by the judicial tests. The business purpose requirement has proved particularly troublesome.9
The regulations require that the purpose of the transaction be "germane to the business of the distributing corporation, the controlled corporation, or the affiliated group . . . to which the distributing corporation belongs."10
The purpose need not be the principal purpose for the transaction or even the most important purpose, as long as it motivates the transaction in substantial part.
There must be a business purpose for both the separation of the businesses and for the distribution of Controlled stock to the Distributing shareholders. The regulations illustrate that principle with an example in which a corporation is engaged in the toy and candy businesses. The shareholders want to protect the candy business from the risks of the toy business, so they cause the corporation to transfer the toy business to a new corporation, the stock of which it distributes to its shareholders. The IRS concludes that the purpose of protecting the candy business from the risks of the toy business is achieved by transferring the toy business to a new corporation and, because the distribution of that corporation's stock is unnecessary to achieve that objective, the distribution fails to qualify under section 355.11
In the Service's view, the business purpose must be a corporate purpose and not a shareholder purpose.12 Although some courts have suggested that a shareholder purpose will suffice,13 the IRS has drawn a line in the sand on this issue and prudent taxpayers should assume that a corporate business purpose will be required for a spinoff to be tax free.
The IRS has approved a variety of business purposes over the years. Enhancing a corporation's access to additional funds by borrowing or raising equity capital has often been held to be a proper business purpose under section 355.14 In a typical situation, the ability to raise funds to finance one business may be enhanced if another business, regarded as entailing some risks, is transferred to a separate corporation that is not formally affiliated with the first. A spinoff of the stock of a real estate subsidiary by a parent engaged in a high-technology business to facilitate a public offering of the parent's stock was held to be for a proper business purpose.15 Distributions to enable a critical employee to acquire an equity interest in the operation of one or more of the corporation's businesses have been held to qualify under section 355.16 Distributions intended to separate feuding shareholders have long been approved under section 355.17 Other business purposes include separating products of two businesses in order to enhance consumer acceptability,18 insulating one business from labor problems of another business,19 and reducing regulatory burdens.20
The Service has been firm in maintaining that saving federal taxes of any kind is not an acceptable business purpose.21 The reference to federal taxes in the regulations literally applies to all federal taxes, apparently including federal excise or withholding taxes. However, the IRS considers saving state and local taxes to be an acceptable business purpose.22 Matters get more complicated when a distribution would reduce both federal taxes and state and local taxes. The regulations provide that a purpose of reducing nonfederal taxes will not be a corporate business purpose if the transaction will also reduce federal taxes because of similarities between the federal tax law and the state tax law and the reduction of federal taxes is "greater than or substantially coextensive with the reduction of non-Federal taxes."23 The IRS has approved a distribution intended to break nexus with particular states to avoid having to collect sales and use taxes.24 A reduction in state corporate franchise taxes when the tax is imposed on the amount of a corporation's capital rather than on its net income would probably justify a spinoff, even if the corporation also realized federal income tax savings.
The applicable provisions of the IRC may depend in part on the form of the transaction. If Controlled is a preexisting subsidiary, the only statutory requirements that must be met are imposed by section 355. If the business to be distributed to the Distributing shareholders is conducted directly by Distributing in a division, it will have to be transferred to another preexisting corporation or to a new corporation formed for the purpose of effecting the distribution. The transfer of the assets to Controlled followed by a distribution of Controlled stock will, if the appropriate requirements are met, be treated as a reorganization under IRC section 368(a)(1)(D). Qualification as a reorganization will ensure that the transfer of the assets to Controlled in exchange for Controlled stock will be tax free (subject to the provisions of section 357, regarding liabilities), as well as the distribution of Controlled stock to the Distributing shareholders.
Qualification for State Tax-Free Treatment
A spinoff that meets the federal requirements for tax-free treatment will generally be treated as tax free for state purposes as well. Most states have not tried to adopt separate provisions governing tax-free reorganizations and distributions but have instead relied on general principles of conformity to the federal tax laws.25
There are some areas of nonconformity, however, and although it can be time consuming, a survey of the laws of all the states is often in order for businesses considering spinoffs.
Mississippi, for example, while exempting the shareholders from tax on the receipt of the distribution, taxes Distributing on any gain in the Controlled stock that is distributed, analogous to IRC section 311(b).26 A few years ago, the Mississippi Legislature reconsidered a number of areas of nonconformity to the IRC in the corporate area, but this provision was left untouched.
Complications have developed in several states in recent years because of an amendment to the IRC. Effective May 17, 2006, section 355(b)(3) was added to the IRC, providing that the active trade or business (ATOB) requirement will be met for Distributing or Controlled if any member of the corporation's federal affiliated group that it controls is engaged in an ATOB. Before the change, each corporation involved in the spinoff had to be engaged in an ATOB. In applying the old rule, the code provided that a corporation would be deemed to be engaged in an ATOB if substantially all of its assets consisted of stock of corporations that were themselves engaged in an ATOB (known generally as the holding company rule). Spinoffs that are structured to take advantage of the new affiliated group rule and in which either corporation is not itself engaged in an ATOB will fail to qualify for tax-free treatment in states that conform to the IRC as it existed as of a date before May 17, 2006. That will be a problem in New Hampshire, which conforms to the code as it existed on December 31, 2000. It is also a problem in California because, although California adopted legislation conforming to the IRC as it existed on January 1, 2010, that legislation may be invalid under voter-approved Proposition 26, which imposed specific requirements for tax increases to be adopted. The prior conformity date was January 1, 2005, so it appears that section 355(b)(3) is not effective in California. That means that each corporation must be engaged in an ATOB for a spinoff to be tax free in California even though that is not required for the spinoff to be tax free for federal tax purposes. Since California now conforms to the code as of January 1, 2005, it appears that the holding company rule, which was repealed with the enactment of section 355(b)(3), has been reinstated, although recent conversations with the Franchise Tax Board have indicated that the board is unwilling to rule on this point because of the uncertainty caused by Proposition 26.
One interesting aspect of the federal-state relationship is suggested by a spinoff that is prompted by a desire to save state income taxes. As indicated above, the IRS regards saving state income taxes as an acceptable business purpose under section 355. May state tax authorities argue that saving income taxes of their state is not an acceptable business purpose, which could mean that a spinoff that was tax free for federal purposes might be taxable for state purposes? If taxable income is defined for state tax purposes as being federal taxable income with specific adjustments and the treatment of spinoffs is not included in the adjustments, a state tax department would seem to be unable to reach that result under the statute even if the argument has a certain theoretical appeal (at least to the tax administrator). However, in a state that does not base its definition of taxable income on federal taxable income, this risk may be more serious. If the corporations are doing business in several states, that may be less of a problem because the spinoff may result in saving taxes in states other than the taxing state.
Qualification for tax-free treatment is often a more serious consideration for state and local tax purposes than it is for federal tax purposes. If all of Distributing's stock is owned by another U.S. corporation that files consolidated federal income tax returns with Distributing, the immediate federal tax consequences of a spinoff of Controlled stock that is determined not to qualify for tax-free treatment may not be too severe because any recognized gains will not be taxed immediately but will be deferred under the federal consolidated return regulations. If Distributing and its controlling corporate shareholder do not file combined or consolidated returns in one or more of the states in which they do business, however, state income taxes may be immediately payable if the transaction fails to qualify for tax-free treatment even though federal taxes are not payable or are deferred. Under those circumstances, it often makes sense to get an IRS ruling regarding tax-free treatment, which may be easy to obtain because of the relatively low federal tax stakes involved. An IRS ruling can then be presented to state tax administrators, although some revenue department representatives may regard themselves as not being bound by IRS rulings. Several years ago, a proposal was advanced in Congress to make all intragroup spinoffs taxable. The proponents thought that this would cause no immediate tax effect because any recognized gains would be deferred under the federal consolidated return regulations. When this writer and others pointed out that the proposal would create immediate tax liabilities in separate return states, the proposal was abandoned.
Sales Tax on Transfer to Controlled
If the business to be spun off is operated by Distributing as an unincorporated division before the transaction, its assets will have to be transferred to Controlled before the spinoff. That transfer may have sales tax implications. Asset transfers also occur in many transactions for business reasons, so Distributing and Controlled will have the desired configuration of businesses and assets after the transaction. I am now working on one transaction in which the transaction charts consist of 217 pages. Only the last two pages describe the actual spinoff. The other 215 pages describe the pre-spinoff transactions that are necessary so that Distributing and Controlled will have the right mix of assets and liabilities.
States generally have an exemption from the sales tax for transfers to a corporation in exchange for an equity interest in the corporation. The exemptions are analogous to the income tax exemption for a transfer to a controlled corporation in exchange for its stock under IRC section 351. The scope of the state exemptions varies considerably, however. The following discussion illustrates some of the problems that can arise, but it does not purport to be a comprehensive analysis of the laws in all of the states. The sales tax laws of each state in which assets are located should be reviewed separately.
Missouri has a generous exemption that extends to any transfer to a corporation solely in exchange for that corporation's stock or as a capital contribution. The transferor need not control the transferee.27
In New York, New Jersey, and Vermont, however, the exemption is limited to a transfer to a corporation "upon its organization in consideration for the issuance of its stock."28 The states take literally the requirement that the transfer be on the corporation's organization. In New York, for example, a transfer on the activation of a dormant shell corporation that was formed sometime before is taxable if new stock is issued.29 The problem can be avoided for a transfer to a preexisting subsidiary if the transfer is made as a capital contribution without the issuance of additional stock. Although one can argue that under those circumstances the transferring corporation should be viewed as making a constructive distribution of stock,30 form often prevails over substance in the sales tax area and the transfer of assets to a preexisting subsidiary as a capital contribution without the issuance of additional stock will be regarded as a transfer for no consideration for sales tax purposes.31 In holding that a transfer of assets to a wholly owned corporation was subject to sales tax, the New York State Division of Tax Appeals in Weichbrodt pointed out that the problem could have been avoided if the transfer had been effected by a capital contribution without the issuance of new (and meaningless) stock.32
Making the transfer to a preexisting subsidiary without the issuance of additional stock may be particularly important in states such as Texas where the exemption for a transfer in exchange for an equity interest is limited to a transfer of "substantially all of the property used by a person in the course of an activity."33 "Substantially all" means 80 percent or more.34 Although in the typical spinoff situation an entire business will be transferred to Controlled -- thus, presumably, qualifying as a transfer of all of the property used in the course of an activity -- the statutory language is sufficiently nebulous to raise questions in some cases regarding whether the business transferred to Controlled will constitute a separate activity under Texas law apart from other activities of Distributing.
The business that is transferred to Controlled will ordinarily include liabilities that Controlled assumes or takes subject to. Even if transfers in exchange for Controlled stock are exempt from sales tax, there is a danger that the assumption of liabilities by Controlled or the receipt by Controlled of assets subject to liabilities will be regarded as a transfer by Controlled of additional consideration that will result in a sales tax liability on the transaction.
California's regulations, for example, state that, although ordinarily transfers to a corporation on its commencement of doing business in California are exempt from sales tax if they are in exchange for the corporation's stock, the tax applies if the transferor receives other consideration such as an assumption of indebtedness.35 New York exempts transfers in exchange for the assumption of liabilities only if the liabilities are secured by the transferred assets.36 Maryland, which exempts transfers only if they are "principally" in exchange for the transferree corporation's stock, does not take assumed liabilities into account in applying the principally test, but only if the transferor does not regularly sell tangible personal property or a taxable service.37
The liabilities that are transferred to Controlled must be allocated among the transferred assets. Of course, not all of the transferred assets will be subject to the sales tax. Typically, only tangible personal property will be subject to the sales tax, and specific exemptions may apply based on the nature of the property. For example, property used in manufacturing other tangible personal property for sale is typically exempt, as is inventory, which is exempt as property held for resale. Although the normal approach is likely to be to allocate all liabilities among all assets in proportion to their fair market values, taxpayers may want to take the position that a liability secured by particular assets (typically real estate) should be allocated only to those assets and should not be regarded as being assumed in exchange for other assets.
Nexus and Combined Reporting Aspects
If Controlled was a preexisting subsidiary that was not formed for the purpose of the spinoff transaction, it is likely that it filed consolidated federal income tax returns with Distributing. It does not necessarily follow that the two corporations were filing consolidated or combined state returns in all states in which they were doing business. Many states do not permit those returns under any circumstances, and other states permit them only if the corporations are engaged in a unitary business or other requirements are met. A spinoff of a preexisting subsidiary can result in the triggering for federal income tax purposes of gains resulting from intercorporate transactions under the deferred intercompany transaction rules of the federal consolidated return regulations. If the corporations were filing separate state returns, it is likely that those transactions were previously taxed for state purposes, and the parties should remember to subtract those gains from the federal income that is recognized for state purposes under the general conformity provisions of the state law.
A new analysis of the combined report and nexus status of the affected corporations should be made before the spinoff occurs. In many situations, Controlled will itself have subsidiaries. Some of the subsidiaries may have been connected with other subsidiaries of Distributing that are not part of the Controlled group of corporations. The departure of the Controlled group of corporations may affect the relations among Distributing's remaining subsidiaries and the eligibility of those corporations to file combined reports with each other may be affected by the departure of the Controlled corporations.
In fact, it makes sense for the tax managers of both Distributing and Controlled to do independent reviews of their post-spinoff filing status in the states in which they do business to see whether taxes can be saved by rearranging existing subsidiaries and divisions. If one or more of the businesses that leave the Distributing group with Controlled had been conducted by Distributing as unincorporated divisions, Distributing may find that it is no longer taxable in the states in which those businesses were conducted previously. In other states, the departure of the Controlled businesses may reduce Distributing's connections with the state so dramatically that only a small amount of additional restructuring will be necessary to break nexus for income or sales and use tax purposes. Assume, for example, that before the spinoff Distributing conducts a mail-order business that involves mailing catalogs to prospective buyers in State X. It also has five offices in State X, four of which are a critical part of a separate business unrelated to the mail-order operation. If those four offices are transferred to Controlled as part of the spinoff, Distributing may be able to avoid obligations to collect use tax in State X in the future by closing the one remaining office, whereas before the spinoff closing all five offices, four of which were an important part of another business, may not have been feasible. Similarly, it may be possible to obtain the protection of Public Law 86-272 for state income tax purposes in a given state after businesses previously conducted by Distributing are transferred to Controlled and spun off.
A spinoff typically presents the affected corporations with an opportunity to reconsider their tax structures. When Controlled is a newly formed corporation, it is likely that its tax personnel will be new on the scene. They will no longer be limited by relationships and attitudes of Distributing's management and a fresh look may be called for. The tax personnel at both Distributing and Controlled should prepare projections of income and expense for the principal states in which they expect to do business, with a view to developing a sound structure that reduces state and local taxes to the greatest extent possible under the post-spinoff arrangement.
1 IRC section 355(a)(1)(A).
2 IRC section 368(c). Revenue Ruling 59-259, 1959-2 C.B. 115. Nonvoting nonparticipating preferred stock described in section 1504(a)(4), which is not taken into account for many purposes of the code, is taken into account in applying the control test under section 368(c).
3 IRC section 355(a)(1)(C) and (b).
4 IRC section 355(b)(3).
5 IRC section 355(a)(1)(B).
6 IRC section 355(b)(2)(D).
7 IRC section 355(a)(1)(D).
8 Reg. section 1.355-2(b) and (c).
9 See, generally, Peter L. Faber, "Business Purpose and Section 355," 43 The Tax Lawyer 855 (1990).
10 Reg. section 1.355-2(b)2.
11 Reg. section 1.355-2(b)(4), Example (3).
12 Reg. section 1.355-2(b)(2).
13 See, e.g., Estate of Parshelsky v. Commissioner, 303 F.2d 14 (2d Cir. 1962).
14 See, e.g., Rev. Rul. 85-122, 1985.2 C.B. 118.
15 Rev. Rul. 82-130, 1982-2 C.B. 83.
16 Rev. Rul. 85-127, 1985-2 C.B. 119.
17 See, e.g., Badanes v. Commissioner, 39 T.C. 410 (1962).
18 Rev. Rul. 59-197, 1959-1 C.B. 77.
19 Olson v. Commissioner, 48 T.C. 855 (1967).
20 Rev. Rul. 88-33. 1988-1 C.B. 115.
21 Reg. section 1.355-2(b)(2).
22 Rev. Rul. 76-187, 1976-1 C.B. 97.
23 Reg. section 1.355-2(b)(2).
24 LTR 9011044.
25 See, e.g., Florida Department of Revenue, Technical Assistance Advisement 95(C)1-005.
26 Reg. section 801(f).
27 Missouri Revised Statutes section 144.617(1)(3)-(4).
28 New York Tax Law section 1101(b)(4)(iv)(A)(IV); New Jersey Revised Statutes section 54:32B-2(e)(4)(E); and Vermont Statutes Annotated section 9742(5).
29 Reg. section 526.6(d)(5)(iii).
30 See, e.g., Lessinger v. Commissioner, 85 T.C. 824 (1985).
31 See, e.g., N.Y.S. Regs. section 526.6(d)(8)(ii).
32 N.Y.S. Div. Tax App. 2002.
33 Texas Code section 151.304(b)(3).
34 Rule 34 TAC section 3.316(e)(3).
35 California Regs. section 1595(b)(4); see also Beatrice Co. v. SBE, 6 Cal.4th 767 (1993).
36 Reg. section 526.6(d)(5)(v).
37 Tax General Article section 11-209(c)(2).
END OF FOOTNOTES
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