The Section 355(d) Regulations: Narrowing the Scope of an Overly Broad Statute

Section 355(d) of the Internal Revenue Code imposes limitations on a distributing corporation’s ability to distribute the stock of a controlled subsidiary tax free under section 355, when such distributing corporation or controlled subsidiary has been "recently" purchased.

Section 355 generally permits a corporation to distribute to its shareholders appreciated stock of a subsidiary corporation without triggering any gain at either the corporate or the shareholder level. Since the repeal of the General Utilities doctrine in the Tax Reform Act of 1986 (the "1986 Act"), section 355 has provided one of the only ways in which a corporation may distribute stock of a subsidiary to its shareholders without a corporate-level tax.

After the 1986 Act, however, Congress became concerned that taxpayers were using section 355 to "bust up" recently purchased corporations tax free, thereby circumventing the repeal of the General Utilities doctrine. Congress responded in 1987 and 1988 by amending section 355(b)(2)(D), which denies application of section 355 where a corporate distributee or a distributing corporation has acquired control of the distributing or controlled corporation within the five-year period before the distribution. However, section 355(b)(2)(D) did not capture all of the bust-up transactions that Congress intended to prevent, so Congress enacted section 355(d) in 1990.

Section 355(d) is an extremely broad provision that goes well beyond the intended purpose of preventing bust-up transactions. It imposes a corporate-level tax on a distribution if, immediately after the distribution, a shareholder holds a 50-percent or greater interest in either the distributing or a spun-off corporation, and that interest is attributable to stock purchased within the five-year period before the distribution. In an apparent attempt to mitigate the breadth of section 355(d), Congress granted the Treasury Department ("Treasury") authority to issue regulations to exclude from section 355(d) distributions that "do not violate the purposes of this provision." As a result, on May 3, 1999, almost nine years later, the Internal Revenue Service (the "Service") responded by issuing Proposed Treasury Regulation § 1.355-6. The proposed -regulations provided much needed guidance under section 355(d) and were finalized, with some modifications, on December 20, 2000. The regulations adopt a practical approach to section 355(d) and significantly limit the reach of the statute, for which the Service should be congratulated. The regulations are effective for all distributions occurring after December 20, 2000.

This article examines the purpose of section 355(d) and analyzes the regulations under section 355(d). Part II describes the history and purpose of section 355(d); Part III provides an overview of section 355(d); and Part IV analyzes the regulations.

HISTORY AND PURPOSE OF SECTION 355(d)

A. Mirror Transactions

Prior to the 1986 Act, corporations could liquidate without recognizing corporate-level gain or loss (except for recapture items). As a result, purchasers of corporations could dispose of unwanted assets without recognizing gain by purchasing the stock of the target corporation, making a section 338 election to treat the stock purchase as a purchase of assets (thereby obtaining a stepped-up basis in the target corporation’s assets) and then selling the unwanted assets for their fair market value. Although the 1986 Act repealed the nonrecognition rule of sections 336, 337, and 338 for less-than-80-percent-owned subsidiaries, taxpayers nonetheless devised a way to sell the stock of a subsidiary without corporate-level tax -- the so-called "mirror subsidiary" transaction.

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