United States: Using Tax-Free Section 355 Split-Off In Corporate Division

Sometimes, it becomes necessary for a corporation to be divided, in which a shareholder or a group of shareholders would separate from the corporation and take with them a business division, unit or location. Parties contemplating such a business split should consult their tax advisors, as Section 355 of the Internal Revenue Code may provide for a tax-efficient structure for the split.

A common transaction structure under Section 355 (among other structures commonly referred to as "spin-offs," "split-ups" or "split-offs") that achieves the split is the "divisive D reorganization." First, the existing corporation ("ExistingCo") transfers the business being split off to a new corporation ("NewCo") controlled by ExistingCo. ExistingCo then distributes the stock of NewCo to ExistingCo's departing shareholders, whose stock in ExistingCo is redeemed. The end result is that the business being split off is held by NewCo, which is owned by the departing shareholders. ExistingCo, which continues to be owned by the remaining shareholders, retains the business that is not split off to NewCo.

Generally, a Section 355 transaction is treated as a non-recognition event (i.e., no taxable gain or loss) at both the shareholder level and the corporate level, subject to various exceptions and limitations under the Internal Revenue Code. In order to qualify for the non-recognition treatment under Section 355, the transaction must generally meet the following statutory requirements:

  • ExistingCo must be in "control" of NewCo prior to the distribution of NewCo stock.
  • ExistingCo must distribute enough of NewCo stock to the departing shareholders so as to constitute "control" to the departing shareholders.
  • Both ExistingCo and NewCo must be engaged in the "active conduct of a trade or business" immediately after the distribution and for a 5-year period preceding the transaction.
  • ExistingCo's distribution of NewCo stock must not have been used principally as a "device" for the distribution of the earnings and profits of any of ExistingCo or NewCo.

Additionally, non-statutory limitations generally require the following:

  • The split off must be carried out for an "independent corporate business purpose."
  • ExistingCo's shareholders (as of prior to the split off) must maintain adequate "continuity of interest" in each of ExistingCo and NewCo after the transaction.
  • The "continuity of business enterprise" test must be met with respect to ExistingCo and NewCo after the transaction.

A correctly structure Section 355 transaction can provide great tax benefits in a corporate division. However, Section 355 is a complex provision with a number of landmines and nuances that provide for various exceptions, limitations and qualifications to the general requirements summarized in this article. Thus, parties should seek the advice of their tax advisors in order to ensure a favorable tax treatment.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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