A business division doesn’t need to have actually collected income to qualify as a “trade or business,” and, thus, could be spun-off without tax recognition if other conditions were met, according to a recent IRS private letter ruling.
The division at issue had never collected receipts, but it could qualify as a trade or business under tax code Section 355, if for at least five years, it had actively conducted the “trade or business,” despite the lack of reciepts. (PLR 202009002, released Feb. 28, 2020.)
The distributing corporation (Distributing) was publicly traded and owned all of the stock of Subsidiary 1. Distributing was an “Industry A” corporation. Industry A corporations seek to create “Items A.” Typically, for Items A to be commercialized, they go through a four-step process: Step 1, Step 2, Step 3, and Step 4. Each step is composed of subparts. Step 2, for example, is composed of the following subparts: Step 2A, Step 2B, Step 2C, and Step 2D. Step 2C is composed of Step 2C1 and Step 2C2.
Distributing’s historical business consisted of the activities in Step 1 through Step 2C2, (Business 1). Business 1 relied on its research and development to identify and create “new Products A.” Products A were then tested and modified to create Items A for later testing and ultimate commercialization. Over the years, Distributing has created Items A and continued to create other Items A.
Prior to the commencement of Distributing’s Business 2, Steps 2C2 through Step 4 (the remaining steps necessary to bring Items A to commercialization) were not a part of Distributing’s business. Instead, these steps were performed by third party Industry AA companies pursuant to license and collaboration agreements.
On Date A, a date more than five years from the date of the proposed transaction, Distributing began conducting research, development, testing, and regulatory functions for “Item 1,” developed in Business 1 through Step 2C2. Distributing intends that it will develop Item 1 from Step 2C2 through Step 3, (Business 2). After Step 3, but before Step 4, Business 2 would partner or collaborate with one or more Industry AA partners to move Item 1 efficiently through the next steps. Distributing incurred “significant salary and wage expense” in connection with Business 2.
Lack of Income Overlooked
For more than five years, Business 1 consistently generated income through contractual relationships with Industry AA companies from research-oriented contracts or certain licensing. Even though Business 2 had never generated income, Distributing believed that Business 2 had the ability to generate income since Date A through licensing of certain rights to Item 1 or partnering with Industry AA companies.
However, Distributing has decided to forego immediate collection of income from Business 2 in favor of the prospect of collecting significantly greater income after Step 3 was completed with respect to Item 1. After Step 3, but before Item 1 is commercialized, Business 2 intends to partner or collaborate with Industry AA partners that have the experience, knowledge, and a sales force to move Item 1 efficiently through the next steps. Business 2 will then generate income at this step through receipts of royalties, milestone payments, or profit-splits.
For what are represented to be valid corporate business purposes, Distributing proposed to engage in the following transaction to separate Business 1 from Business 2:
(1) Distributing would form a State A corporation (Controlled), and contribute Business 2 to Controlled in exchange for all of the stock of Controlled and the assumption by Controlled of Business 2’s liabilities; and
(2) Distributing would distribute all of the stock of Controlled pro rata to Distributing’s shareholders. Following the distribution, Distributing would continue to conduct Business 1, and Controlled would conduct Business 2.
Distributing made certain representations with respect to the proposed transaction:
(1) Immediately after the distribution, the fair market value of the gross assets of the trade or business on which each of Distributing and Controlled would rely, i.e., Business 1 and Business 2, respectively, to satisfy the “active trade or business requirement” of Section 355(b), would be, in each case, at least 5% of the fair market value of the total gross assets of that corporation. For this purpose, Distributing and Sub 1 would be treated as one corporation; and
(2) Immediately after the distribution, the fair market value of the “gross investment assets” of each of Distributing and Controlled would be less than two-thirds of the fair market value of its total gross assets (investment asset percentage). For this purpose, the IRS noted, the term, investment assets, has the meaning as defined in Section 5.01(3) of Revenue Procedure 2018-3.
Investment assets have the meaning given such term by Section 355(g)(3)(B) except (i) in the case of stock or securities in a corporation any stock of which is traded on an established financial market. Section 355(g)(3)(B)(iv) is applied by substituting “50%" for “20%;" and an interest in a publicly traded partnership is treated in the same manner as publicly traded stock.
Under proposed regulations regarding the “device” test—to determine whether a transaction is a tax avoidance “device”—a per se rule operates where the “nonbusiness asset percentage” of the distributing corporation or the controlled corporation is two-thirds or more, and the nonbusiness asset percentage of the other corporation is less than 30%. Nonbusiness assets are all assets other than business assets, i.e., assets used in businesses conducted by the corporation. Here, the investment asset percentage of each of distributing and controlled fell below the critical two-thirds line, such that the per se device rule should not be a factor.
Thus, much analysis remains to be performed before it can be concluded that the distribution meets the requirements of Section 355, including determining whether the trade or business on which Controlled will be relying has been actively conducted throughout the five year period ending on the date of distribution, and whether the distribution is used principally as a “device” for the distribution of earnings and profits of Distributing, Controlled, or both such corporations. Nevertheless, had the IRS not conceded that Controlled’s activities amounted to a trade or business, we could not have proceeded to the remainder of the analysis. The fact that a trade or business can be found without the collection of income therefrom is a major concession on the IRS’s part.
A corporation shall be treated as engaged in a trade or business immediately after the distribution if a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such group include every operation that forms a part of, or a step in, the process of earning income. Such group of activities ordinarily must include the collection of income and the payment of expenses. The IRS, in Revenue Ruling 82-219, indicated that the word “ordinarily” was to be accorded significance. It ruled, there, that the word, ordinarily, “indicates that there are exceptional situations where there is no concurrent receipt of income and payment of expenses which, nevertheless, will constitute an active trade or business.” In that ruling, however, the failure to receive receipts was “unforeseen and caused by events outside of the corporation’s control.”
The dearth of receipts emanated from a conscious choice made by the parent corporation to forego current receipts in the hope of scoring larger receipts later. Thus, in a sense, this private letter ruling amplifies Rev. Rul. 82-219 as regards the trade or business impact of a lack of receipts. It still must be determined, moreover, whether the trade or business has been actively conducted throughout the five-year period ending on the date of the distribution. A trade or business is considered actively conducted where the corporation itself, i.e., through its employees, performs, with respect to the trade or business, active and substantial managerial and operational functions. See Rev. Rul. 73-234.
This column does not necessarily reflect the opinion of The Bureau of National Affairs, Inc. or its owners.
Robert Willens is president of the tax and consulting firm Robert Willens LLC in New York and an adjunct professor of finance at Columbia University Graduate School of Business.