Avoiding Tax When Splitting Up A Business Taxed As A Corporation Among Shareholders

By: Attorney Dan Pettit

A distribution of property from a partnership to a partner in exchange for his or her partnership interest will generally be tax-free to the partnership and the partner, if the distribution does not exceed the partner’s basis in his or her partnership interest. This concept applies equally to state law partnerships and LLCs taxed as partnerships. Distributions from corporations have much more undesirable tax affects. A corporation distributing non-cash property to a shareholder in redemption of the shareholder’s stock, whether an S corporation or a C corporation, must recognize gain as if it has sold the property to the shareholder at its fair market value. In the case of an S corporation, the gain is then passed through to the shareholder.  With a C corporation, the corporation will be taxed on any gain, and the shareholder will generally also have to recognize gain or loss based on the fair market value of the property received versus his or her stock basis.  When the distribution of assets is made to a shareholder to spin-off part of the business, the corporate form can present tax inefficiencies for the redeemed shareholder wishing to continue the business post spin-off. This is relevant in any number of situations where shareholders wish to part ways with both the remaining shareholder(s) and the departing shareholder(s) wishing to continue in the corporation’s current business, or one of several of the corporation’s lines of business, using some of the corporation’s assets.  Examples would include situations where: (i) spouses run two separate hardware stores owned by a single corporation and wish to divorce with each spouse thereafter continuing to run one of the stores through separate entities; (ii) where siblings run multiple restaurant locations through a single corporation and wish to split-up so that each can bring his or her kids into the business; or (iii) where a dental practice has operated as a corporation and the two shareholder/dentists are no longer compatible and wish to split up their practice.

Fortunately, in these situations, where applicable, IRC §355 allows a corporation, including an LLC taxed as a corporation, to split off part of its business to a shareholder or shareholders on a tax-free basis.  To qualify as a tax-free split-off under IRC §355, a transaction must satisfy seven requirements[1]:  The requirements can be summarized as follows:

(1)        Control.  The proposed transaction must involve stock of a controlled subsidiary.  A corporation is considered to “control” another corporation for purposes of IRC §355 if it owns stock representing at least 80% of the voting power, in addition to at least 80% of all non-voting stock of the other corporation.  Importantly, the subsidiary does not need to be a pre-existing subsidiary to satisfy the “control requirement”. The subsidiary can be created, and assets transferred to it, solely for the purpose of completing the spin-off.

(2)        Distribution.  The proposed transaction must involve a distribution of all the stock of the controlled subsidiary in exchange for the distributing corporation’s stock.

(3)        Business Purpose.  A transaction must be carried out for one or more corporate business purposes. To satisfy the business purpose requirement, a split-off must be motivated in whole or in substantial part by one or more corporate business purposes. The regulations define a corporate business purpose as a real and substantial non-federal tax purpose relevant to the business of the distributing corporation (i.e. the old corporation) or the controlled corporation (i.e. the new subsidiary). A few examples of recognized business purposes include (a) “fit and focus” (i.e. concentrating the activities of a single entity on a single business or group of businesses), (b) risk reduction (i.e. segregating businesses with more or different risks away from other businesses), and (c) separating shareholders (i.e. separating dissident shareholders or allowing shareholders interested in only one of the corporation’s lines of business to restrict their investment to only that line of business).

(4)        Device to Distribute Earnings and Profits.  The proposed transaction must not be principally a “device” to distribute earnings and profits of the corporation.  The focus of the anti-device requirement is to prevent shareholders from bailing out corporate earnings and profits at capital gains rates (as opposed to as dividends).  Whether a transaction is used principally as a device for the distribution of earnings and profits is determined by a review of all the facts and circumstances surrounding the transaction.  For instance, a transaction would fail the “device” test if the corporation held on to all its operating assets and distributed all its account receivables and marketable securities to a subsidiary and then distributed the subsidiary to one of the shareholders in exchange for his or her stock in the parent corporation. 

(5)        Active Business. The proposed transaction must satisfy the active business requirement of IRC §355.  To meet the active business requirement imposed by §355, both the parent and subsidiary corporations must be engaged immediately after the spin-off in the active conduct of a trade of business. The fundamental requirement is that the entities engage in an “active” business, rather than merely holding a package of investment assets.  Unfortunately, this requirement generally prevents corporations from spinning off their real estate holdings in an IRC §355 transaction.

(6)        Continuity of Interest.  There must be continuity of ownership in both the distributing corporation and the new subsidiary corporation after the separation.  There is some flexibility, but generally speaking, the IRS considers “continuity of interest” to exist when one or more persons who, directly or indirectly, were the owners of the enterprise before the distribution own, in the aggregate, 50% or more of the stock in each of the modified corporate forms after the separation.  No particular shareholder or shareholders of the distributing corporation is required to maintain continuity in the distributing and/or distributed corporation after the separation, so long as some shareholders of the distributing corporation retain the required percentage (i.e. 50%) in each of the distributing corporation and the distributed corporation after the separation.

(7)        Continuity of Business Enterprise.  In general, both the distributing corporation and the distributed corporation are required to continue at least one of the corporation’s historic businesses, or to use a significant portion of its historic business assets in a business, following the spin-off.

While splitting up an entity taxed as a corporation can be a bit more challenging than splitting up an entity taxed as a partnership, IRC §355 presents corporations and their shareholders an opportunity to avoid the draconian tax consequences that would befall them if they were to split up a corporation without the benefit of IRC §355.  While the technical requirements of IRC §355 can seem daunting, in most closely-held business situations where the shareholders genuinely wish to continue in business apart from each other (as opposed to spinning off non-operating assets in a pseudo redemption transaction), it can actually be quite straightforward to structure an IRC §355 spin-off to be tax-free to the corporation and shareholders. 

[1] Four of the seven requirements are imposed by the internal revenue code, while three of the requirements are judicially imposed.