Final Section 355(e) Regs Apply to Synthetic Spin-offs

(Parker Tax Publishing January 2020)

The IRS finalized regulations on the distribution by a distributing corporation of stock or securities of a controlled corporation to provide that Code Sec. 355(e) applies to synthetic spin-offs. In particular, the final regulations (1) provide guidance in determining whether a corporation is a predecessor or successor of a distributing or controlled corporation for purposes of the exception under Code Sec. 355(e) to the nonrecognition treatment afforded qualifying distributions; (2) provide certain limitations on the recognition of gain in certain cases involving a predecessor of a distributing corporation; and (3) provide rules regarding the extent to which Code Sec. 355(f) causes a distributing corporation (and in certain cases its shareholders) to recognize income or gain on the distribution of stock or securities of a controlled corporation. T.D. 9888.

Code Sec. 355 was enacted to permit the tax-free division of existing business arrangements among existing shareholders. Under Code Sec. 355(a)(1), if certain requirements are met, a corporation (Distributing) may distribute stock, or stock and securities, of a controlled corporation (Controlled) to Distributing's shareholders, or to its shareholders and security holders, without recognition of gain or loss to, or inclusion of any amount in income of, the distributees upon receipt (Distribution). Code Sec. 355(c) generally provides that no gain or loss is recognized to Distributing upon a Distribution of qualified property which is not in pursuance of a plan of reorganization. Code Sec. 355(c)(2)(B) refers to Controlled stock and Controlled securities as "qualified property." If Distributing distributes property other than qualified property in a Distribution and the fair market value of such property exceeds its adjusted basis, gain is recognized to Distributing as if the property were sold to the distributee at its fair market value.

Taxpayers also may carry out a Distribution as part of a "divisive reorganization" under Code Sec. 368(a)(1)(D). A divisive reorganization is a transfer by Distributing of part of its assets to Controlled if, immediately after the transfer, one or more of the shareholders of Distributing (including persons who were shareholders immediately before the transfer) have control, as defined in Code Sec. 368(c), of Controlled, but only if, in pursuance of the plan, stock or securities of Controlled are distributed in a Distribution. Code Sec. 361(c) generally provides that no gain or loss is recognized to Distributing upon a Distribution of qualified property in pursuance of a plan of reorganization. Code Sec. 361(c)(2)(B) defines "qualified property" as (1) any stock, right to acquire stock, or obligation (including a security) of Distributing, or (2) any stock, right to acquire stock, or obligation (including a security) of Controlled received by Distributing as part of the divisive reorganization. If Distributing distributes property other than qualified property in a Distribution as part of a divisive reorganization and the fair market value of such property exceeds its adjusted basis, gain is recognized to Distributing as if the property were sold to the distributee at its fair market value.

Although a Distribution is generally tax-free under Code Sec. 355 and Code Sec. 361, Congress determined that recognition of corporate-level gain by Distributing is appropriate in cases in which it is intended that new shareholders will acquire ownership of a business in connection with a distribution because the overall transaction more closely resembles a corporate level disposition of the portion of the business that is acquired. As a result, Congress enacted Code Sec. 355(e). Under Code Sec. 355(e), stock or securities of Controlled generally will not be treated as qualified property for purposes of Code Sec. 355(c)(2) or Code Sec. 361(c)(2) if the stock or securities are distributed as part of a plan or series of related transactions (Plan) pursuant to which one or more persons acquire directly or indirectly stock representing a "50-percent or greater interest" in the stock (Planned 50 Percent Acquisition) of Distributing or Controlled. For purposes of Code Sec. 355(e), any reference to Controlled or Distributing includes a reference to any predecessor or successor of such corporation. However, Code Sec. 355(e) does not define the terms "predecessor" and "successor." The IRS subsequently issued proposed regulations in 2004 and temporary and proposed regulations in 2016 to provide guidance under Code Sec. 355(e).

The general theory underlying the 2004 proposed regulations and the 2016 regulations was that Code Sec. 355(e) should apply if a Distribution is used to combine a tax-free division of the assets of a corporation other than Distributing or Controlled (Divided Corporation) with a Planned 50-percent Acquisition of the Divided Corporation. The IRS views this type of transaction as a "synthetic spin-off" of the assets that are transferred by the Divided Corporation to Distributing and then to Controlled.

For example, a synthetic spin-off could be achieved through the following series of transactions occurring pursuant to a Plan (Base Case Example): (1) a corporation (P) merges into Distributing in a reorganization described in Code Sec. 368(a)(1)(A), (2) Distributing contributes some (but not all) of P's assets to Controlled in a reorganization described in Code Sec. 368(a)(1)(D), and (3) Distributing distributes all of the stock of Controlled in a Distribution. In the Base Case Example, the Divided Corporation (that is, P) could have separated its assets in its own Distribution. In that case, the Divided Corporation would have been a Distributing itself, and Code Sec. 355(e) clearly would have applied to the Distribution if it were combined with a Planned 50-percent Acquisition of the Divided Corporation. However, the IRS observed that if a Distribution by a Distributing is used as the vehicle for a synthetic spin-off by the Divided Corporation, the synthetic spin-off would not be subject to Code Sec. 355(e) unless the Divided Corporation is treated as a predecessor of Distributing under Code Sec. 355(e)(4)(D) (Predecessor of Distributing, or POD). Accordingly, the IRS issued the 2004 proposed regulations and the 2016 regulations to treat the Divided Corporation in the Base Case Example as a POD.

On December 17, in T.D. 9888, the IRS adopted the 2016 proposed regulations with limited modifications and removed the 2016 temporary regulations. In general, the final regulations follow the approach of the 2016 regulations with certain clarifications and minor modifications. Specifically, the IRS said it is issuing the final regulations with the goal of ensuring that Code Sec. 355(e) applies to synthetic spin-offs of a Divided Corporation's assets.

The final regulations also provide rules regarding the extent to which Code Sec. 355(f) causes a distributing corporation (and in certain cases its shareholders) to recognize income or gain on the distribution of stock or securities of a controlled corporation. Code Sec. 355(f) generally provides that Code Sec. 355 does not apply to the distribution of stock from one member of an affiliated group to another member of such group if such distribution is part of a plan (or series of related transactions) pursuant to which one or more persons acquire directly or indirectly stock representing a 50-percent or greater interest in the distributing corporation or any controlled corporation.

For a discussion of Code Sec. 355(e) transactions, see Parker Tax ¶47,120.

Disclaimer: This publication does not, and is not intended to, provide legal, tax or accounting advice, and readers should consult their tax advisors concerning the application of tax laws to their particular situations. This analysis is not tax advice and is not intended or written to be used, and cannot be used, for purposes of avoiding tax penalties that may be imposed on any taxpayer. The information contained herein is general in nature and based on authorities that are subject to change. Parker Tax Publishing guarantees neither the accuracy nor completeness of any information and is not responsible for any errors or omissions, or for results obtained by others as a result of reliance upon such information. Parker Tax Publishing assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect information contained herein.

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