S corporations' practical alternatives to a sec. 355 spin-off.

• Author: Kuyath, Ron

S shareholders frequently find it desirable to separate business activities being conducted within one corporation. Most divisive transactions can be structured with little or no tax cost using Sec. 355, Distribution of Stock and Securities of a Controlled Corporation. However, in most (if not all) situations, it is recommended that the taxpayer request a ruling from the IRS for the specific transaction being proposed, and this process call be slow and expensive.

An existing S corporation wishing to separate an activity would use Sec. 355 as follows:

* The S corporation would form a wholly owned subsidiary (Newco) by contributing the assets of the division/activity to be separated to Newco in exchange for all of Newco's stock (Sec. 351).

* The S corporation would then distribute the Newco stock to the S shareholders under Sec. 355. (The basis for this transaction can be found in Rev. Ruls. 72-320 and 73-496, as well as various letter rulings that allow for the brief holding of a wholly owned subsidiary for a period of time not to exceed 30 days; see IRS Letter Rulings 9041022, 8915038, 8801026, 8932020, 8930011, 8921093, 8926016 and 8934020. Without this allowance, the S corporation would be terminated on becoming a member of an affiliated group.)

There are many technical requirements to Sec. 355 that can make what appears to be a simple spin-off a very complicated process. The reason for this stems from different interpretations of two very subjective requirements. There must be a business purpose for the transaction (one that is acceptable to the Service) and the transaction cannot be used as a device for distributing the earnings and profits of the corporation (Sec. 355(a)(1)(b)). Only practitioners can appreciate the work necessary to alleviate any risks associated with an IRS examination challenging a spin-off transaction not previously approved.

In addition to these two requirements, ownership or "control" of Newco must be held by the S shareholders at the time of distribution. No clear guidance exists as to how long the ownership must continue after the distribution to preserve the transaction's tax-free status. The division/activity and the S corporation must have been engaged in the active conduct of a trade or business throughout a five-year period ending on the date of the distribution. Regulations provide several exceptions to the five-year period, one of which (Regs. Sec. 1.355-3(b)(3)(ii)) is especially important for the...