IRS issues helpful regs. on the interplay of active trade and hot stock.

• Author: Sarfo, Kwajo

In response to changes made to the active trade or business requirement in the Tax Increase Prevention and Reconciliation Act of 2005, EL. 109-222 (TIPRA), the Service recently issued temporary and proposed regulations harmonizing the Sec. 355 "hot stock" rule with the TIPRA changes (T.D. 9435, REG-150670-07).

Background

Under Sec. 355(a), a distributing corporation (D) may distribute the stock of a controlled corporation (C) to its shareholders without causing either D or its shareholders to recognize income, gain, or loss. However, Sec. 355(a)(3)(B) provides that C stock acquired by D by reason of any taxable transaction that occurs within five years of the stock distribution will not be treated as C stock but as other property (hot stock). As a result, the distribution of hot stock results in potential gain recognition to both the shareholders and D.

There are a number of requirements for qualifying a distribution under Sec. 355(a). One such requirement is the active trade or business (ATB) requirement found in Sec. 355(a)(1)(C). To satisfy the ATB requirement, both D and C must engage in an ATB immediately after the distribution (Sec. 355(b)(1)(A)). In addition, Sec. 355(b)(1)(B) provides that a corporation meets the ATB requirement if, immediately after the distribution, substantially all of its assets consist of stock and securities of a corporation controlled by it that is so engaged. However, as discussed below, the enactment of Sec. 355(b)(3) overrides the application of Sec. 355(b) (1)(B). In addition, each ATB must have been conducted throughout the five-year predistribution period and must not have been acquired within the predistribution period in a transaction in which gain or loss was recognized, in whole or in part (Secs. 355(b)(2)(B) through (D)).

TIPRA amended the statute by adding the Sec. 355(b)(3) affiliated group rules for determining satisfaction of the ATB requirement. Sec. 355(b)(3)(A) provides that for purposes of determining whether a corporation is engaged in an ATB, all members of the corporation's separate affiliated group (SAG) are treated as one corporation. Sec. 355(b)(3)(B) provides that for purposes of Sec. 355(b)(3), with respect to any corporation, the term "SAG" refers to the affiliated group that would be determined under Sec. 1504(a) if the corporation were the common parent and Sec. 1504(b) did not apply. Sec. 355(b)(3)(C) provides that if a corporation becomes a SAG member as a result of one or more...