The new Section 355 checklist questionnaire.

• Author: Herskovitz, Donald L.

Section 355 of the Internal Revenue Code of 1986 provides for tax-free treatment of the separation of one or more active businesses through the distribution by a corporation (Distributing) of the stock or securities of a controlled corporation (Controlled), either existing or newly formed by the transfer of assets to it, by Distributing. This transaction is described below as the "distribution" or "spinoff."

Usually, the amount of tax at risk, the size and complexity of the transaction, and the presence of public shareholders require obtaining an advance ruling from the Internal Revenue Service when the taxDaver is planning a spin-off. The IRS recently revised its Section 355 Checklist Questionnaire to provide guidelines on the information, representations, and documentation that must be included in a ruling request for the nonrecognition of gain or loss on the distribution of stock or securities in a controlled corporation. Rev. Proc. 96-30, 1996-19 I.R.B. 8, supersedes the prior checklist questionnaire, Rev. Proc. 8641, and related 1991 revenue procedures it also revokes a "no rule" Position on certain corporate business purposes, which was set forth in Rev. Proc. 93-3, 1996-1 I.R.B. 82.

This article is divided into two parts: Part I covers Rev. Proc. 96-30's most important changes to Rev. Proc. 8641, and Part II covers Rev. Proc. 96-30 as a whole, i.e., how to request a private letter ruling under its various provisions.

1. Major Changes

   The major changes of Rev. Proc. 96-30 include (1) the detailed information, representations, and documentation required for establishing a valid corporate business purpose; (2) a description of the facts and circumstances that may qualify the business purpose; (3) a description of each purpose for the spinoff, not just the corporate business purpose; (4) the required information and representations from foreign shareholders and foreign corporations; and (5) the required information and representations where Distributing joins in filing a consolidated return. Other changes made by the revenue procedure are discussed in the second part of this article, relating to obtaining a private ruling letter.

   Purpose and Effect of the Revenue Procedure

   By providing more information through Rev. Proc. 9630, the IRS hopes to speed up the ruling process and narrow the gap between substantive law and the ruling process. The issuance of the revenue procedure has been accompanied by the participation of IRS representatives in discussions with practitioners in various public forums to disseminate widely the IRS's views on the guidelines. The IRS has created an eight-member committee to address novel and significant section 355 issues on a uniform and timely basis. Taxpayers will continue to have pre-submission confereneces hut taxpayers may not meet directly with the committee. According to the IRS representatives, Rev. Proc. 96-30 is likely to increase the number of section 355 ruling requests.

   Business Purpose Guidelines

   Two of the most significant changes in Rev. Proc.9630 are the addition of guidelines, particularly Appendix A, which describe certain corporate business purposes supporting a favorable private letter ruling, request. and the revocation of that part of Rev. Proc. 96-3 establishing a "no-rule" position on certain corporate business purposes. The guidelines do not contain an exclusive list of corporate business purposes. Where the guidelines are not satisfied, taxpayers are invited to describe other corporate business purposes that may persuade the IRS to issue a private letter ruling. Overall, the IRS must be satisfied that there is a substantial corporate, non-federal tax purpose for the distribution, and that the purpose cannot be achieved through a nontaxable transaction that does not involve the distribution of Controlled stock, and which is neither impractical nor unduly expensive. Losing a favorable tax status, such as an existing S corporation election, will be viewed as unduly expensive by the IRS. The specific corporate business purposes described in Appendix A of Rev. Proc. 96-30 are discussed in the ensuing sections of this article. Generally, the IRS will be taking a more active role in scrutinizing the motivations and purposes of the spin-off than in the past.

   1. Key Employee

      Providing a key employee with a stock interest in Distributing or Controlled may be a valid business purpose provided the taxpayer can demonstrate (1) a real and substantial corporate business purpose for the stock transfer, (2) why the individual is a key employee, and (3) why it is necessary to give the individual the type and amount of the proposed stock interest. Also, unless it would be prohibitively expensive, a significant amount of voting stock must be transferred,. The transfer to the key employee should occur within one year of the distribution. The terms of acquisition of the stock should also be described in detail.

      The purpose in transferring the stock to the key employee should not be attainable in an alternative nontaxable transaction that does not involve the distribution of Controlled stock and is not impractical or unduly expensive. Rev. Proc. 96-30 states that the IRS would consider it unduly expensive to create a controlled corporation that would terminate a Subchapter S election, though the taxpayer must also show that using a partnership or limited liability company would be impractical or unduly expensive.

      In general, the IRS expects that the key employees will be given a meaningful voice in the affairs of the corporation. A typical situation that should qualify as a corporate business purpose would exist where employees or a new executive must be offered stock to retain their services in a particular division, and it is not practical to give them an interest in the whole business or more than 20 percent of a subsidiary.(2) In some instances, employee threats to leave the company were mentioned in private rulings, but that should not be required to obtain a ruling.

      Rev. Proc. 96-30 states that the IRS will scrutinize situations in which stock issued to the employee is subject to an option or restriction. Presumably, the IRS's concern is whether the employee's stock ownership will be temporary, thereby defeating the purpose of the distribution.

      The principles relating to key employees will also apply to employee stock ownership plans (ESOPs). The special rules for ESOPs may also justify the corporate business purpose for the distribution.(3)

   2. Stock Offering

      If the corporate business purpose for the distribution is to facilitate a stock offering, the taxpayer must show:

      * The need for substantial capital in the near future for demonstrated corporate business needs that are met with the funds.

      * The funds can be raised with less cost or effort if Distributing and Controlled are separated through a distribution. A professional analysis must be submitted to substantiate this position. The IRS concedes that an offering of publicly traded stock by a widely held corporation with no significant shareholders will raise more funds per share than an offering by the same corporation as a controlled subsidiary.

      * The stock offering will be completed within one year of the distribution.

      * Substantiation of a purchase by a limited amount of investors that is conditioned on the distribution.

      The IRS has issued a number of instructive revenue rulings and private letter rulings relating to public offerings.(4) Caution should be exercised, however, where more than 20 percent of the outstanding stock of the controlled corporation will be issued in a public offering immediately after a transfer of assets and a distribution. The subsequent offering may violate the section 368(c) requirement that at least 80-percent control be distributed. There should be less concern if the public stock offering is by the distributing corporation since no "control" requirement is imposed in respect of its shares. (See discussion of Rev. Proc. 96-39 below.)

   3. Borrowing

      In establishing that the corporate business purpose for the distribution is to facilitate borrowing, the taxpayer must meet requirements similar to those imposed for a stock offering and, if the taxpayer asserts that the distribution will permit borrowing at a lower cost, it must meet the "cost savings" test described in the next section.

   4. Cost Savings

      Where the asserted corporate business purpose of the transaction is "cost savings," the taxpayer must substantiate through a professional analysis that the savings are significant. Significant savings must be demonstrated through the use of a formula set forth in Rev. Proc. 96-30. The formula generally requires a net cost savings of at least one percent of net income of the affiliated group for a three- or five-year period as...