Proposed 'hot dog stand' regulations for spinoffs.

• Author: Gottschalk, Stefan

Completing a tax-free spinoff provides significant tax advantages. In a spinoff, a parent corporation (Distributing) distributes stock of a subsidiary (Controlled) to its shareholders. To qualify for tax-free treatment, Distributing and Controlled must both conduct an active trade or business (ATB) (Sec. 355(b); Regs. Sec. 1.355-3). In addition, the spinoff must not be used principally as a device for the distribution of earnings and profits (Sec. 355(a)(1)(B); Regs. Sec. 1.355-2(d)). Numerous other requirements must also be met.

To address the ATB and device requirements, the Treasury Department and the IRS issued proposed regulations in July 2016 (REG-134016-15). The proposed regulations, generally, are intended to further limit a corporation's ability to separate business assets from nonbusiness assets in a tax-free manner.

Whether the business assets involved in a spinoff must be valuable in relation to the other assets has long been an open question. Because the question can be well-illustrated by a hypothetical "hot dog stand" spinoff, the proposed regulations are popularly known as the hot dog stand proposed regulations. Consider this hot dog stand example: What if Controlled operates a hot dog stand business worth $20,000 and has nonbusiness assets worth $2 million? Prior government guidance did not necessarily deny tax-free treatment to this hot dog stand spinoff. The proposed regulations would.

Under the proposed regulations, spinoffs would not qualify for tax-free treatment where the nonbusiness assets of either Distributing or Controlled have a fair market value (FMV) that is too high in relation to the FMV of the corporation's business assets. In the example above, the hot dog stand worth $20,000 would not support a tax-free spinoff when coupled with $2 million of nonbusiness assets.

Minimum ATB test

To qualify for a tax-free spinoff, both corporations must operate an ATB immediately after the distribution and, generally, must have operated the ATB for the five years prior to the distribution (see Regs. Sec. 1.355-3). Under current law, there is no requirement that the ATB comprise a specific percentage of the corporate assets (Rev. Rul. 73-44).

For issuance of a favorable spinoff private letter ruling, the IRS formerly required that an ATB have an FMV that was at least 5% of the FMV of the total assets of the relevant corporation (Rev. Proc. 96-43). Later, the IRS reduced the availability of private letter rulings, and the 5%...