Sec. 355's expansion exception extended.

• Author: Dailey, Paul
• Position: Tax free spinoff tax guidance

Two recent revenue rulings on the expansion exception to the Sec. 355 five-year active business requirement represent welcome taxpayer-friendly guidance in the tax-free spinoff arena, and can also be viewed as a precursor to a gentler approach in the context of other reorganizations (i.e., Sec. 368).

Overview

Sec. 355 allows shareholders to receive distributions of stock and securities in a controlled corporation tax free, if certain conditions are met. Under Sec. 355(b)(2), among other requirements, (1) each of the distributing and controlled corporations must be engaged, immediately after the distribution, in the active conduct of a trade or business, (2) each active trade or business must have been conducted throughout the five-year period ending on the date of the distribution and (3) neither trade or business was acquired in a taxable transaction within such five-year period.

The five-year requirement is relaxed if a business undergoes expansion or changes (i.e., adds or drops products, changes production capacity, etc.) in a way not equivalent to acquiring a new or different business. According to Regs. Sec. 1.3553(b)(3)(ii), this determination hinges on whether the old and new lines of business can be deemed the same; if yes, there generally has been an expansion.

Recent Rulings

The two rulings involved spinoffs that otherwise would have failed the five-year active business requirement but for the expansion exception. Rev. Rul. 2003-18 involved the acquisition of a franchise to sell and service a new brand of automobile by an existing dealer; Rev. Rul. 2003-38 dealt with a retail shoe store business that created a Web business to sell shoes. In each case, the IRS ruled in the taxpayer's favor; its approach looked to the following three factors:

1. Products;

2. Activities; and

3. Experience and know-how.

The products and activities were easily determined to be similar in the automobile dealer ruling. The dealer's knowledge and experience developed in the sale of a particular automobile line could easily be transferred to sales of another brand. The Service reached the same conclusion for the retail shoe business, notwithstanding some distinctions in selling shoes on the Web as compared to operating a retail store. However, the IRS did concede significant reliance on existing...