PLR 200301011: Business split-off qualifies as a tax-free reorganization

Plain-English summary

A corporation planned to separate one business into a controlled company and distribute that company's stock to holders of one class of its own shares. The IRS ruled that the contribution and distribution would qualify as a section 368(a)(1)(D) reorganization. The distributing and controlled companies would recognize no gain or loss on the contribution or distribution, and the exchanging shareholders would have no income from the stock exchange. Shareholders would carry over their stock basis and, if they held the old shares as capital assets, their holding periods. The IRS also approved specified retained share and debt-for-equity steps, while expressly leaving the later merger and several other matters outside the ruling.

Ruling snapshot

• Question: Does the proposed split-off and its related stock exchanges receive tax-free reorganization treatment?
• Outcome: Approved for the specified steps; the merger and listed other matters were not ruled on.
• Key authorities: IRC §§ 355, 361, 368, 1032, 358, 1223, 312.

Full text (IRS public release)

Internal Revenue Service
Department of the Treasury

Number: 200301011
Washington, DC 20224
Release Date: 01/03/2003
Index Numbers: 0355.01-01, 0368.04-00 Person to Contact:

Telephone Number:
(202) 622-7530
Refer Reply To:
CC:CORP:B04 - PLR-100284-02
Date:
July 2, 2002

Legend

Distributing
=

Controlled
=

Sub 1
=

Sub 2
=

Sub 3
=

Sub 4
=

Target
=

Shareholder A
=
PLR-100284-02
2

Shareholder B
=

Business A
=

Business B
=

Business C
=

Distributing Class A stock =

Distributing Class B stock =

Controlled Class A stock =

Controlled Class B stock =

Controlled Class C stock =

Target Class A stock =

Target Class B stock =

Individual A
=

Date A
=

Date B
=

Date C
=

State A
=

State B
=

a
=

b
=

c
=

d
=

e
=
PLR-100284-02
3

f
=

g
=

Dear
:

This letter responds to your December 19, 2001 request for rulings regarding certain federal income tax consequences of a proposed transaction. The information submitted in that request and in later correspondence is summarized below.

The rulings contained in this letter are based on facts and representations submitted by the taxpayer and accompanied by a penalties of perjury statement executed by an appropriate party. This office has not verified any of the materials submitted in support of the request for rulings. Verification of the information, representations, and other data may be required as part of the audit process.

Summary of Facts

Distributing is the common parent of an affiliated group of corporations that files a consolidated federal income tax return. Distributing is engaged, directly and indirectly, in Business A, Business B, and Business C.

Distributing has two classes of voting common stock outstanding, Distributing Class A stock and Distributing Class B stock, both of which are publicly traded. Shareholder B owns more than five percent of Distributing Class A stock. On Date A, Shareholder B announced an offering of notes that are exchangeable for Shareholder B’s Distributing Class A stock (the “Shareholder B Notes”).

Before Date B, Distributing had a single class of nonvoting preference stock (the “Preference Stock”) outstanding, all of which was owned by Shareholder A. On Date B, the Preference Stock automatically converted into approximately a percent of the outstanding Distributing Class B stock.

Distributing wholly owns Controlled, Sub 1, and Sub 2. Sub 1 wholly owns Sub

3. Sub 3 wholly owns Sub 4.

   Distributing conducts Business A, directly and through controlled entities. Sub 1
   conducts Business B, directly and through controlled entities, including Sub 3 and Sub
   4. Sub 2 conducts Business C directly.

   Financial information has been received indicating that Business A and Business
   B each have had gross receipts and operating expenses representing the active conduct of a trade or business for each of the past five years.
   PLR-100284-02 4

   Target is the common parent of an affiliated group of corporations that files a
   consolidated federal income tax return. Target has two classes of common stock outstanding: Target Class A stock, which is publicly traded, and Target Class B stock, which is owned indirectly by Individual A.

   In response to the consolidation that has occurred in Business B in recent years,
   the managements of Sub 1 and Target have concluded that a combination of Sub 1 and Target will allow the combined entity to compete more effectively in the Business B industry. Target has agreed to merge into Controlled, provided that Controlled is separated from Distributing and holds the Business B operations currently conducted by Sub 1.

                            Proposed Transaction
   
   To accomplish the separation of Business B from Distributing that will facilitate
   

   the merger of Target into Controlled, Distributing has partially completed and proposed the following transaction (the “Proposed Transaction”):

   (i) On Date C, Distributing formed Controlled as a wholly owned subsidiary to
   effect the Proposed Transaction. Controlled currently has a single class
   of common stock outstanding and conducts no operations (other than
   those necessary to effect the Proposed Transaction).

   (ii) Before steps (v) and (vi), Sub 3 and Sub 4 will convert into limited liability
   companies under State A and State B law, respectively.

   (iii) Before steps (v) and (vi), Sub 1 or Sub 3 will borrow up to $b from third
   party lenders (the “Pre-Closing Loan”).

   (iv) Before steps (v) and (vi), Sub 1 will use the proceeds of the Pre-Closing
   Loan (together with other funds available to Sub 1) to make a cash
   distribution of up to $c to Distributing.

   (v) Immediately following step (iv) and for valid business reasons, Distributing
   will contribute all of the stock of Sub 1 to Controlled in exchange for
   Controlled Class C stock (the "Contribution").

   (vi) Following the Contribution, Distributing will distribute all of its Controlled
   Class C stock to holders of Distributing Class B stock in exchange for all
   of their Distributing Class B stock outstanding (the “Distribution”), with the
   exception of (i) up to approximately d shares of Controlled Class C stock
   (representing approximately e percent of the Controlled Class C stock
   outstanding) for use in the Debt-for-Equity Exchanges (described below)
   (the "Exchange Shares") and (ii) approximately f shares of Controlled
   PLR-100284-02 5

        Class C stock (representing approximately g percent of the Controlled
        Class C stock outstanding) (the “Retained Shares”). The exact number
        (and percentages) of the Exchange Shares and the Retained Shares held
        by Distributing immediately after the Distribution will depend on certain
        factors that will not be known until the time of the Distribution, but in no
        event will Distributing hold more than 20 percent of the outstanding
        Controlled Class C stock immediately following the Distribution.
   
        Distributing has been advised by its investment banker that retaining
        Controlled Class C stock will provide Distributing with a source of liquidity
        necessary to prevent the deterioration of the credit ratings of Distributing
        and Sub 2. Distributing will dispose of any retained Controlled Class C
        stock as soon as disposition is warranted, consistent with the business
        purpose for the retention, but in any event not later than five years after
        the date of the Distribution. During the period in which Distributing retains
        any Controlled Class C stock, none of Distributing’s directors or officers
        will serve as directors or officers of Controlled and Distributing will vote
        any retained Controlled Class C stock in proportion to the votes cast by
        the other holders of the Controlled Class C stock.
   

   (vii) Following the Distribution, Target will merge into Controlled in a
   transaction the taxpayer represents will qualify as a reorganization under
   § 368(a)(1)(A) (the "Merger"). Immediately following the Merger,
   Controlled will have three classes of common stock outstanding:
   Controlled Class A stock, Controlled Class B stock, and Controlled Class
   C stock. In the Merger, holders of Target Class A stock will receive
   Controlled Class A stock and holders of Target Class B stock will receive
   Controlled Class B stock. The pre-Merger holders of Controlled Class C
   stock will retain their stock.

        The Controlled Class C stock (excluding any Exchange Shares) will
        represent more than 50 percent of the value of the outstanding Controlled
        stock immediately following the Merger.
   
        The Controlled Class A stock will be entitled to one vote per share. The
        number of votes per share to which the Controlled Class C stock is
        entitled will be determined at the time of the Merger such that the
        Controlled Class C stock held by Distributing (other than the Exchange
        Shares) and certain of Distributing’s historic shareholders will possess
        more than 50 percent of the voting power of Controlled immediately
        following the Merger. The Controlled Class B stock initially will have ten
        votes per share, but that number will be reduced during the two-year
        period following the Distribution and, in certain cases, thereafter, for
        subsequent equity issuances, redemptions, sales and other events to
   

   PLR-100284-02 6

          prevent the voting power of stock deemed to be acquired as part of a plan
          that includes the Distribution under § 355(e) from equaling or exceeding
          50 percent.
   
          All three classes of Controlled stock will vote together as a single class in
          the election of directors and for all other matters. The approval of the
          Controlled Class B stock voting separately as a class, however, will be
          necessary to approve certain enumerated matters submitted to a
          shareholder vote (not including the election of directors).
   

   (viii) Following the Merger, Sub 1 will repay the Pre-Closing Loan and other
   obligations using funds then available to Controlled and its subsidiaries.

   (ix) Either before or within six months after the Distribution, Distributing
   intends to satisfy certain of its outstanding debt by issuing or distributing
   equity to creditors in one or more transactions (the "Debt-for-Equity
   Exchanges"). Any Debt-for-Equity Exchanges completed before the
   Distribution will be effected by Distributing using Distributing Class B
   stock. After the Distribution, Distributing will effect any Debt-for-Equity
   Exchanges using the Exchange Shares. To the extent Distributing does
   not use the Exchange Shares in the Debt-for-Equity Exchanges,
   Distributing intends to either sell such shares for cash within six months
   after the Distribution or retain these shares for the purpose described in
   step (vi).

                                 Representations
   

   The taxpayer has made the following representations concerning the
   Contribution and the Distribution:

   (a) To the extent any indebtedness is owed by Controlled to Distributing after
   the Distribution, such indebtedness will not constitute stock or securities.

   (b) The fair market value of the Controlled Class C stock and other
   consideration to be received by each holder of Distributing Class B stock
   will be approximately equal to the fair market value of the Distributing
   Class B stock surrendered by the shareholder in the exchange.

   (c) Except with respect to the Distributing shareholders who also hold
   Distributing indebtedness and surrender such indebtedness for Controlled
   Class C stock pursuant to the Debt-for-Equity Exchanges, no part of the
   consideration to be distributed by Distributing to the Distributing
   shareholders will be received by a shareholder as a creditor, employee, or
   in any capacity other than that of a Distributing shareholder.
   PLR-100284-02 7

   (d) Except with respect to security holders of Distributing who also hold
   Distributing Class B stock, no part of the consideration to be distributed by
   Distributing will be received by a Distributing security holder as an
   employee or in any capacity other than that of a Distributing security
   holder.

   (e) The five years of financial information submitted on behalf of Business A
   is representative of Business A’s present operations, and with regard to
   Business A, there have been no substantial operational changes since the
   date of the last financial statements submitted.

   (f) The five years of financial information submitted on behalf of Business B
   is representative of Business B's present operations, and with regard to
   Business B, there have been no substantial operational changes since the
   date of the last financial statements submitted.

   (g) Immediately after the Distribution, at least 90 percent of the fair market
   value of the gross assets of Controlled will consist of the stock and
   securities of controlled corporations that are engaged in the active
   conduct of a trade or business as defined in § 355(b)(2).

   (h) Immediately after the Distribution, the gross assets of the active
   businesses conducted directly by each of Distributing and Sub 1 will have
   a fair market value of at least five percent of the total fair market value of
   each corporation’s gross assets, including the stock of subsidiaries.

   (i) Following the Proposed Transaction, each of Distributing and Controlled
   will continue the active conduct of its business independently and with its
   separate employees.

   (j) The Distribution is being carried out: to facilitate the merger of Target into
   Controlled. The Distribution is motivated, in whole or substantial part, by
   this corporate business purpose.

   (k) Other than the disposition by Distributing of the Exchange Shares and the
   Retained Shares, the potential disposition by Shareholder A of its
   Distributing Class B stock or Controlled Class C stock, and the potential
   exchange of the Shareholder B Notes for Shareholder B’s Distributing
   Class A stock, there is no plan or intention by any shareholder who owns
   five percent or more of any class of Distributing stock, and the Distributing
   management, to its best knowledge, is not aware of any plan or intention
   on the part of any particular remaining shareholder or security holder of
   Distributing to sell, exchange, transfer by gift, or otherwise dispose of any
   PLR-100284-02 8

      stock in, or securities of, either Distributing or Controlled after the
      Distribution and the Merger.
   

   (l) There is no plan or intention by either Distributing or Controlled, directly or
   through any subsidiary corporation, to purchase any of its outstanding
   stock after the Proposed Transaction, other than through stock purchases
   meeting the requirements of § 4.05(1)(b) of Rev. Proc. 96-30,1996-1 C.B.
   696, 705.

   (m) There is no plan or intention to liquidate either Distributing or Controlled,
   to merge either corporation with any other corporation (except pursuant to
   the Merger), or to sell or otherwise dispose of the assets of either
   corporation after the Proposed Transaction, except in the ordinary course
   of business.

   (n) For purposes of § 355(d), immediately after the Distribution, no person
   (determined after applying § 355(d)(7)) will hold stock possessing 50
   percent or more of the total combined voting power of all classes of
   Distributing stock entitled to vote, or 50 percent or more of the total value
   of shares of all classes of Distributing stock, that was acquired by
   purchase (as defined in § 355(d)(5) and (8)) during the five-year period
   (determined after applying § 355(d)(6)) ending on the date of the
   Distribution.

   (o) For purposes of § 355(d), immediately after the Distribution, no person
   (determined after applying § 355(d)(7)) will hold stock possessing 50
   percent or more of the total combined voting power of all classes of
   Controlled stock entitled to vote, or 50 percent or more of the total value
   of shares of all classes of Controlled stock, that was either (i) acquired by
   purchase (as defined in § 355(d)(5) and (8)) during the five-year period
   (determined after applying § 355(d)(6)) ending on the date of the
   Distribution or (ii) attributable to distributions on Distributing stock that was
   acquired by purchase (as defined in § 355(d)(5) and (8)) during the five-
   year period (determined after applying § 355(d)(6)) ending on the date of
   the Distribution.

   (p) The Distribution is not part of a plan or series of related transactions
   (within the meaning of § 355(e)) pursuant to which one or more persons
   will acquire, directly or indirectly, stock possessing 50 percent or more of
   the total combined voting power of all classes of stock entitled to vote of
   either Distributing or Controlled, or stock possessing 50 percent or more
   of the total value of all classes of stock of either Distributing or Controlled.
   PLR-100284-02 9

   (q) Except for a secured loan existing between Sub 1 and Sub 2, which is
   intended to reflect arm’s length terms and which will be repaid
   immediately after the Merger, no intercorporate debt will exist between
   Distributing and Controlled at the time of, or after, the Distribution, other
   than payables and receivables that arise in the ordinary course of
   business.

   (r) Immediately before the Distribution, items of income, gain, loss,
   deduction, and credit will be taken into account as required by the
   applicable intercompany transaction regulations (see § 1.1502-13 and §
   1.1502-14 of the Income Tax Regulations as in effect before the
   publication of T.D. 8597, 1995-2 C.B. 147, and as currently in effect; §
   1.1502-13 as published by T.D. 8597). Further, Distributing’s excess loss
   account, if any, with respect to the Controlled stock will be included in
   income immediately before the Distribution (see § 1.1502-19).

   (s) Other than royalty-free licenses for unidentified, incidental intellectual
   property covered by an intellectual property agreement between
   Distributing and Sub 1, payments made in connection with all continuing
   transactions, if any, between Distributing and Controlled will be made for
   fair market value based on terms and conditions arrived at by the parties
   bargaining at arm’s length.

   (t) No two parties to the Proposed Transaction are investment companies as
   defined in § 368(a)(2)(F)(iii) and (iv).

   (u) The Distributing Class B stock is stock of Distributing for federal income
   tax purposes.

   (v) None of Distributing, Sub 1, Controlled, Target, or any controlling
   shareholder of such corporations (within the meaning of § 1.355-7T(h)(3)
   of the Income Tax Regulations) will have entered into at any time during
   the two-year period ending on the date of the Distribution an agreement,
   understanding, arrangement, or substantial negotiations (within the
   meaning of § 1.355-7T(h)(1) of the Income Tax Regulations) regarding an
   acquisition of Controlled stock from Shareholder A following the Merger.

   (w) None of Distributing, Sub 1, Controlled, Target, or any controlling
   shareholder of such corporations (within the meaning of § 1.355-7T(h)(3)
   of the Income Tax Regulations) has discussed (or will discuss before the
   Distribution) the Distribution with Shareholder A, a potential buyer of
   Distributing stock owned by Shareholder A, or any controlling shareholder
   (within the meaning of § 1.355-7T(h)(3) of the Income Tax Regulations) of
   PLR-100284-02 10

        such a potential buyer, other than the provision of information generally
        made available to the investing public.
   

   (x) The Distribution is not motivated by a business purpose to facilitate an
   acquisition of Distributing stock from Shareholder A.

   (y) The Distribution will occur at approximately the same time and in similar
   form regardless of an acquisition of Distributing stock from Shareholder A.

   (z) At the time of the Distribution, no agreement, understanding, or
   arrangement (within the meaning of § 1.355-7T(h)(1) of the Income Tax
   Regulations) will exist regarding any acquisition of the Retained Shares
   and no agreement, understanding, arrangement, or substantial
   negotiations (within the meaning of § 1.355-7T(h)(1) of the Income Tax
   Regulations) regarding any such acquisition will occur or exist at any time
   during the one-year period following the Distribution.

                                   Rulings
   

   Based solely on the information submitted and the representations set forth
   above, we rule as follows:

   (1) The Contribution, followed by the Distribution, will be a reorganization
   under § 368(a)(1)(D). Distributing and Controlled each will be a “party to a
   reorganization” under § 368(b).

   (2) No gain or loss will be recognized by Distributing on the Contribution
   (§ 361(a)).

   (3) No gain or loss will be recognized by Controlled on the Contribution
   (§ 1032(a)).

   (4) No gain or loss will be recognized by Distributing on the Distribution
   (§ 361(c)(1)).

   (5) No gain or loss will be recognized by (and no amount will otherwise be
   included in the income of) the holders of Distributing Class B stock on the
   receipt of Controlled Class C stock in exchange for Distributing Class B
   stock (§ 355(a)(1)).

   (6) A shareholder who receives Controlled Class C stock in the Distribution
   will have an aggregate adjusted basis in the Controlled Class C stock
   PLR-100284-02 11

        immediately after the Distribution equal to the aggregate adjusted basis of
        the Distributing Class B stock surrendered in the Distribution (§ 358(a)(1)).
   

   (7) The holding period of the Controlled Class C stock received by a
   shareholder in the Distribution will include the holding period of the
   Distributing Class B stock surrendered in exchange therefor, provided the
   Distributing Class B stock is held as a capital asset on the date of the
   Distribution (§ 1223(1)).

   (8) Earnings and profits will be allocated between Distributing and Controlled
   in accordance with §§ 312(h) and 1.312-10(a).

   (9) Distributing’s retention of the Retained Shares (and the Exchange Shares
   to the extent not distributed in the Debt-for-Equity Exchanges) will not be
   in pursuance of a plan having as one of its principal purposes the
   avoidance of federal income tax within the meaning of § 355(a)(1)(D)(ii).

   (10) An acquisition from Distributing of any Retained Shares will not be treated
   as part of a plan described in § 355(e)(2) that includes the Distribution.

   (11) An acquisition of Distributing Class B stock or Controlled Class C stock
   from Shareholder A will not be treated as part of a plan described in
   § 355(e)(2) that includes the Distribution.

   (12) No gain or loss will be recognized by Distributing on the Debt-for-Equity
   Exchanges to the extent Distributing uses Distributing Class B stock to
   satisfy outstanding Distributing debt (§ 1032).

   (13) No gain or loss will be recognized by Distributing on the Debt-for-Equity
   Exchanges to the extent Distributing uses Controlled Class C stock to
   satisfy outstanding Distributing debt (§ 361(c)(3)).

                                   Caveats
   

   No opinion is expressed about the tax treatment of the Proposed Transaction
   under other provisions of the Code or regulations or the tax treatment of any conditions existing at the time of, or effects resulting from, the Proposed Transaction that are not specifically covered by the above rulings. In particular, no opinion is expressed on

   (i) the tax treatment of the royalty-free licensing agreement referred to above
   in representation (s);

   (ii) whether the Distributing Class B stock is stock of Distributing for federal
   income tax purposes;
   PLR-100284-02 12

   (iii) whether Distributing’s acquisition of its own debt results in income from
   discharge of indebtedness under § 61(a)(12) or any other provisions;

   (iv) the tax treatment of any sales of the Exchange Shares for cash; and

   (v) the Merger described in step (vii) above.

                               Procedural Statements
   

   This ruling letter is directed only to the taxpayer who requested it. Section
   6110(k)(3) provides that it may not be used or cited as precedent.

   Each taxpayer involved in this transaction should attach a copy of this ruling
   

   letter to the taxpayer’s federal income tax return for the taxable year in which the transaction covered by this letter is completed.

   Under a power of attorney on file in this office, a copy of this letter is being sent
   to your authorized representatives.

                                             Sincerely,
   
                                             Lewis K Brickates
                                             Acting Chief, Branch 4
                                             Office of Associate Chief Counsel
                                             (Corporate)