PLR 200843021: Family shareholders could split an S corporation business tax-free

Plain-English summary

Two related shareholder groups disagreed over how to operate an S corporation’s active business. The corporation proposed transferring part of the business and related liabilities to a new controlled corporation, then exchanging all controlled-company shares for the stock held by one couple. Each resulting corporation would independently operate its share of the business, and the new company would elect S status immediately after distribution. Based on detailed business-purpose, value, liability, continuity, and nonavoidance representations, the IRS approved the contribution and split-off as a Type D reorganization. The corporations and exchanging shareholders generally recognized no gain or loss, with carryover basis, tacked holding periods, and allocated earnings and profits. Momentary ownership by the distributing S corporation did not make the new corporation ineligible for S status, and transferred assets remained outside § 1374 built-in-gain treatment if they were not already subject to it.

Ruling snapshot

• Question: Would the business split-off qualify as a tax-free Type D reorganization while allowing the new corporation to elect S status?
• Outcome: Approved, subject to the stated factual representations and caveats.
• Key authorities: IRC §§ 355, 357, 358, 361, 362, 368(a)(1)(D), 1032, 1223, 1361, 1362, 1374

Full text (IRS public release)

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Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 200843021 Third Party Communication: None
Release Date: 10/24/2008 Date of Communication: Not Applicable
Person To Contact:
Index Numbers: 368.04-00, 355.01-01 ------------------, ID No. -------------
Telephone Number:
---------------------
--------------------------- Refer Reply To:
------------------------------ CC:CORP:B06
------------------------ PLR-117697-08
--------------------------- Date:
July 18, 2008

Legend

Distributing = ------------------------------

Controlled = --------------------------------------------------------

Business = ----------

A = ----------------------

B = ------------------------

C = ---------------------

D = ---------------------

e = ---

f = -----

g = --------

h = --------

i = ---------

j = ---------
PLR-117697-08 2

k% = -------

l% = -------

m% = ------

n% = ---------

o% = ---------

p% = ------

q% = --------

X = ---------

Y = ---------

Dear -------------:

This letter responds to your April 14, 2008 letter from your authorized representatives
requesting rulings on certain federal income tax consequences of a proposed
transaction. Additional information was received subsequently. The information
provided in these letters is summarized below.

The rulings contained in this letter are based on facts and representations submitted by
the taxpayer and accompanied by a penalty 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. In particular, this office has not
reviewed any information pertaining to, and except where expressly provided has made
no determination regarding, whether the distribution (described below): (i) satisfies the
business purpose requirement of § 1.355-2(b) of the Income Tax Regulations; (ii) is
used principally as a device for the distribution of the earnings and profits of the
distributing corporation or the controlled corporation or both (see § 355(a)(1)(B) of the
Internal Revenue Code and § 1.355-2(d)); or (iii) is part of a plan (or series of related
transactions) pursuant to which one or more persons will acquire directly or indirectly
stock representing a 50-percent or greater interest in the distributing corporation or the
controlled corporation (see § 355(e) and § 1.355-7).

Distributing is an S corporation engaged in Business. Distributing has outstanding
voting and non-voting common stock, held as follows:
PLR-117697-08 3

Shareholder Number of Percentage Number of Percentage
Voting Shares Non-Voting Shares
A g n% i m%
B f l% i m%
C h o% j p%
D e k%
Total X q% Y q%

Individuals A and B are married and individuals C and D are married. Individuals A and
C are sisters.

Financial information has been received indicating that Business has had gross receipts
and operating expenses representing the active conduct of a trade or business for each
of the past five years.

For valid corporate business purposes described herein, Distributing desires to separate
Business. The separation is intended to be accomplished by the following steps:

(i) Distributing will transfer p% of the assets used in Business to Controlled, a newly
formed, wholly owned subsidiary, in exchange for all of the Controlled stock and the
assumption by Controlled of certain liabilities associated with the transferred assets
(the “Contribution”). Controlled will have the same number and class of shares as
Distributing.

(ii) Distributing will distribute all of the Controlled stock to C and D solely in exchange
for all of their Distributing stock (the “Distribution”).

(iii) Controlled will elect to be taxed as an S corporation.

The following representations have been made in connection with the Contribution and
Distribution (collectively, the “Proposed Transaction”):

(a) Controlled and its shareholders will pay all expenses associated with the Proposed
Transaction.

(b) Any indebtedness owed by Controlled to Distributing after the Proposed Transaction
will not constitute stock or securities.
PLR-117697-08 4

(c) The fair market value of the Controlled stock received by each of C and D will be
approximately equal to the fair market value of the Distributing stock surrendered by
each such shareholder in the exchange.

(d) No part of the Controlled stock to be distributed by Distributing to C and D will be
received by either of them as a creditor, employee, or in any capacity other than that of
a shareholder of Distributing.

(e) The five years of financial information submitted on behalf of Business that will be
conducted by Distributing immediately after the Proposed Transaction represents its
present operation and, with regard to that business, 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 that will be
conducted by Controlled immediately after the Proposed Transaction represents its
present operation and, with regard to that business, there have been no substantial
operational changes since the date of the last financial statements submitted.

(g) Following the Proposed Transaction, Distributing and Controlled will each continue,
independently and with its separate employee(s), the active conduct of its share of all
the integrated activities of Business conducted by Distributing before the Proposed
Transaction.

(h) The Proposed Transaction will be carried out for the following corporate business
purposes: (i) to eliminate conflicts and disagreements between A and C over how the
Business should be conducted, and (ii) to allow each individual to go her separate way
and apply her own approach to the operation of the Business. The distribution is
motivated, in whole or substantial part, by these corporate business purposes.

(i) The Proposed Transaction will not be used principally as a device for the distribution
of the earnings and profits of Distributing or Controlled or both.

(j) The total adjusted bases and the fair market value of the assets of the Business
transferred to Controlled by Distributing in the Proposed Transaction will each equal or
exceed the sum of: (i) the total liabilities to be assumed (within the meaning of § 357(d))
by Controlled, and (ii) the total amount of any money and the fair market value of any
other property (within the meaning of § 361(b)) received by Distributing from Controlled
and transferred to its creditors in connection with the transaction.

(k) The liabilities to be assumed (within the meaning of § 357(d)) by Controlled in the
Proposed Transaction were incurred in the ordinary course of business and are
associated with the assets being transferred.
PLR-117697-08 5

(l) The total fair market value of the assets that Distributing will transfer to Controlled will
exceed the sum of (i) the amount of any liabilities assumed (within the meaning of
§ 357(d)) by Controlled in connection with the exchange, (ii) the amount of any liabilities
owed to Controlled by Distributing that are discharged or extinguished in connection
with the exchange, and (iii) the amount of any cash and the fair market value of any
other property (other than stock and securities permitted to be received under § 361(a)
without recognition of gain) received by Distributing from Controlled in connection with
the exchange. The fair market value of the assets of Controlled will exceed the amount
of its liabilities immediately after the exchange.

(m) The aggregate fair market value of the assets contributed to Controlled in the
Contribution will exceed the aggregate basis of those assets.

(n) Distributing has not accumulated, and will not accumulate, its receivables or make
any extraordinary payment of its payables in anticipation of the Proposed Transaction.

(o) No intercorporate debt will exist between Distributing and Controlled at the time of,
or subsequent to, the Proposed Transaction.

(p) For purposes of § 355(d), immediately after the Distribution, no person (determined
after applying the aggregation rules of § 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.

(q) For purposes of § 355(d), immediately after the Distribution, no person (determined
after applying the aggregation rules of § 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.

(r) Payments made in connection with all continuing transactions, if any, between
Distributing and Controlled will be for fair market value based on terms and conditions
arrived at by the parties bargaining at arm's length.

(s) To the extent any transfer in the Proposed Transaction is an early disposition of
property for which an investment credit has been (or will be) claimed under § 46, the
income tax liability for the taxable year in which the investment credit property (including
PLR-117697-08 6

any building to which § 47(d) applies) is transferred will be adjusted pursuant to
§ 50(a)(1) or (a)(2) (or § 47, as in effect before amendment by Public Law 101-508, Title
11, 104 Stat. 1388, 536(1990), if applicable) to reflect the early disposition of the
property.

(t) Immediately after the Proposed Transaction, less than two-thirds of the assets of
each of Distributing and Controlled will be investment assets, as defined in
§ 355(g)(2)(B).

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

(v) The Proposed Transaction is not part of a plan or series of related transactions
(within the meaning of § 1.355-7) pursuant to which one or more persons will acquire
directly or indirectly stock representing a 50-percent or greater interest (within the
meaning of § 355(d)(4) in Distributing or Controlled (including any predecessor or
successor of any such corporation).

(w) Upon formation, Controlled will be classified as an association taxable as a
corporation for federal tax purposes.

(x) Upon formation, Controlled will not elect to be classified as qualified subchapter S
subsidiary.

Based on the information submitted and the representations provided, we rule as
follows in connection with the Proposed Transaction:

1. The Contribution and the Distribution will constitute a reorganization within the
   meaning of § 368(a)(1)(D). Distributing and Controlled will each be "a party to a
   reorganization" within the meaning of § 368(b).

2. Distributing will not recognize any gain or loss on the Contribution (§§ 357(a) and
   361(a)).

3. Controlled will not recognize any gain or loss on the Contribution (§ 1032(a)).

4. Controlled's basis in each asset received from Distributing in the Contribution will
   equal the basis of that asset in the hands of Distributing immediately before such
   Contribution (§ 362(b)).

5. Controlled's holding period in each asset received from Distributing in the
   Contribution will include the period during which Distributing held that asset (§ 1223(2)).
   PLR-117697-08 7

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

7. Distributing will not recognize any gain or loss on the Distribution (§ 361(c)).

8. Neither C nor D will recognize any gain or loss (nor otherwise include any amount in
   income) upon the Distribution (§ 355(a)).

9. The basis of the Controlled stock in the hands of C and D, in each case, will be the
   same as the basis in their Distributing stock (§ 358(a)(1)).

10. A Distributing shareholder's holding period in the Controlled stock received will
    include that shareholder's holding period for the Distributing stock surrendered in
    exchange therefor, provided that the Distributing stock is held as a capital asset on the
    date of the Proposed Transaction (§ 1223(1)).

11. The momentary ownership by Distributing of the stock of Controlled, as part of the
    reorganization under § 368(a)(1)(D), will not cause Controlled to have an ineligible
    shareholder for any portion of its first taxable year under § 1361(b)(1)(B). If Controlled
    otherwise meets the requirements of § 1361(b)(1), Controlled will be eligible to make an
    election under § 1362(a) to be classified as a subchapter S corporation for its first
    taxable year, provided such election is made effective immediately after the distribution
    of Controlled.

12. Provided that the assets of Business, currently held by Distributing, are not
    presently subject to the built-in gain provisions of § 1374, the portion of those assets
    transferred to Controlled will continue to not be subject to the built-in gain provisions of
    § 1374 in the hands of Controlled.

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
regarding: (i) whether the Distribution satisfies the business purpose requirement of
§ 1.355-2(b); (ii) whether the Proposed Transaction is used principally as a device for
the distribution of the earnings and profits of the distributing corporation or controlled
corporation or both (see § 355(a)(1)(B) and § 1.355-2(d)); (iii) whether the Proposed
Transaction is part of a plan (or series of related transactions) under § 355(e)(2)(A)(ii),
(iv) whether Distributing is a valid S corporation and, (v) whether Controlled is otherwise
eligible to be an S corporation.

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.
PLR-117697-08 8

In accordance with the Power of Attorney on file with this office, a copy of this letter is
being sent to your authorized representatives.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.

                                   Sincerely,



                                   Alfred C. Bishop, Jr.
                                   Branch Chief, Branch 6
                                   (Corporate)

cc:
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