PLR 200850014: one business split three ways, a pair of shareholders each, with the operating assets deliberately left undivided

Plain-English summary

A nine page private letter ruling, control number "PLR-122642-08", dated September 11, 2008 and released 12/12/2008. It is routed "CC:CORP:02", carries Index Number "355.01-02, 368.04-00", and is signed by Alison G. Burns, Branch Chief, Branch 2, Office of Associate Chief Counsel (Corporate). It answers a letter of May 12, 2008.

Distributing is a State X corporation, organized as a subchapter C corporation on Date 1, with one class of common stock held in equal sixths by six individuals. The letter pairs them: Shareholder 1 and 2 are Group 1, Shareholder 3 and 4 are Group 2, Shareholder 5 and 6 are Group 3. The company is directly engaged in Business A. Six owners want to become three separately run companies.

The interesting thing about the plan is what it refuses to divide.

Only one asset is physically split. Distributing first moves substantially all of its assets other than Asset A into a newly formed wholly owned LLC, which at that moment is disregarded. Then it divides Asset A into thirds, forms Controlled 1, Controlled 2 and Controlled 3, and contributes to each of them one third of Asset A together with one third of its interests in the LLC, taking back that Controlled's stock and having it assume the related liabilities. Handing the LLC interests to three separate owners is what changes the LLC's tax character: it "will convert from a disregarded entity to an entity taxable as a partnership." Distributing then hands each Controlled's stock to its pair of shareholders in exchange for all of their Distributing stock, each Controlled elects S status, and Distributing liquidates. The contributions, the distributions and the S elections "will all occur on the same date."

So the operating business is not carved up at all. It stays in one vehicle, now owned jointly by the three new corporations as a partnership, and what each pair of shareholders actually gets is control of its own company, its own third of Asset A, and a one-third stake in the shared operating vehicle. Representation (e) says as much: each Controlled will "continue, independently and with their separate employees, the active conduct of their share of all integrated activities of Business A". The word integrated is doing real work there. The business was one thing and remains one thing; the ownership above it is what is being divided into three.

The stated business purposes in representation (f) match that design exactly: liability protection for each one-third portion of Asset A, and giving each group control over the operation conducted on its portion. The risk being managed is attached to Asset A, not to the trading business.

Eleven rulings follow, and ten of them are the standard consequences of a split-up carried out as a divisive D reorganization. Each contribution together with its distribution is a reorganization under section 368(a)(1)(D) and the parties are parties to it under section 368(b); Distributing recognises nothing on the contributions under sections 357(a) and 361(a) or on the distributions under section 361(c)(1); the Controlled corporations recognise nothing on issuing their stock under section 1032(a); asset basis carries over under section 362(b) with holding periods tacked under section 1223(2); the shareholders recognise nothing under section 355(a), take a substituted basis allocated under regulations section 1.358-2(a) and sections 358(a) and (b)(2), and tack their holding periods under section 1223(1); and earnings and profits are allocated under section 312(h) and regulations section 1.312-10(a).

Ruling (11) is the one that had to be asked for. An S corporation cannot have a corporation as a shareholder. In a divisive D reorganization, Distributing necessarily holds the stock of each Controlled for an instant before distributing it, which would make a corporation the shareholder of record at the very start of the Controlled's first taxable year. The ruling disposes of that: momentary ownership "as part of the reorganization under § 368(a)(1)(D), will not cause the Controlled Corporations to have an ineligible shareholder for any portion of its first taxable year under § 1361(b)(1)(B)", so the elections under section 1362(a) are good from day one. Without that ruling the three companies would have spent their first year as C corporations.

Two of the five caveats then decline the two questions the structure most obviously raises. Caveat (iv) expresses no opinion on the tax results of the LLC's conversion from a disregarded entity to a partnership, which is the hinge of the whole design. Caveat (v) expresses no opinion on the application of section 1374 to any of the Controlled corporations, which is the built-in gains question that arises whenever a C corporation's assets end up inside an S corporation. The Service ruled that the split-up works and left unanswered what it costs afterwards.

Three defects, recorded rather than repaired, since the document came from a clean text layer.

Representation (r) names companies that do not exist in this letter. It reads "Controlled A, Controlled B, and Controlled C will each elect to be an S corporation pursuant to § 1362(a) on the same date as the Contributions from Distributing and the split-up of Business A." Everywhere else the entities are Controlled 1, Controlled 2 and Controlled 3, each named twenty-one times. Controlled A and Controlled B each appear exactly once in the entire document, both inside that one sentence. The paragraph was carried over from another file and the names were never conformed.

The same sentence holds the only appearance of the word split-up anywhere in the letter, verified to sit inside representation (r) and before the rulings heading. The index row for this document calls its subject Split-Up, capitalised; the letter itself uses the word once, in the paragraph that got the names wrong.

Representation (p) doubles a preposition: "The Distributions are not part of a plan or series of related transactions (within in the meaning of § 1.355-7)". The correct phrase, "within the meaning", appears six times elsewhere in the letter.

Finally, a same-day comparison worth recording, because it shows that two letters out of the same Associate Chief Counsel (Corporate) on one date were not drafted from a common form. Its companion is docs/2008/0850018.md, also dated September 11, 2008, also a section 355 distribution. Three citations diverge. For a disqualified investment corporation, this letter cites section 355(g)(2)(A) and never section 355(g)(3); 0850018 cites section 355(g)(3) and never section 355(g)(2)(A). For the shareholder basis allocation, this letter cites regulations section 1.358-2(a); 0850018 cites section 1.358-2(a)(2). For the definition of purchase, this letter writes "§ 355(d)(5) and (8)" with a single section symbol all three times it appears, while 0850018 prints both the single and the doubled symbol in adjacent representations. The two letters also disagree about headings: this one sets LEGEND in capitals, indented fifty-five columns to the right of the margin, while 0850018 prints no legend heading at all. And the perjury sentence here is plural, "a penalties of perjury statement", where docs/2008/0850015.md two days earlier writes the singular. None of this changes any outcome. It does mean a reader cannot assume that two rulings from the same branch in the same week will cite the same provision for the same proposition.

Which of the two section 355(g) citations is the right one is a question this entry does not answer. The citation check this corpus normally runs could not be performed because the legal research tool is unavailable in this session. Both letters are reproduced as released, and neither has been corrected.

The code sections listed above are every provision cited by number anywhere in the letter. Four of them are printed only in compound form and have been broken out: sections 355(d)(5) and 355(d)(8) from "§ 355(d)(5) and (8)", sections 358(a) and 358(b)(2) from "§ 358(a) and (b)(2)", sections 368(a)(2)(F)(iii) and 368(a)(2)(F)(iv) from "§ 368(a)(2)(F)(iii) and (iv)", and sections 357(a) and 361(a) from "§§ 357(a) and 361(a)". Each is genuinely cited; only the printing is compressed.

Ruling snapshot

• Question: Can a C corporation owned by six shareholders split into three S corporations, one for each pair, by dividing a single asset three ways while leaving the operating business intact in a jointly owned limited liability company?
• Outcome: Approved. Eleven rulings were given, treating each contribution and its matching distribution as a divisive reorganization under section 368(a)(1)(D) with no gain to the company, the new corporations or the shareholders, and confirming that the company's momentary ownership of the new stock will not disqualify the S elections under section 1361(b)(1)(B). No opinion was expressed on business purpose, device, plan under section 355(e)(2)(A)(ii), the conversion of the limited liability company into a partnership, or the application of section 1374.
• Key authorities: Sections 355 and 368(a)(1)(D) with sections 357, 358, 361, 362, 1032(a), 1223, 1361, 1362(a) and 1374, and regulations sections 1.312-10(a), 1.355-2(b), 1.355-2(d), 1.355-7 and 1.358-2(a).

Full text (IRS public release)

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Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 200850014 Third Party Communication: None
Release Date: 12/12/2008 Date of Communication: Not Applicable
Index Number: 355.01-02, 368.04-00
Person To Contact:
------------------------------------- ----------------------------, ID No. --------------
------------------------------- -----------------
----------------------------- Telephone Number:
-------------------------------- ---------------------
Refer Reply To:
CC:CORP:02
PLR-122642-08
Date:
September 11, 2008

                                                   LEGEND

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

State X = --------------

Date 1 = ----------------

Shareholder 1 = -----------------------

Shareholder 2 = ----------------------

Shareholder 3 = -----------------------

Shareholder 4 = --------------------

Shareholder 5 = --------------------

Shareholder 6 = ---------------------------

Business A = ----------
PLR-122642-08 2

LLC = ----------------------------

Controlled 1 = ----------------------------------------------------------

Controlled 2 = --------------------------------------------------------

Controlled 3 = ------------------------------------------------------------

Asset A = -----------------

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

This letter responds to your May 12, 2008, letter requesting rulings as to the federal
income tax consequences of a series of proposed transactions. The information
provided in that request and in later correspondence is summarized below.

The rulings contained in this letter are based upon 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 material 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 has made
no determination regarding, whether the proposed transactions described below: (i)
satisfy the business purpose requirement of § 1.355-2(b) of the Income Tax
Regulations; (ii) are used principally as a device for the distribution of the earnings and
profits of a distributing or controlled corporation or both (see § 355(a)(1)(B) of the
Internal Revenue Code and § 1.355-2(d)); or (iii) are 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 a distributing or controlled
corporation (see § 355(e) and § 1.355-7).

                                      SUMMARY OF FACTS

Distributing is a State X corporation that was organized as a subchapter C corporation
on Date 1. Distributing has one class of common stock, which is owned individually and
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in equal proportion by Shareholder 1, Shareholder 2, Shareholder 3, Shareholder 4,
Shareholder 5, and Shareholder 6. Shareholder 1 and Shareholder 2 collectively form
“Group 1,” Shareholder 3 and Shareholder 4 collectively form “Group 2,” and
Shareholder 5 and Shareholder 6 collectively form “Group 3.” Distributing owns all of
the ownership interests in LLC, a newly-formed entity disregarded as an entity separate
from its owner for federal income tax purposes, which was created for the purpose of
carrying out the Proposed Transactions (described below).

Distributing is directly engaged in Business A. Distributing has submitted financial
information which indicates that Business A has had gross receipts and operating
expenses representative of the active conduct of a trade or business for each of the
past five years.

                           PROPOSED TRANSACTIONS

For what are represented to be valid business reasons, Distributing has proposed the
following transactions (the “Proposed Transactions”):

(i) Distributing will create Controlled 1, Controlled 2, and Controlled 3
(collectively, the “Controlled Corporations”).

(ii) Distributing will transfer substantially all of its assets other than Asset A to
LLC in constructive exchange for ownership interests in LLC.

(iii) Distributing will divide Asset A and transfer one-third of Asset A and one-third
of its ownership interests in LLC to each of Controlled 1, Controlled 2, and
Controlled 3 in exchange for all of the stock of each of the Controlled
Corporations and the assumption by each of the Controlled Corporations of
the liabilities related to the assets transferred (the “Contributions”). Upon the
contribution of the LLC interests to the Controlled Corporations, LLC will
convert from a disregarded entity to an entity taxable as a partnership.

(iv) Distributing will distribute half of the stock of Controlled 1 to each of
Shareholder 1 and 2, half of the stock of Controlled 2 to each of
Shareholder 3 and 4, and half of the stock of Controlled 3 to each of
Shareholder 5 and 6, in exchange for all of the Distributing stock held by each
Shareholder (the “Distributions”).

(v) Each of the Controlled Corporations will elect to be taxed as a subchapter S
corporation.

(vi) After the Distributions, Distributing will liquidate.
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(vii) The Contributions, the Distributions, and the S corporation elections will all
occur on the same date.

After the Proposed Transactions, each Controlled Corporation will be managed
independently by its own shareholder group, bear its own financial risk of loss, make its
own financing decisions, and hedge its own risks.

                              REPRESENTATIONS

The taxpayer makes the following representations regarding the Proposed
Transactions:

(a) The fair market value of the Controlled 1, Controlled 2, or Controlled 3 stock,
and other consideration, to be received by each Shareholder will be
approximately equal to the fair market value of the Distributing stock
surrendered by each Shareholder in the exchange.

(b) No part of the consideration to be distributed by Distributing will be received
by a shareholder as a creditor, an employee, or in any capacity other than
that of a shareholder of Distributing.

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

(d) Neither Business A nor control of an entity conducting this business was
acquired during the five-year period ending on the date of the Distributions in
a transaction in which gain or loss was recognized (or treated as recognized)
in whole or in part.

(e) Following the Proposed Transactions, Controlled 1, Controlled 2, and
Controlled 3, in conjunction with LLC, will each continue, independently and
with their separate employees, the active conduct of their share of all
integrated activities of Business A conducted by Distributing prior to
consummation of the Proposed Transactions.
PLR-122642-08 5

(f) The Distributions will be carried out for the following corporate business
purposes: (i) to provide substantial liability protection for each one-third
portion of Asset A being contributed to Controlled 1, Controlled 2, and
Controlled 3; and (ii) to provide each of the Group 1, Group 2, and Group 3
Shareholders control over the operation of Business A to be conducted on the
portion of Asset A contributed to Controlled 1, Controlled 2, and Controlled 3,
respectively. The Distributions are motivated, in whole or in substantial part,
by one or more of these corporate business purposes.

(g) The Proposed Transactions are not used principally as a device for the
distribution of the earnings and profits of Distributing, Controlled 1,
Controlled 2, or Controlled 3.

(h) For purposes of § 355(d), immediately after the Distributions, 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 Distributions.

(i) For purposes of § 355(d), immediately after the Distributions, 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 1,
Controlled 2, or Controlled 3 stock entitled to vote, or 50 percent or more of
the total value of the shares of all classes of Controlled 1, Controlled 2, or
Controlled 3 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 Distributions, 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 Distributions.

(j) The total adjusted bases and the fair market value of the assets transferred to
each of Controlled 1, Controlled 2, and Controlled 3 by Distributing each
equals or exceeds the sum of the liabilities assumed (within the meaning of
§ 357(d)) by each of Controlled 1, Controlled 2, and Controlled 3.

(k) Any liabilities assumed (within the meaning of § 357(d)) by Controlled 1,
Controlled 2, or Controlled 3 in the Contributions were incurred in the ordinary
course of business and are associated with the assets being transferred.
PLR-122642-08 6

(l) Distributing neither accumulated its receivables nor made extraordinary
payment of its payables in anticipation of the Proposed Transactions.

(m) No intercorporate debt will exist between Distributing and Controlled 1,
Controlled 2, or Controlled 3 at the time of, or subsequent to, the
Distributions.

(n) Payments made in connection with all continuing transactions, if any,
between Controlled 1, Controlled 2, Controlled 3, and LLC will be for fair
market value based on terms and conditions arrived at by the parties
bargaining at arm’s length.

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

(p) The Distributions are not part of a plan or series of related transactions (within
in 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 either Distributing, Controlled 1,
Controlled 2, or Controlled 3 (or any predecessor or successor of Distributing,
Controlled 1, Controlled 2, or Controlled 3).

(q) Immediately after the Distributions, neither Distributing, Controlled 1,
Controlled 2, nor Controlled 3 will be a disqualified investment corporation
(within the meaning of § 355(g)(2)(A)).

(r) Controlled A, Controlled B, and Controlled C will each elect to be an
S corporation pursuant to § 1362(a) on the same date as the Contributions
from Distributing and the split-up of Business A. There is no plan or intention
to revoke or otherwise terminate the S corporation election of any Controlled
Corporation.

                                   RULINGS

Based solely on the information submitted and the representations made, we rule as
follows regarding the Proposed Transactions:

(1) Each Contribution, together with its respective Distribution, will be a
reorganization within the meaning of § 368(a)(1)(D). With respect to each
such reorganization, Distributing and the respective Controlled Corporation
will be “a party to a reorganization” within the meaning of § 368(b).
PLR-122642-08 7

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

(3) No gain or loss will be recognized by any of the Controlled Corporations on
the Contributions (§ 1032(a)).

(4) The basis of each asset received by each of the Controlled Corporations in
the Contributions will equal the basis of that asset in the hands of Distributing
immediately before the Contributions (§ 362(b)).

(5) The holding period of each asset received by each of the Controlled
Corporations in the Contributions will include the period during which
Distributing held the asset (§ 1223(2)).

(6) No gain or loss will be recognized by (and no amount otherwise will be
included in the income of) Shareholder 1, Shareholder 2, Shareholder 3,
Shareholder 4, Shareholder 5, or Shareholder 6 on their receipt solely of the
stock of a respective Controlled Corporation in the Distributions (§ 355(a)).

(7) No gain or loss will be recognized by Distributing in connection with the
Distributions (§ 361(c)(1)).

(8) The aggregate basis of the stock of Controlled 1 received by Shareholder 1;
Controlled 1 received by Shareholder 2; Controlled 2 received by
Shareholder 3; Controlled 2 received by Shareholder 4; Controlled 3 received
by Shareholder 5; and Controlled 3 received by Shareholder 6, will each
equal the aggregate basis of the Distributing stock surrendered by each
Shareholder in exchange therefor, allocated in accordance with § 1.358-2(a)
(§ 358(a) and (b)(2)).

(9) The holding period of the stock in the respective Controlled Corporation
received by each Shareholder in the Distributions will include the holding
period of the Distributing stock surrendered in exchange therefor, provided
the Distributing stock was held as a capital asset on the date of the
Distributions (§ 1223(1)).

(10) The earnings and profits of Distributing, if any, will be allocated to each of the
Controlled Corporations in accordance with § 312(h) and § 1.312-10(a).
PLR-122642-08 8

(11) Distributing’s momentary ownership of the stock of the Controlled
Corporations, as part of the reorganization under § 368(a)(1)(D), will not
cause the Controlled Corporations to have an ineligible shareholder for any
portion of its first taxable year under § 1361(b)(1)(B). If the Controlled
Corporations otherwise meet the requirements of a small business
corporation under § 1361, the Controlled Corporations will be eligible to elect
to be subchapter S corporations under § 1362(a) for their first taxable year.

                                     CAVEATS

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

(i) Whether the Distributions satisfy the business purpose requirement of
§ 1.355-2(b);
(ii) Whether the Distributions are being used principally as a device for the
distribution of the earnings and profits of Distributing or the Controlled
Corporations;
(iii) Whether the Proposed Transactions are part of a plan (or series of related
transactions) under § 355(e)(2)(A)(ii);
(iv) The tax results from the conversion of LLC to an entity taxable as a
partnership upon contribution of the LLC interests by Distributing to the
Controlled Corporations; and
(v) The application of § 1374 to any of the Controlled Corporations.

                         PROCEDURAL STATEMENTS

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

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 this
letter ruling.
PLR-122642-08 9

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

                                   Sincerely,



                                   Alison G. Burns
                                   Branch Chief, Branch 2
                                   Office of Associate Chief Counsel (Corporate)

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