Tax-free split-off separating an S corporation's two businesses among feuding shareholders

Plain-English summary

An S corporation ran two separate businesses, one directly and one through a wholly owned subsidiary that had elected QSub status. Its shareholders split into camps that disagreed about the two businesses' prospects and wanted to go their separate ways. The company proposed a divisive reorganization: it would move one business into the subsidiary, then distribute the subsidiary's stock to the shareholders who wanted that business in exchange for their shares in the parent (a "split-off"). The taxpayer asked the IRS to confirm the deal's federal income tax treatment. The IRS ruled the contribution and distribution together qualify as a tax-free "D" reorganization under section 368(a)(1)(D) with a tax-free distribution under section 355, so neither the corporations nor the participating shareholders recognize gain or loss, and it addressed the resulting basis, holding period, earnings and profits, and S corporation and QSub election consequences. The IRS did not rule on the business-purpose, device, or section 355(e) "50 percent acquisition" questions, or on whether the shareholder trusts are eligible S corporation shareholders.

Ruling snapshot

• Question: Do a contribution of one business to a subsidiary and the split-off distribution of that subsidiary's stock qualify as a tax-free divisive reorganization under sections 355 and 368(a)(1)(D)?
• Outcome: Approved (13 rulings granted, subject to stated caveats).
• Key authorities: IRC §§ 355, 368(a)(1)(D), 361, 357, 358, 362, 361(c), 1032, 1223, 312(h), 1361, 1362; Treas. Reg. §§ 1.355-2, 1.358-2, 1.312-10, 1.1361-5, 1.1368-2; Rev. Proc. 2017-52.

Full text (IRS public release)

 Internal Revenue Service                                          Department of the Treasury
                                                                   Washington, DC 20224

 Number: 202309013                                                 Third Party Communication: None
 Release Date: 3/3/2023                                            Date of Communication: Not Applicable
 Index Number: 355.01-01, 368.04-00
                                                                   Person To Contact:
 -------------------                                               -------------------, ID No. -----------------
 -------------------------------                                   Telephone Number:
 --------------------------                                        --------------------
 ----------------------------------------                          Refer Reply To:
 --------------------------                                        CC:CORP:B05
                                                                   PLR-116813-22
                                                                   Date:
                                                                   December 02, 2022




Legend

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

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

Business X                          =        --------------------------------

Business Y                          =        -------------------------

Individual A                        =        -------------------------

Individual B                        =        ------------------------

Individual C                        =        ------------------

Individual D                        =        -------------------

Individual E                        =        --------------------

Trust 1                             =        ------------------------------------------------------------------------
------------------------------------------------------------------------------------------------------------
                                             -------------

Trust 2                             =        ------------------------------------------------------------------------
                                             -------------------------

Trust 3                             =        ------------------------

Trust 4         =        ------------------------

Trust 5         =        ------------------

Trust 6         =        -------------------

Trust 7         =        --------------------

Trust 8         =        ------------------------------------------------------------
                -------------

Bank            =        -----------------------------

Date 1          =        -------

Date 2          =        ----------------------

State A         =        -------------

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

Asset B         =        ----------------------------------------------

Asset C         =        ------------------------------------------------------------------------
                ---------------------------------------------------------------------------------
                ----------------------------
                ------------------------------------------------------------
                --------------------------------------------------------

a               =        -----

b               =        ----

c               =        --

d               =        ------

e               =        ---------

f               =        ---------

g               =        ---------

h               =        ---------

i                          =     ---------

j                          =     ---------

k                          =     ---------

l                          =     ---------

m                          =     ---------

n                          =     ---------------

o                          =     ---------------

p                          =     --------

q                          =     -------------

r                          =     -------------

s                          =     -------------------

t                          =     -----

u                          =     -----------

v                          =     -----------------

w                          =     ---------

y                          =     ---------------


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

This letter responds to a letter dated September 2, 2022, submitted on behalf of the
taxpayer, requesting rulings on certain federal income tax consequences of a series of
proposed transactions (the “Proposed Transactions”). The material information
submitted in that request is summarized below.

This letter is issued pursuant to Rev. Proc. 2017-52, 2017-41 I.R.B. 283, regarding one
or more “covered transactions” under sections 355 and 368 of the Internal Revenue
Code (the “Code”). This office expresses no opinion as to any issue not specifically
addressed by the rulings below.

The rulings contained in this letter are based upon information and representations
submitted by the taxpayer and accompanied by a penalties of perjury statement
executed by an appropriate party. While this office has not verified any of the materials
submitted in support of the request for rulings, it is subject to verification on
examination.

We have made no determination regarding whether the Distribution (i) satisfies the
business purpose requirement of Treas. Reg. § 1.355-2(b), (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 section 355(a)(1)(B) and Treas. Reg. § 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 within the meaning of
Treas. Reg. § 1.355-8T. See section 355(e)(2)(A)(ii) and Treas. Reg. § 1.355-7.

                                    Summary of Facts

Distributing was formed on Date 1 as a State A corporation. On Date 2, Distributing
elected to be treated as a subchapter S corporation for Federal income tax purposes
under section 1362(a) of the Code.

Distributing is engaged in Business X, which it operates directly and through a
disregarded entity, and Business Y, which is operated by Controlled, a State A
corporation wholly owned by Distributing that has elected to be treated as a qualified
subchapter S subsidiary for Federal income tax purposes under section 1361(b)(3)(B) of
the Code (a “QSub”).

Distributing has two classes of stock outstanding, all of which are directly owned by
Individuals A, B, C, D, and E, or trusts for their benefit. Distributing’s Series A shares
represent a percent of the vote and b percent of the value. Distributing’s Series B
shares represent c percent of the vote and d percent of the value.

Individual A owns e percent of the Distributing Series A shares. Individual B owns f
percent of the Distributing Series A shares. Trust 1 owns g percent of the Distributing
Series A shares. Trust 2 owns h percent of the Distributing Series A shares.
Trust 3 owns i percent of the Distributing Series B shares. Trust 4 owns j percent of the
Distributing Series B shares. Trust 5 owns k percent of the Distributing Series B shares.
Trust 6 owns l percent of the Distributing Series B shares. Trust 7 owns m percent of
the Distributing Series B shares.

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

Over time, a disagreement among Distributing’s shareholders has developed over the
relative prospects of Business X and Business Y. Individuals A and B believe Business
X has stronger prospects than Business Y. Individuals C and D believe Business Y has
stronger prospects than Business X. These four shareholders want to operate their
preferred business separate and apart from the other shareholders and business.
Individual E does not have a strong preference for Business X or Y.

                                 Proposed Transactions

To allow Business X to be operated separately from Business Y, Distributing proposes
to split Business Y from Business X in the following steps, which will occur sequentially
unless otherwise stated:

    1. Trust 7 will transfer n Distributing Series B shares to Trust 8.

    2. Distributing will contribute certain business assets of Business Y, Asset A, Asset
      B, and Asset C to Controlled, and Controlled will assume liabilities associated
      with the transferred assets of Business Y (the “Contribution”).

    3. Distributing will cause Controlled to enter into a loan with Bank (the “Controlled
      Loan”). Controlled will transfer $o of the Controlled Loan proceeds to
      Distributing. Distributing will use the loan proceeds from the Controlled Loan it
      receives from Controlled to reduce the outstanding principal on its loan with Bank
      (the “Distributing Debt”) by $o.

    4. Controlled will amend its articles of incorporation to authorize issuance of p
      shares of Series A common stock and q shares of Series B common stock to
      facilitate the Proposed Transactions. Controlled will issue r Series A shares and s
      Series B shares to Distributing in exchange for Distributing’s t shares of
      Controlled common stock.

    5. Distributing will distribute (1) Controlled Series A and Series B shares to Trust 2,
      Trust 5, Trust 6, and Trust 8 in exchange for all of their Distributing Series A and
      Series B shares, (2) the remaining u Controlled Series A shares to Trust 1 in
      exchange for an equivalent number of Distributing Series A shares, and (3) the
      remaining v Controlled Series B shares to Trust 7 in exchange for an equivalent
      number of Distributing Series B shares.

    6. Controlled will elect under section 1362(a) of the Code to be treated as an S
      corporation on the first available date, effective as of the date of the Distribution.

    7. Under agreements entered into on or before the Distribution, w Controlled Series
      A shares and y Controlled Series B shares may be transferred in exchange for
      fair market value consideration by Trust 1 and Trust 8 to Controlled and
      Individuals C and D (or trusts for their benefit).


Following the Distribution, Distributing will engage in certain continuing business
relationships with Controlled (collectively, the “Continuing Relationships”). All of the
Continuing Relationships will be governed by contracts with arm’s length terms.

Following the Distribution, Individuals B and E will be employed by Distributing.
Individuals A and B will also serve on Distributing’s board. In addition, Individual C will
be employed by Controlled and serve on Controlled’s board.

                                     Representations

With respect to the Distribution, except as set forth below, Distributing has made all of
the representations in Section 3 of the Appendix to Rev. Proc. 2017-53, 2017-41 I.R.B.
283 in the form set forth therein.

Distributing has made the following alternative representations set forth in Section 3 of
the Appendix to Rev. Proc. 2017-52:

       Representations 3(a), 8(a), 11(a), 15(a), 22(a), 31(a), and 41(b).

Distributing has not made the following representations, which do not apply to the
Proposed Transaction:

       Representations 5, 6, 19, 20, 24, 25, 35, 36, 37, 38, 39, and 40.

Distributing has made the following modified representation:

       Representation 18: The total adjusted basis and the fair market value of assets
       transferred by Distributing to Controlled will each equal or exceed the sum of: (a)
       the total amount of the liabilities assumed (within the meaning of section 357(d),
       but excluding any liabilities to which section 357(c)(3) applies) by Controlled, and
       (b) the total amount of any money and the fair market value of other property, if
       any, received by Distributing and transferred to its shareholders and its creditors.

In addition, except as set forth below, Distributing has made all of the representations in
Section 3.04 of Rev. Proc. 2018-53, 2018-43 I.R.B. 667.

Distributing has made the following modified representation:

       Representation 4: A portion of the Controlled Loan was obtained to substitute for
       an equivalent amount of Distributing Debt. Distributing incurred the Distributing
       Debt that will be satisfied with the Controlled Loan (a) before the request for any
       relevant ruling is submitted and (b) no later than 60 days before the earliest of
       the following dates: (i) the date of the first public announcement (as defined in
       § 1.355-7(h)(10)) of the Divisive Reorganization or a similar transaction, (ii) the
        date of entry by Distributing into a binding agreement to engage in the Divisive
        Reorganization or a similar transaction, and (iii) the date of approval of the
        Divisive Reorganization or a similar transaction by the board of directors of
        Distributing.

                                         Rulings

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

    1.    The Distribution will cause a termination of Controlled’s QSub election because
         Controlled will cease to be a wholly-owned subsidiary of an S corporation. For
         federal income tax purposes, Controlled will be treated as a new corporation
         acquiring all of its assets and assuming all of its liabilities from Distributing
         immediately before the termination of Controlled’s QSub election in exchange
         for the stock of Controlled, pursuant to Treas. Reg. § 1.1361-5(b)(1)(i) and
         section 1361(b)(3)(B) and (C).

    2.    The Contribution and the Distribution, together, will be a “reorganization” within
         the meaning of section 368(a)(1)(D). Distributing and Controlled will each be “a
         party to the reorganization” within the meaning of section 368(b).

    3.    Distributing will not recognize gain or loss on the Contribution. Sections 361(a)
         and 357(a).

    4.    Controlled will not recognize gain or loss on the Contribution. Section 1032(a).

    5.    Controlled’s basis in each asset received in the Contribution will be the same
         as the basis of that asset in the hands of Distributing immediately prior to the
         Contribution. Section 362(b).

    6.    Controlled’s holding period in each asset received in the Contribution will
         include the period during which Distributing held such asset. Section 1223(2).

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

    8.    Controlled’s shareholders will not recognize gain or loss on the receipt of the
         stock of Controlled in the Distribution. Section 355(a)(1).

    9.    Each participating shareholder’s aggregate basis in its Controlled stock
         immediately after the Distribution will equal such shareholder's aggregate basis
         in the Distributing stock surrendered in the Distribution and will be allocated
         among the shares received in the manner described in Treas. Reg. § 1.358-
         2(a). Section 358(a)(1) and (b)(1).

    10. Each participating shareholder’s holding period in its Controlled stock received
       in the Distribution will include the holding period of the Distributing stock
       received in exchange therefor, provided that such Distributing stock was held
       as a capital asset on the date of the Distribution. Section 1223(1).

    11. As provided in section 312(h), proper allocation of earnings and profits among
       Distributing and Controlled will be made in accordance with Treas. Reg.
       § 1.312-10(a).

    12. Distributing’s accumulated adjustments account immediately before the
       transaction will be allocated between Distributing and Controlled in a manner
       similar to the manner in which Distributing’s earnings and profits will be
       allocated under section 312(h). See Treas. Reg. §§ 1.312-10(a) and 1.1368-
       2(d)(3)).

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

                                          Caveats

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax treatment of the Proposed Transactions under any provision of the Code and
regulations or the tax treatment of any condition existing at the time of, or effects
resulting from, the Proposed Transactions that is not specifically addressed by this
letter.

We express or imply no opinion regarding whether the purported shareholder trusts are
or were eligible S corporation shareholders, or whether certain other transactions not
ruled on in this letter have the tax consequences intended.

                                  Procedural Statements

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.

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.

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



                                                   Sincerely,

                                                   _________________
                                                   John Lovelace
                                                   Senior Attorney, Branch 3
                                                   Office of Associate Chief Counsel (Corporate)



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