Tax 4022/5022 Tax 4022/5022 Federal Income Tax II Federal Income Tax II

Corporate Divisions Corporate Divisions Chapter: NoneChapter: None

Dr. Robert R. OlivaDr. Robert R. Oliva

Professor and ChairpersonProfessor and Chairperson

Department of AccountingDepartment of Accounting

University of Arkansas at Little RockUniversity of Arkansas at Little Rock

DivisionsDivisions

Copyright, 1996 © Dale Carnegie & Associates, Inc.

TIP For additional advice seeDale Carnegie Training® Presentation Guidelines

AgendaAgenda

• Reasons for Division: Need to Reasons for Division: Need to segregate ownershipsegregate ownership

• ABC v. D typeABC v. D type

• Elements and RequirementsElements and Requirements

• Restrictions of some unintended Restrictions of some unintended benefitsbenefits

Why segregate Why segregate ownership?ownership?

• Business Business

• LegalLegal

BusinessBusiness

• Shareholder disputesShareholder disputes

• InsulationInsulation

• Discontinue part of a businessDiscontinue part of a business

• Need to transfer some of its assetsNeed to transfer some of its assets

• Split operationsSplit operations

• Single focus; Wall Street Single focus; Wall Street

LegalLegal

• Compliance requirementsCompliance requirements

• Estate planningEstate planning– Beware: Is the reason for the Beware: Is the reason for the

reorganization personal or business?reorganization personal or business?

ABC v. DABC v. D

• A, B, and C: Corporate combinationsA, B, and C: Corporate combinations

• D reorganization: Corporate D reorganization: Corporate divisionsdivisions– Tax free if IRC 354, 355, or 356 Tax free if IRC 354, 355, or 356

satisfied.satisfied.

Elements: IRC 368(a)(1)Elements: IRC 368(a)(1)(d)(d)

• a transfer by (transferor) corporation of all or a transfer by (transferor) corporation of all or part of its assets to (transferee) corporation if part of its assets to (transferee) corporation if immediately after the transfer the transferor immediately after the transfer the transferor (and/or) one or more of its shareholders … is (and/or) one or more of its shareholders … is (are) in control of the (transferee) (are) in control of the (transferee) corporation...; but only if … stock and corporation...; but only if … stock and securities of the (transferee) corporation … securities of the (transferee) corporation … are distributed in a transaction which are distributed in a transaction which qualifies under section 354, 355, or 356. qualifies under section 354, 355, or 356.

• Transferor must transfer all or part Transferor must transfer all or part of its assets to transferee of its assets to transferee corporationcorporation

• If “substantially all”, then also meet “C” If “substantially all”, then also meet “C” but treated as “D” but treated as “D”

• Transferor or its shareholders end Transferor or its shareholders end up in control of transfereeup in control of transferee

• Transferee’s “stock and securities” Transferee’s “stock and securities” distributed pursuant to IRC 354, distributed pursuant to IRC 354, 355, or 356. 355, or 356.

Note:Two steps or one Note:Two steps or one stepstep

• IRC 368(a)(1)(D): comes into play if there is a IRC 368(a)(1)(D): comes into play if there is a need to create a need to create a new subnew sub with a view to have with a view to have a division.a division.– Transfer of assets: tax free: IRC 361(a)Transfer of assets: tax free: IRC 361(a)

– Assumption of liabilities: IRC 357; particularly IRC Assumption of liabilities: IRC 357; particularly IRC 357( c)(1)357( c)(1)

– IRC 362(b); basisIRC 362(b); basis

• If subs in placeIf subs in place, IRC 355 takes effect without , IRC 355 takes effect without IRC 368(a)(1)(D). IRC 368(a)(1)(D).

RequirementsRequirements

• Common lawCommon law

• Statutory: Effect on shareholders Statutory: Effect on shareholders and Security Holdersand Security Holders– IRC 354; 355; 356IRC 354; 355; 356

Common law Common law requirementsrequirements

Business purposeBusiness purpose

• Transferor must have a substantial Transferor must have a substantial business purposebusiness purpose

CPICPI

• Pre-transaction shareholders need a Pre-transaction shareholders need a continuing equity interest in post-continuing equity interest in post-transaction corporations.transaction corporations.

Statutory requirements to Statutory requirements to D reorganizationsD reorganizations

• Requirements pursuant to IRC Requirements pursuant to IRC 368(a)(1)(D) applicable to all D 368(a)(1)(D) applicable to all D type: type: – Transferor must transfer all or part of Transferor must transfer all or part of

its assets to transferee corporationits assets to transferee corporation

– Transferor or its shareholders end up in Transferor or its shareholders end up in control of transfereecontrol of transferee

TypesTypes

• Spin-offs Spin-offs

• Split-offsSplit-offs

• Split-upsSplit-ups

Spin-offs: Works in the Spin-offs: Works in the form of a form of a dividenddividend of of subsidiary stock to subsidiary stock to parents’ shareholdersparents’ shareholders• Transferor transfers part of its business to Transferor transfers part of its business to

aa new new controlled controlled corporation.corporation.– An IRC 351 transaction by itselfAn IRC 351 transaction by itself

• S/S in a S/S in a controlled controlled corporation transferred corporation transferred to transferor’s shareholders to transferor’s shareholders – Recently createdRecently created or or preexisting subsidiary preexisting subsidiary

– Shareholders Shareholders do not paydo not pay any consideration in any consideration in return. return.

Spin-off Spin-off

• Results: Transferor’s shareholders Results: Transferor’s shareholders end up owning stock in 2 different end up owning stock in 2 different corporations.corporations.

Split-offs: Works in the Split-offs: Works in the form of a form of a redemptionredemption of of parent stock.parent stock.• Transferor transfers part of its business to Transferor transfers part of its business to

aa new new controlled controlled corporation.corporation.

• S/S in S/S in controlled controlled corporation transferred to corporation transferred to some (not all) transferor’s shareholders some (not all) transferor’s shareholders

• HoweverHowever, shareholders pay consideration, shareholders pay consideration• Transferor’s shareholders surrender Transferor’s shareholders surrender partpart of their of their

parent stock in return for stock in the parent stock in return for stock in the controlled controlled corporation. corporation.

Split-offSplit-off

• Results: Some of transferor’s Results: Some of transferor’s shareholders may own shareholders may own – the transferor only the transferor only

– the subsidiary only the subsidiary only

– both transferor and subsidiary both transferor and subsidiary

Split-ups: Works in the Split-ups: Works in the form of a form of a liquidationliquidation of of parent stockparent stock

– Transferor transfers part of its assets to Transferor transfers part of its assets to two two or moreor more new new controlled controlled corporation.corporation.

– S/S in S/S in controlled controlled corporations transferred to corporations transferred to transferor’s shareholders transferor’s shareholders

– HoweverHowever, transferor’s shareholders pay , transferor’s shareholders pay considerationconsideration

– Transferor’s shareholders surrender Transferor’s shareholders surrender allall of of their parent stock in return for stock in the their parent stock in return for stock in the controlled controlled corporations; transferor liquidatescorporations; transferor liquidates

Split-up Split-up

• Result: Transferor does not surviveResult: Transferor does not survive

Additional requirement Additional requirement playing a role on the tax playing a role on the tax effect on shareholders: effect on shareholders:

• Transferee’s “stock and securities” Transferee’s “stock and securities” are to be distributed by transferor are to be distributed by transferor pursuant to IRC 354, 355, or 356. pursuant to IRC 354, 355, or 356.

IRC 354(a); (b): No gain or IRC 354(a); (b): No gain or loss recognition by loss recognition by shareholders when shareholders when • S/S in one party to the reorganization is S/S in one party to the reorganization is

exchangedexchanged for S/S of that corporation or for S/S of that corporation or another party to the reorganization. another party to the reorganization.

• Transferee corporation Transferee corporation acquiresacquires substantially all of the transferor’s assets.substantially all of the transferor’s assets.

• Transferor’s Transferor’s distribution to its distribution to its shareholders: shareholders: completecomplete divestment divestment

ExchangeExchange

• No gain/loss recognized if S/S exchanged No gain/loss recognized if S/S exchanged solely for S/Ssolely for S/S

• ExceptionsExceptions: : – nonqualified preferred stock received in nonqualified preferred stock received in

exchange for exchange for • stock stock is notis not considered S/S considered S/S

• other nonqualified preferred stock other nonqualified preferred stock is is considered considered S/SS/S

– Principal securities: received > surrendered Principal securities: received > surrendered

AcquisitionAcquisition

• A party to the reorganization (e.g., A party to the reorganization (e.g., controlled transferee) acquires controlled transferee) acquires substantially all of the transferor substantially all of the transferor assetsassets

DistributionDistribution

• Transferor corporation distributes Transferor corporation distributes – S/S and properties received by S/S and properties received by

transferor transferor and and

– other other property in the hands of property in the hands of transferor are distributed. transferor are distributed.

IRC 355(a)(1)IRC 355(a)(1)

• Solely S/S for S/SSolely S/S for S/S

• Device restrictionDevice restriction

• ““Active Trade or Business” Active Trade or Business” limitationlimitation

• ““Distribution” requirementDistribution” requirement

Solely S/S for S/SSolely S/S for S/S

• DistributingDistributing corporation distributes corporation distributes to a shareholder … or a security to a shareholder … or a security holder… solely holder… solely S/SS/S … in (a)… … in (a)… controlled controlled corporation corporation

Device restrictionDevice restriction

• transaction … not used principally as a transaction … not used principally as a devicedevice for the distribution of EP of the for the distribution of EP of the distributing distributing and/orand/or the the controlled controlled corporationscorporations– A device to bail out EP of any of the A device to bail out EP of any of the

corporations.corporations.

• Strong evidence: Strong evidence: Prearranged salesPrearranged sales of of property to third parties property to third parties afterafter the the reorganization to claim c/g treatment.reorganization to claim c/g treatment.

““Active Trade or Active Trade or Business” limitation: IRC Business” limitation: IRC 355(a)(1)(c ); IRC 355(b)355(a)(1)(c ); IRC 355(b)• distributing distributing and and controlled controlled

corporation(s) engaged in an corporation(s) engaged in an active active trade ortrade or businessbusiness – All corporations must be engaged in an ATOB, All corporations must be engaged in an ATOB,

or or

– S/S received are of corporation(s) engaged in S/S received are of corporation(s) engaged in an ATOB.an ATOB.

– Cannot spin-off liquid assets or passive assets.Cannot spin-off liquid assets or passive assets.

ATOB: “Active trade or ATOB: “Active trade or business”business”

• Who?Who?

• How long?How long?

• How acquired?How acquired?

Who must be engaged in Who must be engaged in ATOB?ATOB?

• A corporation must be engaged in A corporation must be engaged in ATOB or ATOB or

• its assets are its controlled its assets are its controlled corporation’s S/S and it is engaged corporation’s S/S and it is engaged in ATOB in ATOB

For how long?For how long?

• Must have been engaged in a ATOB Must have been engaged in a ATOB for the for the 5-year prior to 5-year prior to reorganizationreorganization..

How was ATOB acquired?How was ATOB acquired?

• 5 year “look back”: ATOB could not 5 year “look back”: ATOB could not have been acquired in a taxable have been acquired in a taxable transaction in prior 5 years.transaction in prior 5 years.

““Distribution” Distribution” requirementrequirement

• Distributing Distributing corporation corporation distributesdistributes – all all S/S held in S/S held in controlled controlled corporation, orcorporation, or

– at least controlat least control, if the retention of any , if the retention of any controlled controlled corporation stock by corporation stock by distributing distributing corporation was not part of corporation was not part of plan having as one of its principal plan having as one of its principal purposes to avoid FIT purposes to avoid FIT • 80% voting; 80% of each nonvoting class80% voting; 80% of each nonvoting class

The following shall not The following shall not prevent the prevent the nonrecognition of gain nonrecognition of gain (loss): IRC 355(a)(2)(loss): IRC 355(a)(2)• non pro rata distribution with respect non pro rata distribution with respect

to the shareholders of the to the shareholders of the distributingdistributing corporation corporation

• distributingdistributing corporation shareholders corporation shareholders surrender their stocksurrender their stock

• distribution is not in pursuance of a distribution is not in pursuance of a plan of reorganizationplan of reorganization

NoteNote

• Shareholders do not need to hold their Shareholders do not need to hold their stockstock

– but may be considered a “device” if there is but may be considered a “device” if there is a prior binding agreement to sella prior binding agreement to sell

• Distributing corporation (TOR) mat Distributing corporation (TOR) mat become TEE’s minority shareholder become TEE’s minority shareholder because it does not have to distribute because it does not have to distribute 100% of stock,only “control”. 100% of stock,only “control”.

Gain (loss) recognized: Gain (loss) recognized: IRC 355(a)(3)(A)IRC 355(a)(3)(A)

• Principal amount of securities Principal amount of securities received > principal amount of received > principal amount of securities surrendered securities surrendered

• Boot Boot

Gain (loss) recognized: Gain (loss) recognized: IRC 355(a)(3)(B)IRC 355(a)(3)(B)

• IRC 355(a)(1) requires that IRC 355(a)(1) requires that distributingdistributing corporation exchange its S/S for the corporation exchange its S/S for the S/S of its S/S of its controlled controlled corporation.corporation.

• However, However, stock acquired within 5 years stock acquired within 5 years priorprior in a taxable transaction shall be in a taxable transaction shall be considered as “other property”.considered as “other property”.

• Such stock is “Such stock is “bootboot””

Gain (loss) recognized: Gain (loss) recognized: IRC 355(a)(3)(D)IRC 355(a)(3)(D)

• nonqualified preferred stock nonqualified preferred stock received in exchange for received in exchange for – stockstock is notis not considered S/S considered S/S

– otherother nonqualified preferred stock nonqualified preferred stock is is considered S/Sconsidered S/S

Tax effectTax effect

• Transferor corporationTransferor corporation

• Transferor’s shareholdersTransferor’s shareholders

Consider IRC Consider IRC 351/301/302351/301/302: :

• Transferor corp (TOR) creates a Transferee corp Transferor corp (TOR) creates a Transferee corp (TEE). (TEE).

• No gain (loss) when No gain (loss) when TOR gets TEE stockTOR gets TEE stock. . – Except: assumption of liabilities by TEE > AB; boot Except: assumption of liabilities by TEE > AB; boot

property distributed property distributed

• But if TOR wants to transfer But if TOR wants to transfer TEE stock to TOR’s TEE stock to TOR’s shareholdersshareholders there is either a 301 or 302 there is either a 301 or 302 distribution.distribution.– TOR recognizes gain on appreciated propertyTOR recognizes gain on appreciated property

Transferor corporation: Transferor corporation: IRC 355/361IRC 355/361

• Consider IRC 361(c) if transaction Consider IRC 361(c) if transaction preceded by a type D drop downpreceded by a type D drop down

• If not preceded by Type D, then IRC If not preceded by Type D, then IRC 355(c)355(c)

IRC 361 IRC 361

• IRC 361: Prevents recognition if TOR IRC 361: Prevents recognition if TOR transfers TEE’s S/S to TOR’s shareholders.transfers TEE’s S/S to TOR’s shareholders.

– No gain recognition on distributions of No gain recognition on distributions of appreciated “qualified property” appreciated “qualified property”

• But like IRC 351, recognize But like IRC 351, recognize

– assumption of liabilities by TEE > AB [IRC assumption of liabilities by TEE > AB [IRC 357(c)(1)(B)]357(c)(1)(B)]

– boot property distributed boot property distributed

Transferor’s shareholdersTransferor’s shareholders

• No g/l if TEE stock is exchanged for TOR No g/l if TEE stock is exchanged for TOR stock.stock.

• No g/l if TEE securities is (swapped) No g/l if TEE securities is (swapped) exchanged for TOR securitiesexchanged for TOR securities

• Unless Unless – principal received > principal surrenderedprincipal received > principal surrendered

– devicedevice

– boot received (o/t S/S)boot received (o/t S/S)

Shareholders’ AB & HP: Shareholders’ AB & HP:

• No Boot: AB: IRC 358(b); (c)No Boot: AB: IRC 358(b); (c)– Aggregate AB on TOR’s S/S before the Aggregate AB on TOR’s S/S before the

distribution is allocated among the S/S distribution is allocated among the S/S after the distribution, on the basis of their after the distribution, on the basis of their FMV. FMV.

• HP: IRC 1223(1)HP: IRC 1223(1)– Includes the HP of the S/S of distributing Includes the HP of the S/S of distributing

corp held by shareholders corp held by shareholders

Boot: AB: Nonrecogniton Boot: AB: Nonrecogniton property: property:

• IRC 358(a)(1): c/o AB + gain IRC 358(a)(1): c/o AB + gain recognized - boot recognized - boot

• IRC 358(b)(2): Aggregate AB IRC 358(b)(2): Aggregate AB allocated among S/S in proportion allocated among S/S in proportion to FMVto FMV

BootBoot

• moneymoney

• cash equivalentcash equivalent

• tainted stock or securitiestainted stock or securities

• property other than “stock and property other than “stock and securities”securities”

Character of the boot Character of the boot recognizedrecognized

• Alleged spin off treated as a Alleged spin off treated as a dividend dividend

• C/G: OtherC/G: Other

• AB and HP: FMV; day of distributionAB and HP: FMV; day of distribution

Prevention of disguised Prevention of disguised sales of subsidiariessales of subsidiaries

• Purchaser of <80% of a parent may Purchaser of <80% of a parent may use IRC 355 to acquire a subsidiary use IRC 355 to acquire a subsidiary – without the parent having pay any without the parent having pay any

taxestaxes

– having the buyer use stepped-up FMV having the buyer use stepped-up FMV AB in sub’s c/s AB in sub’s c/s

How: Alleged split-off How: Alleged split-off

• Purchaser buys parent stock with Purchaser buys parent stock with same value to the desired same value to the desired subsidiarysubsidiary

• Purchaser agrees to exchanges his Purchaser agrees to exchanges his stock for stock of subsidiary.stock for stock of subsidiary.

Prevention: IRC 355(d): Prevention: IRC 355(d): Gain recognized by Gain recognized by distributing corporation if, distributing corporation if, • immediately after distribution, immediately after distribution,

• shareholder holds a => 50% interest in shareholder holds a => 50% interest in a distributed subsidiary a distributed subsidiary

• that is attributable to a stock that is attributable to a stock

• that was acquired by purchase within 5 that was acquired by purchase within 5 years prior ending on the date of years prior ending on the date of distribution.distribution.

Distributing corporation Distributing corporation recognizes gain recognizes gain

• disqualified distribution of stockdisqualified distribution of stock

Disqualified distribution of Disqualified distribution of stockstock

• Any IRC 355 distribution, if after Any IRC 355 distribution, if after distribution, any person holds distribution, any person holds “disqualified stock” in parent or “disqualified stock” in parent or subsidiary corporationssubsidiary corporations

• constituting a >=50% interest in constituting a >=50% interest in such corporationsuch corporation

““disqualified stock”disqualified stock”

• stock in distributing corporation or stock in distributing corporation or in controlled corporationin controlled corporation

• acquired by purchaseacquired by purchase

• during five year period ending on during five year period ending on date of distribution.date of distribution.

IRC 355 attribution rulesIRC 355 attribution rules

• 50% or greater ownership determined 50% or greater ownership determined using attribution from related parties.using attribution from related parties.– IRC 267(b): family; ind shareholder>50% = 1 IRC 267(b): family; ind shareholder>50% = 1

person person

– IRC 707(b)(1): partner and partnership where IRC 707(b)(1): partner and partnership where partner owns > 50% of partnership = 1 partner owns > 50% of partnership = 1 personperson

– IRC 318(a)(2) [AFE]: shareholder and IRC 318(a)(2) [AFE]: shareholder and corporation owned = > 10% of corporation.corporation owned = > 10% of corporation.

IRC 355(e): Additional IRC 355(e): Additional limitation limitation

• Restricts tax free spin-offs to new shareholdersRestricts tax free spin-offs to new shareholders

• Spin-offs distributions are NOT considered Spin-offs distributions are NOT considered “qualified property” under IRC 355(c)(2) or “qualified property” under IRC 355(c)(2) or 361(c)(2)361(c)(2)

• Acquisitions by purchase as well as other Acquisitions by purchase as well as other meansmeans

• Where 1 or more persons acquire 50% or more Where 1 or more persons acquire 50% or more interest in distributing corporationinterest in distributing corporation

Operation:Operation:

• Distributing corporation recognizes gain Distributing corporation recognizes gain if:if:

– controlled or distributiong corporation stock controlled or distributiong corporation stock is acquired, is acquired,

– pursuant to a plan or arrangement in pursuant to a plan or arrangement in existence on the distribution date.existence on the distribution date.

• Exception: > 50% shareholders of Exception: > 50% shareholders of historical shareholders retain ownershiphistorical shareholders retain ownership

Pursuant to a plan or Pursuant to a plan or arrangementarrangement

• Acquisitions within 4 year period Acquisitions within 4 year period beginning 2 years before beginning 2 years before distribution are presumed to have distribution are presumed to have occurred pursuant to such a plan or occurred pursuant to such a plan or arrangement. arrangement.