The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 10, May 2002, Panel Publishers, New York, NY.


By Robert W. Wood, San Francisco

M&A Tax Report readers know our collective fascination with Section 355. Revered, exploited, criticized or neglected (and sometimes all of these things at once), Section 355 is still one of the few holes in the dyke of General Utilities repeal. For those of you who don't remember, the 1986 Tax Reform Act reshaped Subchapter C by doing away with the venerated General Utilities doctrine, thus making corporate dispositions considerably more expensive. Section 355 (even with its relatively recently imposed demon subpersonality of Section 355(e)), offers, quite simply, a chance to separate on a tax-free basis. The simplicity of Section 355 ends there. Much of the meat of Section 355 lore, and much of the necessary planning, involves either what happens before or after such a division. And that, of course, is the main topic addressed by Section 355(e).

To Rule or Not to Rule?

Section 355 has traditionally been one of the few areas where most advisors admonished that getting a ruling from the IRS was necessary. Our collective knee-jerk reaction was (and continues to be) that the stakes in a spinoff are high enough (obviously, depending on the numbers) and a couple of uncertainties significant enough that if (and usually we stressed the IF) the deal went bad, the corporate gain on the distribution and the corollary dividend treatment to shareholders would be disastrous. The relative ease or difficulty of obtaining a Section 355 ruling has waxed and waned over the years, but certain features of a ruling request (such as the fundamental prerequisite of showing a good business purpose) have sometimes been difficult to overcome.

Showing that a transaction was not a device could also be dicey (more about the "device" problem appears below). To be sure, a significant number of spinoffs (and even some large ones) have been done without the benefit of the IRS' advance blessing. Closing transactions based on opinions of counsel became popular, although many of those opinions (as legal opinions are often wont to be) had significant enough qualifiers that I question in many cases whether the company really got what it thought it was buying.

But however the transaction is closed, whether with a ruling or without, I believe many have assumed that Section 355 transactions were relatively unlikely to be attacked by the IRS. That makes the recent Tax Court case of South Tulsa Pathology Laboratory, Inc. v. Commissioner, 118 T.C. No. 5 (Jan. 28, 2002), especially important. The Tax Court there held that the spinoff of a corporation was a device to distribute earnings and profits, that the corporation lacked sufficient business purpose to overcome the device argument, and that section 311(b) required the corporation to recognize gain.

Trouble in Oklahoma

South Tulsa Pathology Laboratory Inc. (South Tulsa) was a C corporation owned by physicians which provided pathology-related medical services. Apart from rendering medical services, it also ran a clinical laboratory operation. South Tulsa received offers to purchase its clinical business but refused until 1993, when the shareholders decided to sell the clinical business, fearing they would be forced out by competition from national laboratories.

In 1993 South Tulsa was approached about purchasing the clinical business and decided to sell it to National Health Laboratories Inc. (NHL). The parties negotiated a sales price and structured the sale as a sale of stock of a yet-to-be-incorporated laboratory company that would be capitalized with the clinical business and spun off from South Tulsa. South Tulsa formed Clinpath Inc. on October 5, 1993, and purchased all of its common stock. On October 29, 1993, South Tulsa entered into a reorganization agreement with the shareholders and contributed the clinical assets for the stock and then distributed the stock to the shareholders. On October 30, 1993, the shareholders transferred the stock to NHL for $5,530,000. As a condition of the sale, each shareholder agreed not to compete with NHL in the clinical laboratory business within the 918 area code of Oklahoma for five years. NHL paid each physician $10,000 for the covenant not to compete.

The IRS audited and asserted that the spinoff was bad. In Tax Court, Judge Marvel concluded that the spinoff wasn't a D reorganization under section 368(a)(1)(D) because there was no qualified stock distribution under section 355. The court concluded that the spinoff and sale were prearranged, and that South Tulsa must recognize gain on the stock distribution. The court concluded that there was substantial evidence that the transaction was used principally as a device for the distribution of E&P of South Tulsa. The court pointed toward several factors that favored the finding that it was a device, such as the proportional distribution of the stock to the shareholders, the sale of the stock after the distribution, and the negotiated agreement before the distribution.

Judge Marvel rejected South Tulsa's reliance on Pope & Talbot Inc. v. Commissioner, 104 T.C. 574, (1995) affd. 162 F.3d 1236 (9th Cir. 1999), and noted that the issue was whether South Tulsa must recognize gain under section 311(b) and not the value under section 311(d). M&A Tax Report readers will surely remember Pope & Talbot. In the first iteration of the Pope & Talbot case, 104 T.C. 574 (1995), Pope & Talbot transferred partnership units, and the big question was valuation. The distribution was clearly taxable, with the common shareholders of Pope & Talbot receiving partnership interests in a partnership that held some of the assets that were previously held by Pope & Talbot.

The question was how much these partnership units were worth. The taxpayer argued the fair market value of the property should be determined by the value of the partnership units received by each shareholder. The IRS, on the other hand, argued that Section 311(d) required the fair market value of the property distributed to be determined as if the property had been sold in its entirety. The Tax Court concluded that the IRS was right.

The next iteration of Pope & Talbot was two years later, T.C. Memo 1997-116 (1997). This Pope & Talbot case considers primarily INDOPCO v. Commissioner, 503 U.S. 79 (1992). In addition to INDOPCO issues, reverting to the issue in the first case, the Tax Court calculated the fair market value of the distributed property by determining what a willing buyer would pay in a hypothetical sale of the property on the date of the distribution.

Pope & Talbot was not finished, though. On appeal in the Ninth Circuit, the taxpayer challenged the methodology by which the Tax Court valued the distributed properties, and challenged the value placed on those properties. See Pope & Talbot, Inc. v. Commissioner, 162 F.3d 1256 (9th Cir. 1999). The Ninth Circuit disagreed with all of the taxpayer's arguments, concluding that the property distributed by the corporation had to be valued as if the taxpayer had sold the property at the time of the distribution. For full discussion, see Wood, "Pope & Talbot's Last Gasp," Vol. 8, No. 1, The M&A Tax Report (August 1999), p. 1.

In any case, the court in South Tulsa rejected the valuation "expert" report as not credible. Noting that in an arm's-length sale between NHL and the shareholders, NHL paid $5,530,000 for the stock, the court said South Tulsa failed to reconcile the sale with the valuation. Thus, Judge Marvel held that the fair market value of the stock on the distribution date was $5,530,000 and that South Tulsa has gain.

No Ruling

How important was it that no ruling was obtained on this transaction? I suppose no one knows the answer to that question. Some believe that disclosing a Section 355 transaction on a return (where there has been no ruling and one by definition cannot attach the ruling to the return), will pique the IRS' interest. Here, whether that was the reason, or whether it was mere coincidence, the South Tulsa return did get examined.

When the IRS concluded that the distribution of stock to the South Tulsa shareholders failed the tests of Section 355, the asserted consequences were severe: the excess of the fair market value of the assets distributed over their tax basis was to be taxable income to South Tulsa. Plus, the fair market value of the spun off company (Clinpath) stock was a taxable dividend to the South Tulsa shareholders who received it. The corporate treatment to South Tulsa was before the Tax Court, and the Tax Court noted that there were four requirements that needed to be methodically reviewed in order to determine whether Section 355 had been satisfied:

The court also noted that the business purpose requirement had to be met, and even that there had to be continuity of proprietary interest after the distribution. (These nonstatutory requirements are contained in Reg. §1.355-2(b) and (c).)


Perhaps it is ironic that the test the Tax Court determined was flopped here was the second requirement: the transaction cannot be a device to distribute earnings and profits. I say that seems ironic, because that is the most amorphous test, and therefore the one that (in the absence of a ruling blessing the transaction) is always the hardest one to say convincingly has been avoided. Truth is, a majority of Section 355 transactions are accomplished — whatever terrific business purposes there may be — at least in part because of tax savings opportunities.

There is nothing wrong with that. But the "no device" prohibition is a little frightening. Admittedly, the "no device" moniker is modified by the word "principally," so that presumably one could have a transaction where at least part of your motivation (and part of your use of the stock distribution) is to distribute E&P. You simply can't use the distribution "principally" for that bad and nefarious aim.

Why did the IRS argue here that this was a device to distribute E&P? The IRS referred to both of the requirements added by the regulations. The IRS argued that the distribution was principally a device to distribute earnings and profits to the physician/shareholders, that it had no independent corporate business purpose, that it failed the continuity of interest test because the Clinpath stock was sold immediately under a prearranged plan. It looked pretty bad.

The device argument hinged on the two factors noted in the regulations for evoking evidence of a device to distribute earnings and profits to the shareholders. The first factor is that the distribution is pro rata. A dividend, of course, would be pro rata. Note that certainly does not mean that any pro rata spinoff is a device. That is obviously not true. Still, it has always been true that there is significantly less scrutiny on a non-pro rata spinoff.

The second factor is that the distributed stock was subsequently sold or exchanged. This is important. In this case, the Clinpath stock was immediately sold to NHL for cash, and this produced the same economic effect for the shareholders as if South Tulsa had sold the Clinpath assets for cash, and then just distributed the proceeds. Of course, it was especially nefarious here, said the Service, that the sale to NHL occurred under an agreement that was entered into before Clinpath was even created.

How convincing was it that South Tulsa argued that it was the buyer, NHL, that insisted on this deal structure? The judge in the Tax Court dismissed this. The Tax Court pointed out that NHL usually structured its acquisitions as asset purchases, thus undercutting the notion that NHL would have insisted on buying Clinpath stock. Moreover, the court simply divined that the spin followed by the immediate sale of the Clinpath stock (on the same day) was simply designed to eliminate the corporate level tax that would have been due had South Tulsa sold its clinical business to NHL directly or distributed the clinical business to its shareholders prior to their sale.

E&P Levels

How significant is the level of E&P? This is an interesting one. South Tulsa argued that however the transaction took shape, it could not be a device simply because South Tulsa's accumulated earnings and profits figure (then $226,347 as of July 1, 1993) was not significant enough to warrant the conclusion that the spinoff was a device. I actually kind of liked this argument. Menacingly, though, the Tax Court observed that the regulation provided no safe harbor for corporations with insignificant or minimal earnings and profits. At the same time, it seems to me that the "principally" modifier that is supposed to qualify the device prohibition ought to take into account implicitly the level of E&P. The court, though, didn't buy it.

More difficult still was the effect on E&P that the distribution of the stock had. The IRS argued that the distribution of the Clinpath stock itself would have generated an additional $5,424,985 of pretax earnings and profits as of October 30, 1993. This amount, according to the IRS and the court, could in no way be viewed as insignificant or minimal. Using the well-worn "bail out" metaphor, the IRS argued that the corporate profits the South Tulsa shareholders intended to bail out were the anticipated profits of the prearranged sale. It was not merely the E&P accumulated through operations — whether one views that $226,347 number as insignificant or not.

Did it matter that South Tulsa was a professional corporation that, as do most, paid out substantially all of its earnings in deductible compensation annually? South Tulsa argued that this method of distribution virtually assured that there would be little or no corporate income tax liability, irrespective of the ultimate outcome of the spinoff. The Tax Court characterized this argument as disingenuous.

Good Business Purpose?

As we noted in the advance ruling context, a business purpose is one of the lynchpins of Section 355. And, given the "device" discussion above, a really solid business purpose can counteract — or in the words of Judge Marvel in the South Tulsa case, can "trump" — a conclusion that the transaction was used principally as a device to distribute earnings and profits. The much paraphrased definition of a good business purpose is a real and substantial non-federal tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group. I find the business purpose discussion in this case quite interesting, particularly since it ties into issues that come up on ruling requests (even though the South Tulsa transaction was presumably a long way away from ruling discussion!).

One age-old question about business purpose is whether you want to advance more than one. Does listing more than one business purpose serve to water down your best business purpose, or does it help to have more than one. Are business purposes like partygoers, the more the merrier?

In Tax Court, South Tulsa argued there were three business purposes:

How did all of these business purpose assertions fare? The competitive problem (business purpose assertion 1) explained why South Tulsa might want to sell the clinical laboratory part of its business. The stock ownership problem (business purpose assertion 2) might explain why NHL could not purchase the South Tulsa stock, but it didn't explain why the Clinpath stock was not sold to NHL by South Tulsa (with no distribution of Clinpath stock). The covenant not to compete argument (the third asserted business purpose) was, according to Judge Marvel of the Tax Court, based on an overly narrow view of the Oklahoma law governing noncompete agreements.

In short, all of these asserted business purposes made some sense. The problem was that all of them suggested a separation of the professional corporation from the clinical laboratory services, but none of them suggested any reason why the distribution of the Clinpath stock needed to occur! That is the kind of issue that presumably would have come up in a heartbeat in a ruling request setting.

For example, if market conditions, investment bankers, insurance brokerage issues, risks and vicissitudes of several different lines of business, distribution schemes, competition issues with other companies — or whatever it may be — favor separating business B from the corporate umbrella of business A, you must query whether these business goals would be satisfied by having a common parent. Is a separate corporate shell sufficient? Sometimes it may be, and sometimes not. And it may be on this point that South Tulsa shareholders simply did not go far enough in thinking this through.

Their second asserted business purpose, that Oklahoma law prevented nonphysicians from owning stock in a professional corporation like South Tulsa, just doesn't go far enough. If the facts showed that the professional corporation owned purely by doctors and the clinical laboratory services business could not be run under the same corporate roof (or even under the same corporate parent) because to survive the laboratory business needed to admit shareholder/employees, perhaps this would have worked. The "key employee" purpose for a spinoff has been much touted over the years, and like many features of Section 355 lore, this business purpose has waxed and waned. Whatever would have happened with South Tulsa, though, probably nothing could have cured the bad sale immediately after the distribution.

Anyway, after reviewing all of the asserted corporate business purposes, the Tax Court concluded that there was substantial evidence of a device and that this evidence was not overcome by substantial evidence of nondevice (or by proof that there was a lack of current or accumulated earnings and profits).

How Much Is It Worth?

In what seems to have been a Hail Mary pass, South Tulsa argued that even if the distribution was taxable, the fair market value of the Clinpath stock was only $1,040,000, not the $5,530,000 asserted by the IRS. This number was important, since that was the number used for purposes of measuring gain on the stock distributed to the South Tulsa shareholders. Remember, in this case, we're talking about not the shareholders' gain, but rather the South Tulsa corporate level gain triggered by distributing appreciated property (here, the Clinpath stock).

To support the barely more than $1 million figure, South Tulsa called an expert witness to testify about the Clinpath stock merely being worth the value of the underlying clinical laboratory assets. This seemed like a nice try, but the Tax Court found it quite succinctly "simply not credible." In defense of the expert and the South Tulsa shareholders, this million dollar value was supported (at least arguably supported) by the notion that Clinpath was then a brand new corporation, and that the goodwill of the clinical laboratory business had been generated by the South Tulsa physician/shareholders, not by Clinpath itself.

The court, though, noted that there was a heck of a lot of goodwill missing somewhere if this argument worked. After all, the physician/shareholders had testified that the $10,000 each had received for their noncompete agreements had been reasonable. The Tax Court reasonably asked why these paltry $10,000 payments were made and were reasonable, if the vast goodwill of the clinical laboratory business really belonged to them? Presumably the physician/shareholders would have been way better off had they said that the $10,000 payments were really token, and that a good chunk of the value they received on the sale of Clinpath to NHL really was for noncompete payments.

Obviously, the noncompete payments to the physician/shareholders would be taxable as ordinary income, not as capital gain. But if this argument worked (and perhaps it might have), then at least they would be paying only one level of tax, albeit at ordinary rates. Presumably, the individual shareholders would have had to ratchet up their respective goodwill payments (the aggregate was roughly $4,500,000, represented by the difference between the IRS' asserted value of $5,530,000 and the South Tulsa argument that the Clinpath stock was only worth $1,040,000). Instead, the physician/shareholders said the $10,000 noncompete payments each of them received (reported as ordinary while the rest of it was reported as capital) was reasonable.

Whether a different handling of this valuation problem would have made a difference to the result in the case or not, it was hardly surprising, given the way this was presented, that the Tax Court dismissed the $1,040,000 value and easily found the best evidence of market value to be the actual sale which occurred immediately after the spin. Come on guys, that seemed like a no-brainer. Since the Clinpath stock was sold immediately after the spin for $5,530,000, and since NHL was an independent party that clearly negotiated at arms' length, that was the value. End of story.

Anti-Morris Trust Rule

Turning back to where we started, let's not forget about Section 355(e), added by the Taxpayer Relief Act of 1997. (Don't you love how arguably confiscatory provisions are added under the cloak of euphemistic bill names?) Section 355(e) brackets the asserted spinoff by looking two years before and two years after a distribution of the controlled corporation's stock. If there is an acquisition (whether taxable or tax-free) of a 50% or greater interest in either the distributing corporation or any controlled corporation during this four-year window, the otherwise good spinoff spoils like an overripe fruit in the sun.

As M&A Tax Report readers well know by now, Section 355(e) involves running the gauntlet of just what is a "plan," and that is supposed to involve an assessment of all the facts and circumstances. There are six regulatory safe harbors, and they are worth a read. See Temporary Regulations, T.D. 8960. Of course, it does not require any serious analysis to know that the South Tulsa situation would never have been even attempted after the 1997 enactment of Section 355(e).

For those who haven't looked at all of the safe harbors and the status of regulations under Section 355(e), they are certainly worth a read. For coverage, see Wood, "Morris Trust Regulations At Last," Vol. 8, No. 3, M&A Tax Report (October 1999), p. 7. See also Wood, "Morris Trust Regulations At Last, Part Two," Vol. 8, No. 4, The M&A Tax Report (November 1999), p. 7.

More Spin News

The spate of spinoffs seems not to be abating, and new phrases are even being coined. Referring to the current breakup trend, of which Tyco was merely one big example, one author recently called this Wall Street's "urge to purge." See Lim, "Wall Street's Urge to Purge," U.S. News and World Report, Feb. 25/March 4, 2002, p. 32. We've noted Tyco's plans before, see Wood, "Spins In the News Again," Vol. 10, No. 8, The M&A Tax Report (March 2002), p. 1. See also Hechinger and Johannes, "Tyco Pledges to Hasten Breakup Efforts," Wall Street Journal, Feb. 7, 2002, p. A3. TRW is also in the news for its anticipated split into three pieces following a hostile bid from Northrup Grumman. See Larsen, "TRW Plans Split After Rejecting $6bn Bid," Financial Times, March 14, 2002, p. 15.

Dow Corning has also announced plans to split its operations into two. See Firn, "Silicone Split for Dow Corning," Financial Times, March 6, 2002, p. 18. Circuit City has said it would spin off its profitable CarMax unit. See Spagat, "Circuit City Cuts Estimates, Citing Inventory Shortages," Wall Street Journal, Feb. 25, 2002, p. B13. General Electric Co. is considering splitting off its property and casualty insurance operations. See "GE May Shed Property-and-Casualty Unit," Wall Street Journal, March 15, 2002, p. A3. Georgia-Pacific Corp. said it plans to split into two companies to more effectively compete. See Terhune, "Georgia-Pacific to Split Into Two Firms to Boost Consumer-Products Business," Wall Street Journal, April 1, 2002, p. C6.

All this, it is hardly surprising, prompts many to note the new bifurcation trend. And it also affects equity markets. The IPO market had an awfully slow first quarter in 2002, but the highlights were certainly spinoffs. The largest offering was from Citigroup, which spun off its Travelers property casualty insurance unit, raising $3.9 billion in an IPO. See Postelnicu and Chung, "Spin-offs Hold Sway in IPOs," Financial Times, April 1, 2002, p. 17. The whole "we are creating shareholder value" mantra is sometimes questioned, and one recent article gave the unflattering comparison to spinoffs to create shareholder value as a "lottery." See Lucier and Bellaire, "Three Steps to a Successful Spin," Financial Times, Feb. 20, 2002, p. 11.

On the other side, there have been some repurchases of spun off companies, including Tyco's repurchase of some of Tycom, Sabre's repurchase of part of Travelocity, SBC Communications' repurchase of Prodigy, and so on. A good collection appears in Larsen, "Reeling In the High-Tech Spin-offs," Financial Times, April 4, 2002, p. 15.

Last Word

Given the enactment of Section 355(e), some may dismiss the South Tulsa case as of purely historical interest. On the other hand, many of us who have worried about the device test from time to time should find the case fascinating, even though it does read somewhat like a "how not to do it" manual. The result in South Tulsa is hardly surprising. Section 355(e) or not, the planning was hardly sophisticated.

Still, we should gather any crumbs of learning about the device test we can. There have been all too few times when the device test has really made a lot of sense. One case we commented about a few years ago was Pulliam v. Commissioner, T.C. Memo 1997-274 (1997). There, the Tax Court found that the business purpose supporting a spin (a "nondevice" factor) outweighed evidence of a device. The IRS issued a nonacquiescence. See AOD 1998-007 (Nov. 20, 1998), Tax Analysts Doc. No. 98-33972. See Wood, "Bad 'Device' Present in Cable & Wireless Deal," Vol. 8, No. 2, The M&A Tax Report (Sept. 1999), p. 7.

For discussion of the way in which device evidence of a and "nondevice" interrelate (a tortured use of English to be sure), see Wood, "Devices Under Section 355: Who, Me?" Vol. 8, No. 3, The M&A Tax Report (Oct. 1999), p. 6. All in all, the device test is likely to be with us as long as we continue to have Section 355.

Spinoffs: The Good, the Bad, and the Ugly, Vol. 10, No. 10, M&A Tax Report (May 2002), p. 1.