The following article is reprinted from The M&A Tax Report, Vol. 11, No. 12, July 2003, Panel Publishers, New York, NY.


By Robert W. Wood

Readers of The M&A Tax Report are well aware that Section 355 has been a bit of a passion (obsession maybe?) for this newsletter. Perhaps this is understandable, since Section 355 is an enormously important provision of the Code, made considerably more important since the 1986 Act's radical restructuring of Subchapter C. The Service has had its own peccadillos about Section 355, one of them, of course, being business purpose.

At the annual ABA Tax Section shindig in Washington in May, IRS Chief Counsel B. John Williams mentioned recent Section 355 guidance, calling for circumstances in which the business purpose requirement of Section 355 will be deemed satisfied. Chief Counsel Williams, long a vocal advocate of more guidance from the IRS (and we applaud that), indicated that the future of IRS guidance should be (and will be) addressing common questions that affect many taxpayers in a generic way, rather than providing guidance to individual taxpayers.

This general guidance simply uses IRS resources more effectively, and serves the public in a more egalitarian way. Of course, taxpayers should be pleased to be able to more effectively get to rely on such guidance (rather than individual private letter rulings that are prominently stamped "Don't Rely On This!"). Plus, Chief Counsel Williams gets out of the deal a reduced burden on Chief Counsel's lawyers (not to shabby of a deal for them either).

Revenue Ruling 2003-52, 2003-22 IRB 1, and Revenue Ruling 2003-55, 2003-22 IRB 1, both offer the kind of guidance that we think is good for both taxpayers and the government. Sounds rather Pollyannaish doesn't it? With good reason.

Family Harmony?

Revenue Ruling 2003-52 involves a dysfunctional family farming business owned 25% by a father, mother, son and daughter. Though the father and mother participate in some major management decisions, most of the management (and all of the operational activities) are performed by the son and daughter, as well as several farm hands. The farm operation consists of breeding and raising livestock and growing grain.

As often happens in family businesses, the son and daughter now disagree over the future direction of the farming business (gee, I've never seen this before!). The son wants to expand the business, and the daughter is vehemently opposed to expansion because it would require borrowing additional capital. In point of fact, the daughter suggests selling the livestock business and concentrating solely and exclusively on the grain business. But this is not a circumstance of overt hostility and invective. The siblings cooperate on the operation of the farm in its historical manner, and there is no disruption.

What about mom and dad? Where are they during all of these disagreements between their daughter and son? They are neutral with respect to the disagreement between the kids, though they would actually prefer to bequeath separate interests in the farm business to their children. For reasons unrelated to the farm business, the facts of the ruling reveal that the son and the daughter's husband dislike each other (one might only guess how this came to pass). The father and mother believe this situation could become a problem in running a single business under one roof (so to speak).

The father and mother wish to enable the son and daughter to devote their undivided attention to (and apply a consistent business strategy to) the farming business in which they individually are most interested. Of course, the father and mother also want to further their own estate planning goals (of being able to transfer separate interests to the two children). They want to promote family harmony, too, in a global way. So, they propose that the farm operation should transfer the livestock business to a newly-formed subsidiary, and then distribute 50% of the stock to the son in exchange for all of the son's stock in the original farm operation.

As part of the deal, the parent company will also distribute the remaining stock in the new livestock company equally to the father and mother in exchange for half of their stock in the parent. Thus, going forward, the daughter will manage and operate the farm company, and she will have no interest in the livestock company (we can only assume the daughter's husband, who does not get along with the son, is thrilled with this result). The son will manage and operate the livestock company, and will have no stock interest in the farming operation. Father and mother will also amend their wills to call for the son and daughter to inherit stock only in their respective operations.

Note that after the distribution, the father and mother will still own 25% of each of the respective companies. They will also continue to participate in at least some of the major management decisions related to the business of each company. Clearly, the distribution will be intended to address, at least in part, the personal estate planning goals of the father and mother. Equally clearly, the distribution is intended to promote family harmony. Notwithstanding the foregoing, the IRS in Revenue Ruling 2003-52 concludes that this transaction is motivated in substantial part by a real and substantial non-federal tax purpose that is germane to the business of the farming company.

This determination was recently (May 10) reiterated by Wayne Murray, Special Counsel to the IRS Associate Chief Counsel (Corporate), when while discussing Revenue Ruling 2003-52 he informed the ABA Section of Taxation's Corporate Tax Committee, "Even though there may be significant shareholder purposes, you can still have a good 'going your way' business purpose." Mr. Murray further informed his audience that in a situation such as this that the threshold for meeting the business purpose requirement is somewhat lower because there is a less risk of device in a split-off. Mr. Murray concluded his remarks by commenting that the application of this ruling to publicly-traded corporations would be the subject of several yet-to-be-released revenue rulings. Section 355 has therefore successfully run the business purpose gauntlet.

Dual Purposes

It has long been clear, of course, that there are often several purposes for a transaction (really, in most cases how can there not be?). Particularly with closely-held businesses (which still make up a huge part of Section 355 lore), these shareholder goals are indisputably important. Sometimes, it becomes difficult to separate shareholder goals from the goals of the company. Not only does Revenue Ruling 2003-52 recognize this relationship implicitly, but it explicitly says that despite the existence of rather clear shareholder goals, a good business purpose can still exist. Of course, business purpose is usually easier to satisfy in the case of a non-pro rata distribution, such as the family harmony ruling here discussed.

Change of Circumstances

Revenue Ruling 2003-55 deals with quite a different circumstance, involving a publicly-traded corporation that conducts certain businesses through its wholly-owned subsidiary. In this ruling, a business conducted by the subsidiary needs to raise substantial capital in the near future. The purpose of the capital is to invest in plant and equipment, and to make acquisitions. The parent company was advised to raise this capital by an initial public offering of stock in the subsidiary only after the subsidiary has been separated from the parent (sounds like the good old investment banker shuffle, doesn't it?).

The investment banker who advised the corporation believes that such an offering would be more efficient than a stock offering by the subsidiary or by the parent without first separating one from the other. Why? Because, says the investment banker, it would raise the needed capital with significantly less dilution of the existing shareholders' interests in the combined enterprises. The capital, after all, is needed in the subsidiary, not the parent. Why dilute the interest of the parent shareholders, when new money will go solely into the sub?

To accomplish this goal, the parent now plans to distribute the stock of the subsidiary to its shareholders. The subsidiary then will offer its stock to the public as soon as practicable, but with a target date approximately six months after the distribution of the subsidiary's stock. Following this stock distribution, though, and before the IPO can be undertaken, market conditions unexpectedly deteriorate. In fact, they plummet to such an extent that the company and its advisors determine in their best judgment that the IPO should be postponed (does this situation sound familiar?).

Unfortunately, conditions have not improved sufficient to permit this offering to go forward even one year after the stock distribution. The subsidiary needs to fund its capital needs, and eventually does so through a sale of debentures. The question in Revenue Ruling 2003-55 is simply whether the facts and circumstances have sufficiently changed after the distribution of stock, or not. Why is a change of this nature important to pinpoint?

This question goes back to our old friend, the business purpose doctrine. There was a good business purpose (says the IRS) at the time the original stock distribution of the subsidiary was undertaken. After all, the investment banker said that money should be raised this way, and that it would not dilute the parent's shareholders, etcetera. At the time of the distribution, that plan made sense. What is important here is that there is compliance with the business purpose requirement, since the distribution — at the time of the distribution — was motivated (in whole or in substantial part) by a corporate business purpose.

Times, They are a Changin'

But as the saying goes, everything changes. When the original business purpose cannot be achieved as the result of an unexpected change in circumstances following the distribution, the business purpose requirement is not retroactively jinxed. Instead, the original business purpose is still good.

Revenue Ruling 2003-55 is yet another chapter in the voluminous book of "unexpected event" rulings requested from the Service each year. The Service has made clear in Revenue Ruling 2003-55 that the business purpose requirement is satisfied when a distribution is prompted by a legitimate business purpose, notwithstanding the fact that as a result of the altered circumstances the business purpose can no longer be accomplished following the distribution. "If the distribution was truly motivated by the equity offering, the fact that [the] controlled corporation cannot follow through will not prevent the distribution from satisfying the business purpose requirement," said Special Counsel to the IRS Associate Chief Counsel Murray at the ABA Section of Taxation's Corporate Tax Committee meeting on May 10th.

Clearly this ruling is intended to exemplify an across-the-board point about changes in circumstances on the whole. Special Counsel to the IRS Associate Chief Counsel Murray proffered:

The broader point is that when you are dealing with a 'state of mind' issue, such as business purpose or device or 'plan' under Section 355(e), and the proper state of mind exists at the time of the distribution, then a change in the state of mind following the distribution will not cause the distribution retroactively to be disqualified under Section 355, provided that the change of mind was caused justifiably by an unexpected change in circumstances.

Now if the Service could just do something about the ailing economy which necessitated this ruling in the first place we would really have something.

Business Purpose Redux?, Vol. 11, No. 12, The M&A Tax Report (July 2003), p. 2.