The following article is adapted and reprinted from the M&A Tax Report, Vol. 11, No. 2, September 2002, Panel Publishers, New York, NY.


By Robert W. Wood

M&A Tax Report readers know that Section 355 contains a number of hurdles, all of which must be successfully navigated before that hallowed Code Section's tax-free treatment can apply. Some of the requirements are a lot easier to satisfy than others, and involve considerably more certainty. For example, the business purpose test is one that over the years has become clearer than it used to be. The IRS has even provided lists of appropriate business purposes, although clearly business purpose analysis still has significant elements of subjectivity. For recent discussion, see Wood, "Spinoff Business Purpose: Two is Better than One," Vol. 8, No. 6, The M&A Tax Report (January 2000), p. 7.

In contrast, the "not a device to distribute E&P" test is one that is always nettlesome. Regarding device, see Wood, "Spinoffs: The Good, the Bad and the Ugly," Vol. 10, No. 10, The M&A Tax Report (May 2002), p. 1. Since these two requirements often offset one other (evidence of a device can negate even a good business purpose), Section 355 analysis invariably requires a keen eye and a steady hand. Anyone who has to evaluate this stuff needs a kind of Clint Eastwood grit. (Who says tax lawyers aren't cool?)

Active Business

The requirement that one conduct an active trade or business for five years before the distribution seems pretty straightforward. How could there be disputes about this? True, there will always be issues about whether certain activities rise to the level of an "active" business. Real estate rental, for example, inherently runs the risk of being considered merely portfolio asset management. Still, the Service has had a come-to-Jesus reckoning on this issue, and is significantly more liberal on the topic than, say, 20 years ago.

However, what about operating a business — that is indisputably active — through a tiered structure? If two corporate joint venturers operate a business through a partnership or limited liability company, can either (or both) meet the active business requirement of Section 355? If they operate independently for several years, and then form the joint venture and continue operating, does the joint venture period count for purposes of Section 355's five-year rule?

In this current era of flow-through entities, the Service has provided important and helpful guidance about meeting the five-year active conduct of a trade or business requirement through limited liability companies. Revenue Ruling 2002-49, 2002-32 I.R.B. 1, considers a corporation that holds a membership interest in a member-managed LLC. The corporation purchases the remaining interests in the LLC, then contributes a portion of the business to a newly-formed controlled subsidiary, and then distributes the stock fo the controlled subsidiary to its shareholders. The question addressed in the ruling is whether that distribution qualifies under Section 355.

Since this ruling will be looked to by operators of various pass-through entities, the facts are important. This particular LLC, like most, is classified as a partnership for federal income tax purposes. That makes the guidance provided by the ruling equally applicable to partnerships. The LLC owned several office buildings leased to unrelated third parties. At the outset, Corporation D owns a 20% interest in the LLC, and that interest constitutes all of D's business assets. Another corporation, Corporation X, also owns a 20% interest in the LLC. The remaining 60% of the LLC is held by others. The LLC performs a variety of upkeep and maintenance services to manage the property.

However, both corporations (D and X) have equal control over the management of the LLC, and the officers of D and X perform active and substantial management functions with respect to the LLC's activities, including decision making regarding significant business decisions (significant renovations, purchase and sale of properties, significant financing and refinancing, etc.). The ruling sets out a fact pattern to suggest that both D and X are active with respect to the buildings. Interestingly, neither D nor X can make significant business decisions without the consent of the other.

The transaction goes like this: Corporation D purchases all of the remaining membership interests in the LLC from the other members of the LLC. As a result, D owns all of the LLC, making the LLC a disregarded entity. After the purchase, Corporation D's officers continue to conduct the activities of the LLC. Three years later (in year 6), Corporation D causes the LLC to distribute some of its rental properties (40% by value). Corporation D then drops those properties into a new wholly-owned subsidiary, and distributes the stock of that subsidiary pro rata in a transaction intended to qualify under Section 355.

Is It Active?

In this situation there is little question that both Corporations D and its subsidiary C are engaged in the active conduct of a trade or business. To qualify the distribution under Section 355, they both must be so engaged immediately after the distribution. The question is whether this trade or business has been actively conducted throughout the five-year period ending on the date of the distribution.

And that's not all. Even if the five-year active business test is met, a second question is whether it can be said that this business has not been acquired within that five-year period in a transaction in which gain or loss was recognized in whole or in part. Relying Revenue Ruling 92-17, 1992-1 C.B. 142, the IRS sensibly concludes that Corporation D is treated as engaged in the active conduct of the commercial office leasing business throughout this period. And, it is the same business actively conducted in the first several years through the LLC as in the later years directly. When, in year 3, Corporation D purchases the rest of the LLC membership interests, causing the LLC to become a disregarded entity, that does not spell the acquisition of a new or different business. See Reg. §1.355-3(b)(3)(ii).

One More Thing?

Revenue Ruling 2002-49 considers a second situation that is worth noting. The ruling assumes the same facts as in the primary discussion, but considers what would occur if Corporation D instead were to acquire the interest in the LLC by contributing appreciated securities to the LLC in a transaction described in Section 721. Here, the Service notes that prior to Corporation D's purchase of the remaining interests in the LLC, D owns its 20% interest and conducts active and substantial management functions with respect to the LLC.

Likewise, Corporation D regularly participates in the overall supervision, direction and control of the LLC employees. Corporation D is considered to be engaged in the active conduct of a commercial office leasing business. Just as in the other case, the purchase of the remaining LLC interests in year 3 is not treated as the acquisition of a new or different trade or business.

Strangely enough, however, here is where the ruling gets interesting. Unlike the first situation, the ruling suggests that Corporation D will be treated as having acquired this trade or business in a transaction in which gain or loss was recognized within the five years preceding the distribution. That violates Section 355(b)(2)(C). Corporation D's acquisition of the interest was a transaction in which no gain or loss was recognized under Section 721.

However, had D instead directly acquired the trade or business that the interest represents in exchange for the property that D contributed to the LLC, that exchange would have been a transaction in which gain or loss was recognized. If you're scratching your head here about where gain was recognized on a Section 721 transaction, focus on the words "would have been" here! The ruling concludes that D must therefore be treated as acquiring the trade or business attributable to the interest in a taxable transaction.

Both immediately before and immediately after the distribution, Corporations D and C are engaged in a trade or business that is treated as having been acquired in a transaction in which gain or loss was recognized within the prohibited five-year period. Again, that means the distribution violates the five-year prohibition. See I.R.C. §355(b)(2)(C).

Maybe I'm missing something here, but does this distinction make sense?

Do It Through A Conduit: Active Businesses Under Section 355, Vol. 11, No. 2, The M&A Tax Report (September 2002), p. 6.