Sec. 355s Expansion Exception Extended

Two recent revenue rulings on the expansion exception to the Sec. 355 five-year active business requirement represent welcome taxpayer-friendly guidance in the tax-free spinoff arena, and can also be viewed as a precursor to a gentler approach in the context of other reorganizations (i.e., Sec. 368).

Overview

Sec. 355 allows shareholders to receive distributions of stock and securities in a controlled corporation tax free, if certain conditions are met. Under Sec. 355(b)(2), among other requirements, (1) each of the distributing and controlled corporations must be engaged, immediately after the distribution, in the active conduct of a trade or business, (2) each active trade or business must have been conducted throughout the five-year period ending on the date of the distribution and (3) neither trade or business was acquired in a taxable transaction within such five-year period.

The five-year requirement is relaxed if a business undergoes expansion or changes (i.e., adds or drops products, changes production capacity, etc.) in a way not equivalent to acquiring a new or different business. According to Regs. Sec. 1.355-3(b)(3)(ii), this determination hinges on whether the old and new lines of business can be deemed the same; if yes, there generally has been an expansion.

Recent Rulings

The two rulings involved spinoffs that otherwise would have failed the five-year active business requirement but for the expansion exception. Rev. Rul. 2003-18 involved the acquisition of a franchise to sell and service a new brand of automobile by an existing dealer; Rev. Rul. 2003-38 dealt with a retail shoe store business that created a Web business to sell shoes. In each case, the IRS ruled in the taxpayers favor; its approach looked to the following three factors:

1. Products;
2. Activities; and
3. Experience and know-how.

The products and activities were easily determined to be similar in the automobile dealer ruling. The dealers knowledge and experience developed in the sale of a particular automobile line could easily be transferred to sales of another brand. The Service reached the same conclusion for the retail shoe business, notwithstanding some distinctions in selling shoes on the Web as compared to operating a retail store. However, the IRS did concede significant reliance on existing experience and know-how and emphasized that the e-commerce business success will depend in large measure on the retail stores goodwill and name. Thus, the businesses in both situations were held to be similar, invoking the exception.

Conclusion

In Rev. Proc. 2003-48, the Service announced a plan to provide more published guidance under Sec. 355, while reducing the letter rulings it will issue. William Alexander, IRS Associate Chief Counsel, elaborated on the expansion doctrine for an active trade or business at a recent conference. The IRSs approach appears to be logical. A car dealer buying a truck dealership should constitute a new and substantial business, not qualifying as an expansion. The same should apply if a bricks-and-mortar business opens an Internet retail site to sell a totally different product.

The IRSs approach is certainly not narrow and will, under the right circumstances, permit corporations to transmute value and assets into a business, via the expansion doctrine, to be distributed tax free to shareholders under Sec. 355. The Services three factors provide a clear road map for structuring a transaction properly to meet Sec. 355s requirements.

Further, as observed by one commentator, it would be helpful if the rulings criteria were applied to other areas in which the same-line-of-business determination is crucial. For example, in Rev. Rul 87-76, the Service invalidated an otherwise good tax-free C reorganization, because the continuity-of-business requirement was not met. One business invested in municipal bonds, the other in taxable securities and stocks. Without much explanation, the Service simply held that the businesses were not similar; this result could differ under the Services current approach.

From Paul Dailey, CPA, New York, NY