Expansion vs. Acquisition of an Active Trade or Business for Sec. 355 Purposes

When a business grows, it may treat acquisitions as either an expansion of the existing business or as the creation of a new one. The distinction has important tax consequences for both acquisitions and subsequent dispositions. In clarifying when a business acquisition is an expansion qualifying for gain nonrecognition on a subsequent Sec. 355 stock distribution, the Service recently issued Rev. Rul. 2003-18, continuing its trend of issuing more published guidance.

However, Rev. Rul. 2003-18 provides guidance on only one aspect of the Sec. 355 active trade or business requirement. Thus, for a corporation to spin off a controlled subsidiary so that the distributing corporation and its shareholders receive tax-free treatment, it must meet many other stringent requirements under the Code, regulations and judicial doctrines. Consequently, many taxpayers should obtain a letter ruling when contemplating a spin-off.

Background

To meet the requirements for a tax-free Sec. 355 division, a distributing corporation and a controlled corporation must have been actively conducting a trade or business (through the date of the transaction) throughout the five-year period before the transaction, and they must not have acquired the trade or business in a transaction in which they recognized gain or loss (in whole or part) within the previous five-year period. In determining whether they were conducting an active business throughout this period, it is irrelevant that the business added new products or changed its production capacity, provided that the change did not constitute the acquisition of a new or different business. A corporation actively engaged in one business that purchases, creates or otherwise acquires another business in the same line, is generally treated as having expanded the original business. The expanded business is then treated as having been actively conducted during the previous five-year period, unless the acquisition effected a significant change that constituted the acquisition of a new or different business. In the past, the IRSs determinations of a separate line of business have tended to be subjective; thus, the standard has remained difficult to interpret.

Facts

Rev. Rul. 2003-18 concluded that the IRS would treat an automobile dealers acquisition of a different or second brand of dealership, under certain circumstances, as an expansion of an existing business, rather than as an acquisition of a new or different one under Sec. 355. This ruling is important; it sets forth the IRSs rationale and criteria in applying Regs. Sec. 1.355-3(b)(3)(ii) to this type of acquisition.

In the ruling, a distributing corporation was engaged under a dealer franchise in the sale and service of a particular automobile brand for several years. For over five years, it had carried on these operations in two buildings in the same city. Several years later, the distributing corporation acquired a franchise for the sale and service of another automobile brand and purchased the inventories, equipment and leasehold of a dealer of that brand who operated in a building adjoining one of the distributing corporations two buildings. Shortly thereafter, it relocated the inventory of its first brand from one building to its other building, and used the first building for the new brand.

A few years later, the distributing corporation transferred all of the assets, as well as the building, and the liabilities of its first dealership to a new corporation in exchange for that corporations stock, and distributed the stock pro rata to its shareholders.

Discussion

The IRS found that the second automobile dealership did not constitute a new trade or business under Regs. Sec. 1.355-3(b)(3)(ii) and that the distributing corporation would have to treat the acquisition as an expansion of an existing business. In reaching its conclusion, the Service relied on certain factors: (1) the business of the first automobile dealership was similar to that of the second; (2) the business activities undertaken by the first dealership were the same as those of the second; and (3) the operation of the purchased automobile dealership relied on the same experience and know-how that the purchasing dealership developed in operating the first dealership.

Prior to Rev. Rul. 2003-18, the IRS issued Rev. Rul. 2002-49, another important ruling on the active trade or business requirement of a spin-off. The latter ruling demonstrated that in certain instances, a taxpayer can look through the underlying business of a limited liability company (LLC) and attribute the LLCs business activities to itself to satisfy the active trade or business requirement.

In this ruling, the Service concluded that the LLCs corporate members purchase of the noncorporate members LLC interest caused the LLC to be treated as a disregarded entity (rather than as a partnership) and did not result in the acquisition of a new or different business. It reached this decision because the corporate member conducted the same active and substantial management functions for the LLC both before and after the purchase. (For a discussion of Rev. Rul. 2002-49, see Schneider and Chui, Corporations & Shareholders: Significant Recent Developments, TTA, January 2003.)

Conclusion

Because the IRS has been providing additional guidance to taxpayers contemplating tax-free spin-offs (most recently in the area of the active trade or business standard), taxpayers can be more confident when spinning off expanded segments of businesses that they have purchased in the prior five years. Although the IRS has been issuing additional guidance via published rulings, taxpayers should still obtain a letter ruling before undertaking a spin-off.

From Christopher J. Galuppo, J.D., CPA, New York, NY