Accurate Records Are Crucial With Planned IRS Rule on Spinoffs

Corporate taxpayers are facing substantial changes in tax reporting under proposed IRS regulations that would require them to share certain information on their annual tax return for five consecutive years after a tax-free spinoff under Section 355 of the federal tax code.

The goal of the additional reporting requirements is to provide more information so the IRS can better identify transactions that should not have tax-free status. Some taxpayers may not be aware how detailed these records need to be to withstand IRS scrutiny.

For one thing, the IRS will always consider whether the corporation’s employees—or in some cases, its officers, if the corporation has no employees—perform the activities required to meet the active trade or business requirement, a key requirement for spinoffs. A general description of the activities or a summary of the activities over a period will likely be insufficient to satisfy an IRS inquiry.

The ATB requirement means that the corporations must perform active and substantial management and operational functions for five consecutive years before the spinoff and immediately after the spinoff. These activities don’t include those performed by independent contractors.

The ATB requirement has always been a complex area that requires a facts-and-circumstances analysis. Because the IRS considers holding real estate for investment purposes a passive activity by default, the ATB requirement can be especially challenging for real estate businesses.

Although real estate investment trusts engage in spinoffs less frequently, REITs can still engage in spinoffs under two exceptions:

• It can distribute a controlled corporation in a tax-free spinoff if both the distributing and controlled entities are REITs immediately after the distribution.
• It can engage in a tax-free spinoff of its taxable REIT subsidiary provided the REIT owned the subsidiary for three years before the distribution.

REITs may satisfy the ATB requirement by showing direct involvement in the business activities by providing services such as furnishing heat and light, cleaning public entrances, exits, stairways, and lobbies, and collecting trash.

Real estate businesses also can obtain a private letter ruling to have some assurance that they satisfy the requirements (at least on the issues that are addressed by the letter ruling). However, not all taxpayers request such a ruling for various reasons, including the cost and time required to do so.

Section 355 is also an effective and acceptable tool for succession planning purposes for closely held family real estate corporations. These businesses may distribute stock to family shareholders tax-free provided they meet Section 355 requirements.

For example, the business purpose of the spinoff must be motivated by one or more non-tax corporate business purposes such as resolving business differences among shareholders or to increase financing opportunities. The distributing and controlled corporations must meet the ATB requirement.

However, the ATB requirement can be challenging for these closely held corporations because these family businesses may have a combination of active management and passive investment activities. If a real estate business doesn’t obtain a private letter ruling for transactions under Section 355, it’s especially important for the business to proactively set up a way to keep detailed contemporaneous records of how the business satisfies the ATB requirement.

To bolster their records, real estate businesses should identify the individuals—preferably employees and officers—who perform the specific management and operational activities and record the actual periods of time those individuals perform the activities to ensure the corporate records are detailed enough to withstand IRS examination of the ATB requirement.

In general, tax professionals should prepare their clients contemplating spinoffs for increased IRS scrutiny and encourage meticulous documentation to meet the enhanced reporting requirements for these transactions.

Tax advisers also may be interested in reviewing the proposed substantive 355 regulations that the IRS issued alongside the proposed reporting requirements to anticipate additional Section 355 requirements under increased IRS focus, such as documentation of the plan of reorganization including its business purpose.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law, Bloomberg Tax, and Bloomberg Government, or its owners.

Author Information

Jean R. Broderick is a retired tax attorney who spent more than 20 years in the corporate tax division of the IRS Office of Associate Chief Counsel.

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