Tax-Free Spin-Off Transaction Rules Open Treasury to Litigation

Tax-free spin-off transactions under Section 355 of the tax code historically have proven difficult for the IRS to regulate, as evidenced by often-shifting guidance and a cycle of proposed and reproposed regulations.

The Office of Management and Budget’s spring 2024 regulatory agenda, released earlier this month, includes four proposals for Treasury Department guidance in this area. But after the June US Supreme Court decision overturning Chevron deference to agencies where laws were ambiguous, more stringent or aggressive interpretations of statutory law by the IRS could increase that lack of clarity, rather than alleviate it, by making new Treasury regulations a target for litigation.

Broadly speaking, Chevron deference permitted Congress to delegate some if its rulemaking function to executive branch agencies without constant judicial challenges to the agencies’ interpretations of statutory law.

Tax laws frequently provide express authority to the Treasury and IRS to publish regulations implementing such legislation, lessening the need for these agencies to rely on Chevron deference. Without it, the Treasury and IRS will likely have less flexibility to address changing circumstances and developing transactional markets absent further grants of congressional authority.

Regulations published under Section 355 have had to constantly evolve to capture congressional intent to disallow applying Section 355 to transactions that are mere distributions of earnings and profits of a corporation to its shareholders.

As these regulations become more complex and based on more liberal interpretations of Section 355 language, they also become more vulnerable to judicial challenge in a post-Chevron deference world. Taxpayers engaged in high-stakes audits and litigation over Section 355 interpretations will have a strong incentive to attack the regulations as unconstitutional, if required, to win their case.

Reiterated Items

Two of the four items on the spring regulatory agenda appear to be reiterations. One relates to proposed regulations issued in May 2007 for the active trade or business requirement under Section 355(b). Another would clarify applying the device prohibition and the active business requirement of Section 355(a)(1)(B) and (C) that were issued in July 2016.

The 2007 proposed regulations generally were welcome guidance for taxpayers, as the rules that had been in place were considered outdated in light of current corporate structures and created unnecessary complexity in spinoff transactions.

The proposed regulations from 2016 included significant changes related to the device prohibition, a rule under Section 355(a)(1)(B) requiring that a transaction not be “used principally as a device” for distributing earnings and profits of a corporation (intending to distinguish between true nontaxable business separations from taxable dividend distributions).

The proposed rules would partially extend the scope of the device prohibition to cover a broader group of business assets. It would do so by focusing on nonbusiness assets rather than investment assets for device purposes, and by providing thresholds for determining whether ownership of nonbusiness assets or differences in nonbusiness asset percentages are evidence of device.

These changes could broaden the net of the device prohibition rules and limit scenarios that previously would have qualified under Section 355, such as spinoffs of assets with limited or de minimis active business activity.

Another item on the spring agenda is a regulatory proposal on the Section 355 requirements addressing other aspects of the active trade or business requirement and the device prohibition.

The final item is a regulatory proposal that would require taxpayers to file a new form if they’re involved in a transaction under Treas. Reg. Section 1.355-5. This requires a corporation and its shareholders to report certain information to the IRS if engaged in a spinoff subject to Section 355.

These proposals for spinoff transaction guidance come on the heels of Rev. Proc. 2024-24, which restricts certain requests a private letter ruling under Section 355 or Section 361—including restrictions related to debt-for-equity exchanges, delayed distributions, and retained controlled stock. The proposals also follow Notice 2024-38, which requests comments on a series of issues to develop potential guidance relating to Section 355 transactions.

The focus on Section 355 in the agenda and the notice and revenue procedure together might represent a new direction in the IRS’s perspective on previously settled spinoff matters. This could relate to issues such as the approach to managing liabilities of the distributing corporation during the spin-off process and post-spin modifications (including refinancing) of securities or debt.

The notice statesthat the issues listed describe the Treasury’s and IRS’s present “views and concerns” and any feedback “will be considered in developing future guidance.”

One concern that tax practitioners might have with the forthcoming guidance centers on their flexibility over how to structure complex transactions. Final regulations over certain fact-intensive applications of Section 355 rules could limit reasonable interpretations of these rules that were historically available if blessed by a tax opinion from counsel.

Outlook

The potential for post-Chevron lawsuits aside, the Treasury’s proposed guidance still represents an opportunity to add clarity to a murky area of the tax code, especially with respect to interactions with new sections, such as the corporation alternative minimum tax and stock buyback excise tax rules.

Each of these new systems reference or interact with Section 355 rules or transactions, but guidance under Section 355 addressing such interactions has yet to be published.

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

Author Information

Ryan Phelps is partner at Holland & Knight focusing on the federal income tax aspects of complex domestic and cross-border transactions.

Brandon Bloom is partner at Holland & Knight advising private equity funds and their portfolio companies, family offices and public companies.

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