How Will the Newly Proposed §355 Rules Work in Practice?

On January 16, 2025, the US Department of the Treasury and the Internal Revenue Service published new proposed regulations under §355 of the Internal Revenue Code of 1986, as amended from time to time (the “Proposed 355 Regulations”) (REG–112261–24, RIN 1545–BR32, 90 Fed. Reg. 5220 (Jan. 16, 2025)), aimed at refining and clarifying the rules governing corporate distributions and related transactions under §357, §361, and §368 (the “Proposed Regulations”) (introducing important clarifications and new provisions aimed at enhancing the clarity, consistency, and integrity of the rules governing corporate distributions and other related corporate transactions). The IRS has stated that, if enacted, these Proposed Regulations are expected to give taxpayers and practitioners greater confidence to engage in certain types of transactions, without first obtaining a private letter ruling.

The authors believe that the Proposed 355 Regulations do indeed promote certainty, but is such certainty won at the cost of transactional flexibility? In order to provide any benefit to taxpayers, the rules governing spin-offs and split-offs must not be so narrow so as to exclude too many potential transactions that are non-abusive and motivated by valid business reasons, must be drafted in a manner that accommodates practical considerations and real world scenarios, and must not impose excessive administrative requirements resulting in an undue burden to taxpayers pursuing such transactions. In order to confirm whether these rules are likely to achieve the taxpayer-friendly objectives outlined by Treasury and the IRS in the Proposed 355 Regulations, this article considers a sampling of safe harbors and administrative requirements that have a high likelihood of impacting taxpayers trying to rely on these rules: the safe harbor for retentions, the new rules for establishing a plan of distribution or reorganization, the direct issuance safe harbor, and the new filing requirements (including, e.g., Form 7216, Multi-Year Reporting Related to Section 355 Transactions).

Proposed Safe Harbor to Address §355(a)(1)(D)(ii) Risk

As previewed in Notice 2024-38, §2.02(2), the Proposed 355 Regulations add a presumption that a plan that includes a retention has tax avoidance “as one of its principal purposes.” However, noting the additional burden created by the new requirements in Rev. Proc. 2024-24 for requesting a private letter ruling on divisive reorganizations, as well as the lack of clear and authoritative guidance over the meaning of the “no tax avoidance purpose” requirement, the Proposed 355 Regulations magnanimously provides a safe harbor to rebut the new presumption of tax avoidance for retentions (See Prop. Treas. Reg. §1.355-10(c)(3)).

Obtaining the protection of this new safe harbor would require that a proposed divisive reorganization satisfy six conditions:

1. The distributing corporation must have a specific corporate business purpose for the retention during the entire holding period of such retention.
2. Stock of the controlled corporation must be widely held during the retention holding period.
3. Any overlap between the officers, directors, or key employees of the distributing corporation and the controlled corporation must be limited in specific ways, including a limitation to permit only essential personnel representing a minority of the board, and elimination of the overlap within two years of the first distribution date.
4. Any continuing arrangements between the distributing corporation and the controlled corporation during the period of retention must be negotiated on and reflect arm’s-length terms, or must be terminated or renegotiated to reflect arm’s-length terms within two years.
5. The plan of distribution must reflect a definite intent in the official records (e.g., the plan of distribution) of the distributing corporation to dispose of all retained controlled corporation stock within five years of the first distribution date.
6. Finally and perhaps most importantly, the disposition of retained controlled corporation stock must not result in a reduction of the distributing corporation’s federal tax liability compared to the hypothetical federal income tax liability the distributing corporation would have incurred had the retention been distributed in the first distribution.

(See Prop. Treas. Reg. §1.355-10(c)(3)(ii) through (vii)).

Safe harbors are generally considered helpful for promoting deal certainty facilitation by taxpayers and practitioners – that is, of course, if the requirements for qualifying for a safe harbor are realistic and practicable. Some factors of the retention safe harbor outlined should provide certainty for taxpayers and fit many fact patterns (e.g., the authors believe that presumptions 3, 4 and 5 generally fit this description). Presumptions 1 and 2 are a jump ball – they may or may not be problematic, depending on a taxpayer’s facts. However, presumption 6 could potentially create current and future concerns for the success of a corporate transaction governed by §355. The Proposed 355 Regulations take into consideration the fair market value (“FMV”) and adjusted basis of the retention as of the first distribution date to calculate whether a “reduction in tax liability” has occurred (See, e.g., Prop. Treas. Reg. §1.355-10(c)(3)(vii)).

The Proposed 355 Regulations provide an example that describes a transaction that includes the retention of stock with an adjusted basis higher than its FMV, and the subsequent sale of such stock (permitting the distributing corporation to recognize a loss) (See Prop. Treas. Reg. §1.355-10(d)(5), Ex. 5). While this example is not particularly instructive given the obvious tax-avoidance motive for the transactions contemplated therein, it highlights two issues:

First, there is no exception for immaterial or de-minimis reductions in the presumption, increasing the potential risk for taxpayers trying to rely on this safe harbor.
Second, there is no consideration made for amendments to a taxpayer’s plan of distribution.

The Proposed 355 Regulations specifically provide for amendments to a taxpayer’s plan of distribution if certain unavoidable events warrant such an amendment (See Prop. Treas. Reg. §1.355-4(e)). However, it appears that taking advantage of such rules could disqualify a taxpayer from the retention safe harbor years after the first distribution and due to facts beyond the taxpayer’s control if the amended transactions would have as a side effect any reduction in federal income tax liability. This represents an inflexibility that is not taxpayer favorable, despite the IRS’s intention to promote certainty by providing such a safe harbor in the first place.

Rules for a Plan of Distribution/Reorganization

In the Preamble to the Proposed 355 Regulations, Treasury and the IRS also identify the “plan of reorganization” requirement to divisive corporate reorganizations as creating significant confusion for taxpayers as a result of inadequate and incomplete guidance and a patchwork of applicable case law. Accordingly, the Proposed 355 Regulations propose a series of parallel provisions pursuant to which a taxpayer would establish its plan of distribution or plan of reorganization, as applicable, under §355 and §368 (See Prop. Treas. Reg. §1.355-4 and Prop. Treas. Reg. §1.368-4).

Helpfully though, the Preamble clarifies that a taxpayer’s failure to comply with these new rules for setting forth a plan of reorganization (or distribution) in a single, comprehensive document would neither be determinative as to the existence or scope of a plan of reorganization (or distribution) for a particular transaction nor would govern the application of any definitional or operative provision to that transaction. Treasury and the IRS believe this guidance should provide taxpayers and practitioners engaging in corporate transactions governed by §355 with greater clarity regarding compliance with and satisfaction of the requirements under such rules, and the authors agree given the significant amount of flexibility built into these rules.

Qualification for the Plan of Distribution/Reorganization
Under newly proposed rules for establishing a plan of distribution or reorganization, a taxpayer would prepare and file a document that satisfies the following requirements with the IRS. Specifically, the plan would:

1. be provided in a single, comprehensive document that lists all relevant parties, steps and facts involved in the plan, describes the intended federal income tax treatment of each transaction listed, and describes the corporate business purpose for each transaction;
2. be finalized and adopted by the distributing corporation, as established by the acts of the distributing corporation’s duly authorized officers and directors as well as the distributing corporation’s official records; and
3. be completed expeditiously as practicable.

(See Prop. Treas. Reg. §1.355-4(c)).

These proposed procedures enable taxpayers and practitioners to clearly identify the transactions intended to be taken together to constitute a corporate transaction governed by §355 in a plan of distribution or reorganization. With such a plan in place, distributions that happen to be carried out in close temporal proximity with the planned transactions would not be included in the plan of distribution and reorganization and, therefore, would not qualify for nonrecognition treatment under §355 (i.e., unless, as noted in the preamble, federal income tax principles like the step transaction doctrine would apply to determine that those distributions are in substance part of the plan).

One new accommodation provided in the Proposed 355 Regulations for establishing a plan of distribution or reorganization is the express blessing of §355 transactions that take more than 12 months to complete (See Prop. Treas. Reg. § 1.355-4(c)(3)(B)). Along with the requirement that a plan be completed as expeditiously as practicable, a distributing corporation may to distribute an amount of stock of the controlled corporation constituting control either (i) within a single taxable year, or (ii) over two taxable years, but only if all distributions up to and including the control distribution are effectuated pursuant to a binding commitment that is described in the plan of distribution or plan of reorganization (as applicable) (See Prop. Treas. Reg. §1.355-4(c)(3)(B)). A two-year limitation for distributing control provides taxpayers with greater transactional flexibility and should increase market confidence that §355 transactions can ultimately be successful (even if such flexibility comes with strings attached, as discussed infra—see the [New Form 7216 Filing Requirements]).

Qualifying Amended Plan of Reorganization
The Treasury Department and the IRS recognize that, in certain circumstances, taxpayers may need to amend their plans of reorganization, and provide rules permitting a taxpayer to amend a plan of reorganization after the first step of the original plan (an “Amended Plan of Reorganization”). Such amendment, if properly made, would generally not cause the taxpayer to fail to satisfy certain “plan of reorganization” requirements (as described in Prop. Treas. Reg. §1.368-4(d)), but only if the following requirements are satisfied:

1. the amendments to the plan must be in direct response to an identifiable, unexpected, and material change in market or business conditions that occurs after the date on which the original plan of reorganization is adopted by the party to the reorganization;
2. the amendments must be necessary to effectuate the reorganization; and
3. the Amended Plan of Reorganization must satisfy all requirements set forth supra to qualify as a plan of reorganization.

(See Prop. Treas. §1.368-4(f)(1)).

If the taxpayer satisfies these requirements, the Proposed 355 Regulations would confirm that the federal income tax consequences of all transactions properly included in the Amended Plan of Reorganization would be determined based on that plan of reorganization (and not on the original plan of reorganization). This flexibility permitting taxpayers to amend their plan of reorganization would provide significant utility to those seeking to ensure compliance with the requirements under the Proposed 355 Regulations, as it would address concerns stemming from unexpected and uncontrollable changes by allowing taxpayers to adapt accordingly.

Direct Issuance Safe Harbor

The IRS has been focused on direct issuance transactions for many years, and continues to focus on these transactions today (as is made clear in the Proposed 355 Regulations). According to the IRS, a “direct issuance” transaction is a transaction in which distributing corporation debt is issued to an intermediary entity and redeemed in close temporal proximity to the issuance (See Notice 2024-38, 1.02(5)). The IRS believes that such a transaction can be recast under general principles of federal income tax law such that the intermediary entity would not be treated as a creditor described in §361(b)(3) or (c)(3). The IRS has stopped accepting certain requests for private letter rulings related to §361, in part due to this type of §361 monetization transaction (See Rev. Proc. 2013-3, §5.01(10), 2013-1 I.R.B. 113).

Despite the IRS’s general skepticism about direct issuances, however, the Proposed 355 Regulations include a new safe harbor (the “Direct Issuance Safe Harbor”) that would permit (in part) a direct issuance transaction to qualify as a qualifying debt elimination transaction (essentially blessing the transaction as qualifying under §361). The Direct Issuance Safe Harbor applies to a direct issuance transaction if:

1. the distributing corporation does not have, at any time, legal or practical dominion or control over any proceeds of the refinanced historical debt;
2. the creditor holds the refinanced historical debt for a period of not less than 30 days;
3. each exchange of §361 consideration for refinanced historical debt is effectuated on arm’s-length terms and conditions;
4. no party to the transaction or a related party thereof participates in or limits any profit gained by the creditor upon the exchange of §361 consideration;
5. the creditor acts for its own account with regard to all components of the direct issuance transaction; and
6. the creditor bears the risk of loss with respect to the refinanced historical distributing corporation debt.

(See Prop. Treas. Reg. §1.361-5(e)(4)(iii)).

Once again, the IRS demonstrates an earnest intention to facilitate §355 transactions by providing a safe harbor for transactions that are becoming more and more prevalent in one form or another, but that historically was a cause of concern. The 30 day holding period requirement in particular represents a good compromise to arrive at a period that is commercially reasonable. It is the authors view that the Direct Issuance Safe Harbor would represent a net benefit for taxpayers considering a §355 transaction.

New Form 7216 Filing Requirements

Concurrently with the Proposed 355 Regulations, Treasury and the IRS published specific guidance related to the enhanced multi-year reporting requirements for corporate separations and related transactions (the “Proposed Reporting Regulations”) (REG–116085–23, RIN 1545–BR00, 90 Fed. Reg. 4,687 (Jan. 16, 2025)). The enhanced multi-year reporting introduced by the Proposed Reporting Regulations would improve the IRS’s ability to verify compliance with all legal requirements under §355 and identify high-risk transactions.

Under existing rules, a distributing corporation in a §355 transaction must report such transaction to the IRS by including a statement with its federal income tax return in the year the §355 transaction occurs. This statement contains general details, such as employer identification numbers, the date of the transaction, the FMVs and basis involved, and date and control number of any private letter rulings issued by the IRS in connection with the transaction.

The Proposed Reporting Regulations introduce more robust reporting requirements, including new Form 7216, Multi-year Reporting Related to Section 355 Transactions (currently in a draft version), which would mandate detailed reporting from certain direct and indirect parties to a corporate transaction governed by §355 (referred to as a “covered filer”). In general, the term “covered filer” includes distributing corporations, controlled corporations, significant distributees, and their successors (as each of these terms is defined under the Proposed Reporting Regulations) (See Prop. Treas. Reg. §1.355-5(b)(1)). Note, however, that the term “covered filer” would be defined to encompass solely taxpayers required to file certain specified federal income tax returns (i.e., Form 1040; Form 1040–NR, Form 1065, Form 1120, Form 1120–F, Form 1120–S, and any other form listed in instructions, guidance, or publications published in the Internal Revenue Bulletin (See Treas. Reg. §601.601(d)(2) and Treas. Reg. §601.602). Under the Proposed Reporting Regulations, a “significant distributee” includes, among others, a holder of stock of a distributing corporation that owns at least 5% (up from the 1% under current law) of the total outstanding stock immediately before the first distribution made pursuant to a plan of reorganization). (See Prop. Treas. Reg. §1.355-5(b)(3)).

Under the Proposed Reporting Regulations, covered filers would be required to file a Form 7216 (or a successor form) for five years starting from the year the initial distribution pursuant to a plan of reorganization is made and include certain data to the IRS regarding their multi-year corporation separation. Further, covered filers would also be required to retain their permanent books and records and make them available for inspection by the IRS. These record would need to contain all information necessary to document and substantiate satisfaction of the requirements under §355.

While the Proposed Reporting Regulations would enable the IRS to gather additional information from taxpayers engaged in corporate transactions governed by §355, they would also impose a significantly more extensive administrative burden on the taxpayer. Taxpayers would have an additional filing requirement with the IRS (given the Form 7216 is still in draft form, it is unclear whether delayed filing or failure to file such form would result in interest and penalties, or keep a tax period open beyond the original statute of limitations). Moreover, taxpayers would need to evaluate whether the books and records they maintain are sufficient for substantiation purposes (introducing new costs associated with maintenance and audit risk related to inadequate record keeping). Depending on how sophisticated a taxpayer is and whether they have the risk tolerance, this increased compliance burden and associate risk could pose challenges for some (but not all) corporate taxpayers and may lead some to explore alternative transaction structures to mitigate the administrative complexity introduced by the Proposed Reporting Regulations.

Conclusion

As stated in and demonstrated by the Proposed 355 Regulations, it is clear that the IRS has leveraged the expertise of their audit and examination personnel to develop proposed rules that, to the extent practicable, employ bright-line safe harbors, objectively verifiable conditions for qualification, and other similar architecture that can be readily reflected on Form 7216. The authors believe that these proposed rules may represent a path forward for taxpayers to utilize the spin-off and split-off rules under §355 more efficiently and more confidently (provided that any such transaction a taxpayer is not too far off the fairway).

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 a partner and Bryan Marcelino is a senior counsel at Holland & Knight focusing on the federal income tax aspects of complex domestic and cross-border transactions, including mergers, acquisitions and (of course) tax-free spinoffs.