- IRS withdrawal of Section 355 proposed rules: The IRS has partially withdrawn the 2016 proposed regulations on the device prohibition and active trade or business requirements for tax-free spin-offs.
- No relaxation of Section 355 standards: The IRS said the withdrawal does not affect existing authorities and that it will keep studying the issues.
- Impact on taxpayers: The withdrawal removes a decade-long source of uncertainty about the per se device rule. Taxpayers planning spin-offs
The IRS recently issued guidance to withdraw portions of long-pending proposed regulations (REG-134016) relating to the device prohibition and active trade or business requirements for tax-free spin-offs under Section 355. The withdrawal removes unpopular proposed rules that had complicated the analysis of some spin-off transactions, but the IRS made clear that it remains committed to challenging transactions inconsistent with the purpose of Section 355.
Background
Section 355 allows a corporation to distribute stock of a controlled corporation without recognizing gain or loss if statutory and regulatory requirements are satisfied. Among those requirements, a distribution cannot be used principally as a device for the distribution of earnings and profits, and both the distributing corporation and controlled corporation generally must satisfy the active trade or business requirement.
In 2016, the IRS proposed regulations that would have modified the rules on the device prohibition and active trade or business requirements. The proposals included a "per se" device rule under which some distributions involving significant levels of nonbusiness assets would automatically be treated as devices despite the existence of otherwise favorable facts, such as a valid corporate business purpose.
The proposed regulations also would have required the assets used in the five-year active trade or business calculation to represent at least 5% of each of the distributing corporation’s and controlled corporation's total assets. A related anti-abuse rule would have disregarded transactions undertaken with a principal purpose of affecting that percentage to avoid failing the proposed minimum. Separate anti-abuse rules similarly addressed transactions intended to manipulate nonbusiness asset percentages.
Withdrawal of Proposed Rules
The IRS noted that it received significant stakeholder feedback criticizing aspects of the 2016 proposed regulations. In response, it announced the partial withdrawal of those regulations; specifically, of the proposed per se device rule and the anti-abuse rules relating to nonbusiness asset percentages and the minimum active trade or business requirement.
In its October 21 announcement to withdraw those provisions, the IRS said it will continue to study the issues addressed by the proposed regulations.
Importantly, the IRS emphasized that the withdrawal does not affect the potential application of existing authorities, including other regulatory provisions and judicial doctrines such as the substance-over-form and step-transaction doctrines.
BDO Insights
- The withdrawal removes a major source of uncertainty that had lingered for more than a decade. In particular, taxpayers and practitioners had expressed concerns that the proposed per se device rule could have produced harsh results by treating some transactions as devices regardless of the presence of legitimate corporate business purposes and other favorable facts.
- Although the withdrawal eliminates parts of the proposed rules, it should not be interpreted as a relaxation of the Section 355 requirements. The IRS expressly reaffirmed the continued availability of existing statutory, regulatory, and judicial authorities to challenge transactions viewed as inconsistent with Section 355. Accordingly, taxpayers contemplating spin-offs and similar transactions should continue to evaluate device and active trade or business considerations under current law.
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