Rev. Rul. 57-464 and Rev. Rul. 57-492 have recently been suspended pending completion of a study by the Treasury Department and Internal Revenue Service concerning the five-year, active trade or business requirement that must be met for a business to qualify for a tax-free spin-off under Sec. 355. See Rev. Rul. 2019-09. According to the Internal Revenue Service's September 25, 2018 statement regarding the active trade or business requirement for section 355 distributions, the goal of the study is to determine "whether a business can qualify as an active trade or business if entrepreneurial activities, as opposed to investment or other non-business activities, take place with the purpose of earning income in the future, but no income has yet to be collected."
Section 355(a)(1) of the Internal Revenue Code provides that, if certain requirements are met, a corporation may distribute stock and securities of a controlled corporation to its shareholders and security holders without recognition of gain or loss or income to the recipient shareholders or security holders. One of the requirements is that both the distributing corporation and the controlled corporation be engaged in an active trade or business immediately after the distribution. Sections 355(a)(1)(C) and (b), and §1.355-3(a)(1)(i). Each trade or business must have been actively conducted throughout the five-year period ending on the date of the distributions. Section 355(b)(2)(B) and §1.355-3(b)(3). Although the regulations under section 355(b) provide that an active trade or business "ordinarily must include the collection of income and the payment of expenses," this interpretation may no longer be suitable.
Over the years, there has been an emergence of entrepreneurial ventures with activities focused on research and development with the purpose of earning income in the future. Entrepreneurial ventures traditionally collect little to no income and incur significant financial expenditures, while day-to-day operational and managerial functions that have historically evidenced an "active" business are performed. The Treasury Department and Internal Revenue Service are now considering guidance to address whether a business can qualify as an active trade or business when income is not immediately generated. The Internal Revenue Service has suspend Rev. Rul. 57-464 and Rev. Rul. 57-492 while this issue is examined, as each ruling could easily be interpreted as requiring income generation for a business to qualify as an active trade or business.
In Rev. Rul. 57-464, the Internal Revenue Service held that the separation of a corporation's manufacturing business from a group of real estate assets did not satisfy the active trade or business requirement. The use of an old factory building for storage "was not in itself the active operation of a business," the rental activities of the corporation "produced only nominal rental" and "negligible" net income, and the properties "were acquired either as an investment or as a convenience to employees of the manufacturing business." In Rev. Rul. 57-492, a corporation engaged in refining, transporting, and marketing petroleum products began a separate operation to explore for and produce oil. The operations incurred significant expenditures but likewise "did not include any income producing activity or any source of income" until less than five years preceding its separation from the primary, refining, transportation, and marketing operation. The Internal Revenue Service held that the exploration and production activities failed to qualify as an active trade or business because, "[before] oil was discovered in commercial quantities..., the venture...did not include any income producing activity or any source of income." Both rulings focus on the issue of income generation.
It is not yet known if the "collection of income" requirement will be modified, withdrawn or expanded or if an exception will be made for business with unique characteristics. As we wait for an answer, the Internal Revenue Service has said that it will entertain requests for private letter rulings regarding the active trade or business qualifications of corporations that have not collected income.
Originally published by Business law today
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