The following article is adapted and reprinted from the M&A Tax Report, Vol. 10, No. 12, July 2002, Panel Publishers, New York, NY.

ANOTHER SPOILED SPINOFF

By Robert W. Wood

It wasn't long ago, in the May 2002 issue of M&A Tax Report, that we reported on a spinoff that can only be described as ugly. See Wood, "Spinoffs: The Good, the Bad and the Ugly," Vol. 10, No. 10, The M&A Tax Report, May 2002, p. 1. Just about everything that could go wrong did go wrong in South Tulsa Pathology Laboratory, Inc. v. Commissioner, 118 T.C. No. 5 (Jan. 28, 2002). In that case, the Tax Court found that a spinoff was a device to distribute earnings and profits, that the company lacked sufficient business purpose to overcome the device point, and that the corporation therefore had to recognize gain. Just about everything the South Tulsa litigants argued against the Service's position failed, including what we characterized as a Hail Mary pass about valuation. Even that pass just didn't fly (sorry).

Now, as if ugly spinoffs weren't ugly enough, there is yet another tax case worth noting in what can only be described as an uncomfortable area for all of us. As much as we fixate on spinoffs, seeing spinoffs go awry hurts!

Spoiling For a Fight

In Douglas P. McLaulin, Jr., et al. v. Commissioner, No. 00-16685, Tax Analysts Doc. No. 2001-31676, 2001 TNT 249-4 (11th Cir., Dec. 21, 2001), the Eleventh Circuit, affirming the Tax Court, has held that a corporation's distribution of another company's stock less than five years after acquiring control of it resulted in gain to the corporation and taxable income to the shareholders. The Tax Court opinion appears at 115 T.C. No. 18 (Sept. 20, 2000).

Three individuals (A, B and C) were equal shareholders of Ridge Pallets Inc. Ridge Pallets become an S corporation in 1986. Ridge Pallets and two other individuals (D and E) incorporated Sunbelt in 1981 and were the equal shareholders until 1986, when Sunbelt redeemed D's shares. E was the president and the chairman of the board of directors of Sunbelt. Both corporations were profitable, but in 1989 Sunbelt entered the millwork business, and that division lost money.

In 1982 Sunbelt borrowed money from a bank through a series of notes with Ridge Pallets as guarantor. In 1990 Ridge Pallets authorized the withdrawal of the guaranty of the debt if the millwork division wasn't liquidated. After Ridge Pallets' withdrawal, the millwork division was liquidated and Ridge Pallets purchased Sunbelt's note from the bank. In 1992 Ridge Pallets and E agreed that Sunbelt would redeem E's shares. After the redemption on January 15, 1993, Ridge Pallets was the sole shareholder. After the redemption, Ridge Pallets distributed its Sunbelt shares to its shareholders.

The Tax Court held that the distribution of stock occurred within five years after Ridge Pallets acquired control of Sunbelt in a transaction in which gain or loss was recognized, thus resulting in gain to Ridge Pallets and taxable income to the shareholders. The court held that the Sunbelt stock distribution failed to qualify as a tax-free spinoff to shareholders under Section 355. The court agreed with the IRS that the distribution didn't qualify because the contemporaneous redemption and distribution didn't meet the active trade or business requirement of Section 355(b). After all, Ridge Pallets acquired control of Sunbelt during the five-year period in a transaction in which gain was recognized, and there was no corporate business purpose.

Following Rev. Rul. 57-144, 1957-1 C.B. 123, the court found that a parent corporation was deemed to acquire control of its subsidiary by the subsidiary's redemption of the stock of another shareholder whose interest in the subsidiary before the redemption exceeded 20 percent. The court found that any distinction between the transaction and a purchase of stock was illusory.

The Eleventh Circuit noted that the issue was whether Ridge Pallets met the remaining requirement of Section 355(a)(1)(C). (The IRS had conceded that the other spinoff requirements were met.) The appellate court agreed with the Tax Court that Rev. Rul. 57-144 was not distinguishable from this case. The court concluded that it did not need to distinguish between: (1) indirect control of Sunbelt by Ridge Pallets at 50 percent ownership; and (2) the direct control of Sunbelt by Ridge Pallets at 100 percent ownership. The court concluded that under the plain meaning of the statute, Ridge Pallets' acquisition of control the moment the taxable redemption of E's stock occurred reset the five-year clock and rendered Ridge Pallets' distribution of the Sunbelt stock taxable.

Five-year Pre-Distribution Requirement

Although it is related to the five-year active business test that is axiomatic to Section 355, the five-year pre-distribution requirement is actually independent. The corporation will be treated as engaged in the active conduct of a trade or business only if control of the corporation was not acquired by any distributee corporation within the five-year period. The control prohibited within this five-year period preceding the distribution may be acquired directly, or through one or more corporations. If control was obtained in a nontaxable transaction, however, the prohibition does not apply.

The rationale for this change (which occurred way back in 1987), was to require a five-year wait before the distribution of stock in a controlled subsidiary that is acquired in a taxable transaction. Before this statutory change in 1987, it was generally assumed that a two-year wait was sufficient. See Revenue Ruling 74-5, 1974-1 C.B. 82, obsoleted by Revenue Ruling 89-37, 1989-11 I.R.B. 4. Before the 1987 statutory change, a corporation could purchase stock in a taxable transaction, wait two years, and then spin off the subsidiary.

Watch Out

We've become so obsessed with talking about Section 355(e) and its two-year rule, that occasionally we may forget the importance of the more venerable five-year rule in question in Douglas P. McLaulin. Now that Section 355(e) seems to be getting a little easier (on this point, see Wood, "E is for Excellent: the New 355(e) Regulations," Vol. 10, No. 11, The M&A Tax Report, June 2002, p. 1), it looks as if a reminder about the importance of the five-year clock is in order. And, Douglas P. McLaulin stands for the proposition that the clock can be reset from time to time by an acquisition of control (even if it occurs by way of a redemption).

Another Spoiled Spinoff, Vol. 10, No. 12, The M&A Tax Report (July 2002), p. 1.