The following article is reprinted from The M&A Tax Report, Vol. 13, No. 5, December 2004, Panel Publishers, New York, NY.

SPINOFF REGULATIONS PROPOSED (PART I)

By Robert W. Wood

The IRS has released Proposed Regulations (REG-145535-02) under Section 355. The area addressed is whether a corporation is a predecessor or successor of either a distributing or controlled corporation under Section 355(e). That Code Section, of course, provides rules governing the recognition of gain on some distributions that occur in connection with acquisitions. Section 355(e) can cause an otherwise good Section 355 transaction to incur the wrath of the government if the distribution is part of a plan (or series of related transactions) in which one or more persons acquire stock representing a 50% or greater interest in the distributing corporation, any controlled corporation, or any successor or predecessor of the distributing corporation, or any controlled corporation.

Section 355(e) was a controversial provision when it was enacted in 1997, although the controversy seems to have died down in recent years. One of the primary objections practitioners have had is the murkiness of what constitutes a "plan." As a result, these proposed regulations attempt to draw bright lines for practitioners, who hopefully will now better be able to discern whether pre-distribution acquisitions will be considered part of a plan.

The key to the new proposed regulations is definitional. Rather than focusing on what constitutes a plan, this set of proposed regulations addresses what constitutes a predecessor corporation on the one hand or a successor corporation on the other. This issue has had some history. Temporary Regulations were published in 2002, providing guidance on whether a distribution and a post-distribution acquisition are part of a plan. See T.D. 8988, Tax Analysts Doc. No. 2002-9964, 2002 TNT 79-9.

Plus, Revenue Procedure 2003-48, 2003 29 IRB 86 (Tax Analysts Doc. No. 2003-15249, 2003 TNT 122-4), outlines rules under which parties seeking 355 rulings must submit representations on business purpose and device requirements, as well as whether there is a Section 355(e) plan. Now, we have proposed guidance on several key definitions.

What is a Predecessor?

The proposed regulations not only need to define what constitutes a predecessor of the distributing corporation, but also what constitutes a predecessor of the controlled corporation. The proposed regulations generally state that a predecessor of the distributing corporation includes a corporation that, before the distribution, transfers property to the distributing corporation in a Section 381 transaction, if the distributing entity transfers some (but not all) of the acquired property to the controlled corporation (or a predecessor of controlled), and if the basis of that property immediately after the transfer is determined by reference to the property's basis in the hands of the distributing corporation immediately before the transfer.

Example: Before the 355 distribution, Corporation X merges into the distributing entity in a statutory merger. The distributing corporation transfers some (but not all) of the acquired assets its gets in the merger to the controlled corporation in exchange for controlled corporation stock in a Section 368(a)(1)(D) transaction. Here, X is a predecessor of the distributing corporation.

Apart from this simple basis rule, a predecessor will also include a corporation that, before the distribution, transfers property to the distributing corporation in a Section 381 transaction if some (but not all) of the property transferred to the distributing corporation includes controlled corporation stock, and if after the combining transaction, the distributing corporation transfers less than all of the property acquired (other than the controlled corporation stock) to the controlled corporation.

Interestingly, the proposed regulations themselves recognize that the definition of a predecessor of a distributing corporation can actually result in a corporation being treated as a predecessor of the distributing corporation even if the distribution and the combination of the predecessor and the distributing entities are not part of a plan. Once the predecessor is identified, of course, one must then determine whether the distribution and any acquisitions (and this would include deemed acquisitions as well as actual ones) of the stock of the predecessor might be part of a plan.

Predecessors of Controlled

The definition of a predecessor of a controlled corporation is somewhat convoluted. Looking at the objectives of the definition might be helpful. The proposed regulations' definition of a predecessor of the controlled corporation is meant to insure that a corporation is treated as a predecessor of the distributing corporation in the following case, plus similar ones:

Example: Distributing acquires all of the assets of X (including all of the outstanding stock of a subsidiary of X, X1), in a transaction to which Section 381 applies. After the acquisition, Distributing causes X1 to merge into Controlled (a wholly-owned subsidiary of Distributing) in a reorganization under Section 368(a)(1)(B). Distributing then distributes the stock of Controlled to its shareholders, pro rata, in a Section 355 transaction. Here, there is a separation of the X assets in a distribution to which Section 355(a) applies. Accordingly, X1 will be treated as a predecessor of Controlled. Plus, because Distributing acquires (in a transaction to which Section 381 applies) stock of a predecessor of Controlled from X, X will be treated as a predecessor of Distributing.

Interestingly, the proposed regulations recognize that the considerations applying to the identification of predecessors of a controlled entity vs. the predecessors of a distributing one are different. Generally speaking, property transferred to a controlled corporation cannot be divided tax-free between Distributing and Controlled in the same way that property transferred to Distributing can be divided tax-free. Nonetheless, there are certain reasons why a definition of a predecessor of the controlled corporation is needed.

Solely for purposes of determining whether a corporation is a predecessor of the distributing corporation, calculating certain limitations on gain recognition, and applying an affiliated group rule, these proposed regulations define a predecessor of the controlled corporation as a corporation that (before the distribution) transfers property to the controlled corporation in a transaction to which Section 381 applies. For no other purpose can a corporation be a predecessor of Controlled.

Thus, acquisitions of stock that are part of a plan that includes a distribution and that in the aggregate represent a 50% or greater interest in a predecessor of Controlled will not cause Distributing to recognize gain. Interestingly, though, the preamble to the proposed regulations indicates that the IRS and Treasury are continuing to study whether there may be other situations in which a corporation should be treated as a predecessor of the controlled corporation.

Multiple Predecessors, Successors and Various Special Rules

Next month, we will include a second portion of this article covering the remaining aspects of the proposed regulations.

Spin-off Regulations Proposed (Part I), Vol. 13, No. 5, The M&A Tax Report (December 2004), p. 8.