Corporate Tax | Just Tax

Tax-Free Spin-Off Core Requirements (§§ 355(a), 355(b), 358(b); Reg. § 1.355-2(b))

This checklist guides the analysis of whether a corporate division qualifies for tax-free treatment under § 355. It covers the control, distribution, device, business purpose, active business, D reorganization, disqualified stock, basis allocation, and reporting requirements that govern spin-offs, split-offs, and split-ups. Use this checklist when advising on any divisive reorganization.

Step 1. The § 355(a) Nonrecognition Framework

"If a corporation (referred to in this section as the 'distributing corporation') -- (i) distributes to a shareholder, with respect to its stock, or (ii) distributes to a security holder, in exchange for its securities, solely stock or securities of a corporation (referred to in this section as 'controlled corporation') which it controls immediately before the distribution, no gain or loss shall be recognized to (and no amount shall be includible in the income of) such shareholder or security holder" (IRC § 355(a)(1)(A))

• Nonrecognition at the shareholder level. § 355(a)(1) provides that no gain or loss is recognized to a shareholder who receives stock or securities of a controlled corporation in a qualifying distribution. The shareholder takes a substituted basis in the controlled stock under § 358(a)(1), allocating basis between distributing and controlled stock based on relative fair market values pursuant to § 358(b)(2) and Treas. Reg. § 1.358-2(a)(2). The holding period of the controlled stock includes the holding period of the distributing stock under § 1223(1).
  • § 358(a)(1) requires the shareholder's basis in distributing stock to be allocated between the distributing stock retained and the controlled stock received, reducing the basis in the former and establishing the basis in the latter.
  • § 358(b)(2) provides that where a shareholder receives both stock and securities of controlled, basis is allocated first to the stock and then to the securities in proportion to their fair market values, but the basis in securities cannot exceed their fair market value.
• Three transaction types. § 355 applies to spin-offs (pro rata distributions where no stock is surrendered), split-offs (non-pro rata distributions where some shareholders exchange distributing stock for controlled stock), and split-ups (distributions of stock of two or more controlled corporations in complete liquidation of distributing). All three transaction types must satisfy the same statutory requirements in § 355(a)(1)(A) through (D).
  • In a spin-off, all shareholders receive controlled stock in proportion to their distributing ownership and retain their distributing stock, resulting in each shareholder owning both corporations. (Rev. Rul. 56-231, 1956-1 C.B. 157) (distributing must have control immediately before distribution)
  • In a split-off, some shareholders surrender distributing stock in exchange for controlled stock, functionally resembling a redemption. The exchanged distributing stock is treated as surrendered for purposes of § 355 qualification. (Rev. Rul. 73-44, 1973-1 C.B. 174) (addresses distribution of stock and securities in § 355 transactions)
• Corporate-level nonrecognition under § 355(c). § 355(c)(1) provides that no gain or loss is recognized to the distributing corporation on any distribution to which § 355 applies, unless the distribution is in pursuance of a plan of reorganization (in which case § 361(c)(2) applies instead). If distributing distributes property other than qualified property (stock or securities of controlled), gain is recognized as if such property were sold at fair market value under § 355(c)(2).
  • "Qualified property" means only stock or securities of the controlled corporation. § 355(c)(2)(B). Any cash, other property, or securities in excess of securities basis triggers gain recognition at the corporate level.
  • Where the distribution is part of a divisive D reorganization under § 368(a)(1)(D), § 361(c)(2) rather than § 355(c)(2) governs gain recognition on boot distributions. Under § 361(c)(2), gain is recognized on distributed property that is not "qualified property," which includes stock or obligations of controlled received as part of the D reorganization.
• Statutory prerequisites (§ 355(a)(1)(A) through (D)). For a distribution to qualify under § 355(a), all four of the following must be satisfied. Each requirement is an independent condition, and failure of any one is fatal to qualification.
  • § 355(a)(1)(A) requires distributing to control controlled immediately before the distribution (the control requirement). § 368(c) defines control as 80% of the total combined voting power and 80% of each class of nonvoting stock.
  • § 355(a)(1)(B) requires that the transaction not be used principally as a device for the distribution of the earnings and profits of distributing, controlled, or both (the device test).
  • § 355(a)(1)(C) requires satisfaction of the active business requirements of § 355(b), meaning both distributing and controlled must each be engaged immediately after the distribution in the active conduct of a trade or business.
  • § 355(a)(1)(D) requires that as part of the distribution, distributing distribute either all of the stock and securities of controlled held immediately before the distribution, or an amount of stock constituting control under § 368(c) plus a showing that retention was not for tax avoidance purposes.

Step 2. Control Immediately Before the Distribution

"Control" means "the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation" (IRC § 368(c))

• Dual 80% threshold. The distributing corporation must own stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote AND at least 80% of the total number of shares of each class of nonvoting stock immediately before the distribution. Both tests must be satisfied. The "all other classes" language requires 80% ownership of each class of nonvoting stock, not merely 80% in the aggregate. (Rev. Rul. 59-259, 1959-2 C.B. 87) (holding that control requires 80% of total combined voting power of all classes of voting stock and 80% of the total number of shares of each class of outstanding nonvoting stock)
  • CAUTION. A momentary lapse of control immediately before the distribution disqualifies the transaction. The control requirement must be satisfied at the instant the distribution occurs. Plan the transaction timeline carefully to avoid any gap.
  • For purposes of the § 368(c) voting power test, all classes of stock entitled to vote are aggregated. The test is satisfied if distributing holds shares that together possess at least 80% of the total combined voting power, even if no single class represents 80%.
• Timing requirement. Control must exist "immediately before the distribution." The Service has not applied the step-transaction doctrine solely because of post-distribution acquisitions or restructurings of controlled. (Rev. Rul. 98-27, 1998-1 C.B. 1159) (post-distribution acquisitions do not negate pre-distribution control). However, control must be maintained without interruption through the moment of distribution.
  • If a threshold D reorganization is involved, distributing or its shareholders must also control controlled "immediately after the transfer" under § 368(a)(1)(D). For this purpose, § 368(a)(2)(H) substitutes the § 304(c) standard (more than 50% of voting power and more than 50% of total value) in place of the § 368(c) 80% standard for nondivisive transactions.
  • (Rev. Rul. 2003-79, 2003-29 I.R.B. 80) (holding that steps (i) and (ii) together meet all requirements of § 368(a)(1)(D), step (ii) meets all requirements of § 355(a), and steps (iii) and (iv) together meet all requirements of § 368(a)(1)(C) in a spin-off followed by acquisition of controlled)
• Continuity of interest and control retention. The control requirement serves as a proxy for continuity of interest. Treas. Reg. § 1.355-2(c) provides that the shareholders of distributing must maintain a continuing proprietary interest in controlled after the distribution. If the distribution results in a disposition of control by the historic shareholders, § 355 does not apply.
  • In Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794 (4th Cir. 1966), aff'g 42 T.C. 779 (1964), the Fourth Circuit held that a spin-off followed by a merger of distributing could qualify under § 355 where there was a strong business purpose and continuity of interest was maintained through the shareholders' continuing indirect ownership.
  • § 355(e), enacted in 1997 as the "anti-Morris Trust" provision, now requires distributing to recognize gain on distributions that are part of a plan (or series of related transactions) pursuant to which one or more persons acquire stock representing a 50% or greater interest in distributing or controlled within the 4-year period beginning 2 years before the distribution. § 355(e)(2)(A)-(B).
• Multiple controlled corporations. Where distributing controls more than one corporation, the control requirement applies separately to each controlled corporation whose stock is distributed. If distributing distributes stock of multiple controlled corporations, each distribution must independently satisfy the control requirement.
  • In a split-up, distributing transfers its assets to two or more new controlled corporations and distributes all controlled stock to its shareholders in complete liquidation. Distributing ceases to exist, and its tax attributes disappear. Each controlled must satisfy the active business requirement independently.
  • TRAP. In a sequential spin-off, the Service will not apply the step-transaction doctrine to cause the first spin-off to fail the control test merely because a second spin-off is contemplated. (Rev. Rul. 62-138, 1962-2 C.B. 95) (second spin-off will not cause first spin-off to fail control test). But plan carefully, as the step-transaction doctrine can apply where the steps are prearranged parts of a single integrated plan.

Step 3. Distribution Requirements

"(D) as part of the distribution, the distributing corporation distributes -- (i) all of the stock and securities in the controlled corporation held by it immediately before the distribution, or (ii) an amount of stock in the controlled corporation constituting control within the meaning of section 368(c), and it is established to the satisfaction of the Secretary that the retention by the distributing corporation of stock (or stock and securities) in the controlled corporation was not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax" (IRC § 355(a)(1)(D))

• Default rule -- distribution of all stock and securities. The default position under § 355(a)(1)(D)(i) is that distributing must distribute all stock and securities of controlled held immediately before the distribution. This is the cleanest path to qualification because it requires no additional showing to the Service. Any retained stock or securities creates a rebuttable presumption of tax avoidance that the taxpayer must overcome.
  • Treas. Reg. § 1.355-2(e)(2) provides that "ordinarily the corporate business purpose or purposes for the distribution require that all of Controlled's stock and securities be distributed." Retention is the exception, not the norm.
  • CAUTION. Where distributing retains any controlled stock or securities, document the business reason for retention contemporaneously. The burden of proof is on the taxpayer to establish that retention was not pursuant to a tax avoidance plan. This is a facts-and-circumstances determination that the Service will scrutinize on examination.
• Retention under § 355(a)(1)(D)(ii) -- control-only distribution. Distributing may retain some controlled stock if it distributes an amount constituting control (80% under § 368(c)) and establishes to the Secretary's satisfaction that retention was not for tax avoidance purposes. The regulation requires that the taxpayer affirmatively prove a nontax business purpose for the retention.
  • (Rev. Rul. 75-321, 1975-2 C.B. 126) (holding that retention of 5% of controlled stock was permitted where the remaining stock was retained to serve as collateral for short-term financing necessary to distributing's remaining business enterprise).
  • The Service's ruling practice for retention cases, as reflected in Rev. Proc. 96-30 and successor guidance, typically requires (1) a separate business purpose for the retention, (2) no overlap between officers and directors of distributing and controlled, (3) disposition of retained stock within 5 years after the spin-off, and (4) voting of retained stock in proportion to votes by other shareholders.
• The "solely stock or securities" requirement. § 355(a)(1)(A) requires that the distribution consist "solely" of stock or securities of controlled. If distributing distributes any other property (boot) to shareholders, the shareholder recognizes gain under § 356(a)(1) to the extent of the lesser of boot received or realized gain, and the character is determined under § 356(a)(2) (ordinarily dividend treatment to the extent of corporate E&P under § 356(a)(2) unless the distribution has the effect of a § 302(a) redemption).
  • Where boot is distributed, the shareholder recognizes gain but not loss. The basis in the controlled stock is reduced by the fair market value of the boot received. § 358(a)(1)(A)(ii) and § 358(a)(2).
  • At the corporate level, distributing recognizes gain on boot distributions as if the boot were sold at fair market value. § 355(c)(2)(A). For divisive D reorganizations, § 361(c)(2) applies instead.
• D reorganization coupling. When § 355 is coupled with a divisive D reorganization under § 368(a)(1)(D), the distribution requirements become more complex. Distributing must first transfer assets to controlled (or a new corporation), receive controlled stock, and then distribute the controlled stock pursuant to § 354, 355, or 356.
  • (Rev. Rul. 2003-79, 2003-29 I.R.B. 80) (holding that in a divisive D reorganization followed by a C reorganization acquisition of controlled, the "substantially all" test for the C reorganization is applied to the acquired corporation (controlled), not the original distributing corporation, overcoming the "Elkhorn Coal" problem from Helvering v. Elkhorn Coal Co., 95 F.2d 732 (4th Cir. 1938) (holding that a transfer was not a tax-free reorganization where the creation of a new company was a mere shifting of charters without business purpose))
  • The D reorganization requires that immediately after the transfer, the transferor or one or more of its shareholders (or any combination thereof) is in control of the corporation to which the assets are transferred. § 368(a)(1)(D).

Step 4. The Device Test

"(B) the transaction was not used principally as a device for the distribution of the earnings and profits of the distributing corporation or the controlled corporation or both (but the mere fact that subsequent to the distribution stock or securities in one or more of such corporations are sold or exchanged by all or some of the distributees (other than pursuant to an arrangement negotiated or agreed upon prior to such distribution) shall not be construed to mean that the transaction was used principally as such a device)" (IRC § 355(a)(1)(B))

• Principal purpose standard. The transaction must not be used "principally" as a device for distributing earnings and profits. This means that distributing E&P need not be the sole purpose, but it cannot be the principal purpose. The statute creates a facts-and-circumstances test under Treas. Reg. § 1.355-2(d)(1). The focus is on whether shareholders can use the § 355 distribution to avoid dividend provisions through subsequent sale or exchange of one corporation's stock while retaining the other.
  • (Rafferty v. Commissioner, 452 F.2d 767 (1st Cir. 1971)) (articulating the "bail-out" concern that the device test prevents shareholders from using § 355 to "convert what would otherwise be dividends taxable as ordinary income into capital gain" by selling distributed stock or liquidating the corporation).
  • A device "can include a transaction that effects a recovery of basis" -- meaning even getting one's own investment back can be a device if it operates to bail out E&P. Treas. Reg. § 1.355-2(d)(1).
• Device factors -- evidence of device. Treas. Reg. § 1.355-2(d)(2) identifies specific device factors. The strength of the evidence depends on all facts and circumstances.
  • Pro rata distribution. Treas. Reg. § 1.355-2(d)(2)(ii). A pro rata or substantially pro rata distribution "presents the greatest potential for the avoidance of the dividend provisions of the Code" and is strong evidence of device. A non-pro rata distribution receives significantly less scrutiny.
  • Prearranged sale or exchange. Treas. Reg. § 1.355-2(d)(2)(iii). A subsequent sale or exchange pursuant to an arrangement negotiated or agreed upon before the distribution is "substantial evidence of device." A sale is prearranged if enforceable rights existed before the distribution or if the sale was discussed and reasonably anticipated by both parties. Post-distribution sales not negotiated before the distribution are not themselves evidence of device.
  • Nature and use of assets (stock comparison test). Treas. Reg. § 1.355-2(d)(2)(iv). Evidence of device exists if (1) assets not related to reasonable business needs are transferred to controlled, (2) controlled has a substantially greater ratio of nonbusiness assets to business assets than distributing had before the transfer (disproportionate transfer), or (3) the transfer leaves distributing with a disproportionate amount of nonbusiness assets. "Assets not related to the reasonable needs of the business" include assets held as investments and reserves for unlikely contingencies, but exclude reserves for working capital, replacement property, and reasonably anticipated market decline.
• Nondevice factors -- evidence of nondevice. Treas. Reg. § 1.355-2(d)(3) identifies factors that weigh against a device determination.
  • Corporate business purpose. Treas. Reg. § 1.355-2(d)(3)(ii). A strong corporate business purpose is evidence of nondevice, but "the stronger the evidence of device, the stronger the corporate business purpose must be to overcome the evidence of device." The assessment considers (A) the importance of the purpose to business success, (B) the extent to which the transaction is prompted by outside factors, and (C) the immediacy of the conditions prompting the transaction.
  • Publicly traded and widely held. Treas. Reg. § 1.355-2(d)(3)(iii). If distributing is publicly traded with no shareholder owning more than 5% of any class, this is evidence of nondevice because it is less likely the transaction is motivated by a shareholder's desire to bail out E&P.
  • Distribution to domestic corporate shareholders. Treas. Reg. § 1.355-2(d)(3)(iv). Distribution to domestic corporations entitled to an 80% or 100% dividends-received deduction is evidence of nondevice because there is less tax incentive to bail out E&P through a spin-off.
• Safe harbors -- transactions ordinarily not devices. Treas. Reg. § 1.355-2(d)(5) specifies three categories of transactions that are ordinarily considered not to have been used principally as a device, even if device factors are present.
  • Absence of earnings and profits. Treas. Reg. § 1.355-2(d)(5)(ii). If distributing and controlled have no accumulated E&P at the beginning of their taxable years, no current E&P as of the distribution date, and no pre-distribution property transfer would create current E&P, the transaction is ordinarily not a device. This is an all-or-nothing safe harbor -- even minimal E&P disqualifies it.
  • § 302(a) and 303(a) transactions. Treas. Reg. § 1.355-2(d)(5)(iii)-(iv). If in the absence of § 355 the distribution would be a redemption to which § 302(a) or § 303(a) applied, the transaction is ordinarily not a device. These safe harbors do not apply if multiple controlled corporations are distributed and the transaction facilitates avoidance of dividend provisions through sale of one and retention of another.
  • TRAP. The E&P safe harbor in (d)(5)(ii) requires absolutely zero E&P -- both accumulated and current. In South Tulsa Pathology Laboratory, Inc. v. Commissioner, 118 T.C. 84 (2002), the Tax Court held that even $226,347 of E&P was fatal to the safe harbor, noting that "the safe harbor in section 1.355-2(d)(5)(ii) requires NO earnings and profits, not merely insignificant earnings and profits." The court found a pro rata distribution combined with a prearranged sale of all distributed stock constituted a device, and the business purpose was insufficient to overcome the strong evidence of device.
• Interaction with business purpose. The device test and the business purpose requirement are independent but interrelated. Treas. Reg. § 1.355-2(b)(1) states that "this business purpose requirement is independent of the other requirements under section 355."
  • (Commissioner v. Wilson, 353 F.2d 184 (9th Cir. 1965), rev'g 42 T.C. 914 (1964)) (holding that a transaction can pass the device test (no evidence of E&P distribution) yet still fail because there is no business purpose, establishing the independence of the two requirements).
  • (Pulliam v. Commissioner, T.C. Memo. 1997-274, IRS nonacq. AOD 1998-007) (holding that a compelling corporate business purpose (preventing competition from and retaining a key employee) could overcome substantial evidence of device (prearranged sale of stock). The IRS nonacquiesced, indicating disagreement with this outcome, so taxpayers should not rely on it).
  • CAUTION. The Service no longer issues advance rulings on the device requirement. Rev. Proc. 2003-48, 2003-28 I.R.B. 86. The device determination will be made on examination, so practitioners must self-assess and document the analysis.

Step 5. The Business Purpose Requirement

"Section 355 applies to a transaction only if it is carried out for one or more corporate business purposes. A transaction is carried out for a corporate business purpose if it is motivated, in whole or substantial part, by one or more corporate business purposes." (Treas. Reg. § 1.355-2(b)(1))

• Independent requirement with affirmative burden. The business purpose requirement is an independent regulatory condition. The transaction must be motivated "in whole or substantial part" by one or more corporate business purposes. The principal reason for this requirement is to provide nonrecognition treatment only to distributions that are "incident to readjustments of corporate structures required by business exigencies." Treas. Reg. § 1.355-2(b)(1). This is an affirmative burden -- the taxpayer must prove a valid business purpose, not merely show absence of tax avoidance.
  • (Gregory v. Helvering, 293 U.S. 465 (1935)) (holding that a transaction that literally complied with the reorganization statute but had "no business or corporate purpose -- a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character" was not entitled to nonrecognition treatment, establishing the foundational business purpose doctrine).
  • (Commissioner v. Wilson, 353 F.2d 184 (9th Cir. 1965), rev'g 42 T.C. 914 (1964)) (holding that without a business purpose requirement, "a corporation could distribute investment assets to its shareholders who could hold such assets for retirement purposes without subjecting them to the risks of the business," and affirming that Congress was willing to concede tax advantages only when the distribution serves a business purpose).
• Definition of corporate business purpose. A corporate business purpose is a "real and substantial non Federal tax purpose germane to the business of the distributing corporation, the controlled corporation, or the affiliated group" to which distributing belongs. Treas. Reg. § 1.355-2(b)(2). Four key elements must be satisfied.
  • The purpose must be "real and substantial" -- not merely colorable. The importance of achieving the purpose to the success of the business, the extent to which the transaction is prompted by outside factors, and the immediacy of the conditions prompting the transaction all bear on this assessment. Treas. Reg. § 1.355-2(d)(3)(ii)(A)-(C).
  • The purpose must be a "non Federal tax purpose." Federal tax reduction alone cannot qualify. A purpose of reducing state or local taxes may qualify, but NOT if "the reduction of Federal taxes is greater than or substantially coextensive with the reduction of non Federal taxes." Treas. Reg. § 1.355-2(b)(2). An S corporation election is NOT a valid business purpose. Treas. Reg. § 1.355-2(b)(5), Examples 6-7.
  • The purpose must be "germane to the business" of distributing, controlled, or the affiliated group. Personal estate planning, family harmony, or shareholder convenience are not corporate business purposes unless they are "so nearly coextensive with a corporate business purpose as to preclude any distinction between them." Treas. Reg. § 1.355-2(b)(2).
• The shareholder purpose limitation and coextensive purpose doctrine. A shareholder purpose (for example, the personal planning purposes of a shareholder) is not a corporate business purpose. However, under the "coextensive purpose" doctrine, a shareholder purpose may be so nearly coextensive with a corporate business purpose that the distinction collapses.
  • (Rev. Rul. 75-337, 1975-2 C.B. 124) (holding that a distribution to facilitate estate planning was nevertheless carried out for a corporate business purpose because the purpose was to preserve distributing's ability to renew its automobile franchise upon the death or retirement of the majority shareholder -- the franchise would be lost without the restructuring, making the corporate purpose dominant).
  • (Rev. Rul. 2003-52, 2003-1 C.B. 960) (holding that a spin-off motivated in part by estate planning and family harmony, but also to eliminate disagreement between siblings and allow each to focus on a particular business, satisfied the business purpose requirement where the personal and corporate purposes were intertwined and a substantial real and substantial non-federal tax purpose germane to the business existed).
• The impractical or unduly expensive test. Under Treas. Reg. § 1.355-2(b)(3), if a corporate business purpose can be achieved through a nontaxable transaction that does not involve the distribution of stock of a controlled corporation and which is neither impractical nor unduly expensive, then the distribution is NOT carried out for that corporate business purpose. This is a demanding standard that eliminates business purposes that could have been achieved through simpler means.
  • Treas. Reg. § 1.355-2(b)(5), Example 3 illustrates this principle. Corporation X has toy and candy businesses. Shareholders want to protect the candy business from the risks of the toy business. Under applicable law, this purpose is achieved as soon as X transfers the toy business to Y (the new corporation). The distribution is NOT carried out for a corporate business purpose because the purpose can be achieved without distribution.
  • CAUTION. Document why any alternative nontaxable transaction would have been impractical or unduly expensive. The Service will look for the least restrictive alternative and may argue that a simple asset transfer or reorganization would have achieved the same result without a distribution of controlled stock.
• Recognized business purposes. Based on regulations, revenue rulings, and case law, the following categories of purposes have been recognized as valid corporate business purposes.
  • Regulatory and compliance purposes. Antitrust divestiture orders (Treas. Reg. § 1.355-2(b)(5), Ex. 1), state law requirements that regulated and unregulated businesses be separated (Treas. Reg. § 1.355-2(b)(5), Ex. 4), franchise requirements (Rev. Rul. 75-337), and removal from regulatory licensing processes (Rev. Rul. 88-33, 1988-1 C.B. 115).
  • Management and operational purposes. Corporate fit and focus (Rev. Proc. 96-30, § 2.05), key employee retention (Treas. Reg. § 1.355-2(b)(5), Ex. 5), resolution of shareholder disputes (Rev. Rul. 64-102, 1964-1 C.B. 136), and capital allocation problem resolution (Rev. Rul. 2003-75, 2003-29 I.R.B. 79).
  • Financial and capital-raising purposes. Facilitating stock or debt offerings (Rev. Proc. 96-30, §§ 2.02-2.03), reducing state and local taxes (Rev. Rul. 76-187, 1976-1 C.B. 97), and increasing stock value to enhance equity-based employee compensation (Rev. Rul. 2004-23, 2004-1 C.B. 585).
• No-ruling policy. The Service eliminated its advance ruling program for business purpose questions. Rev. Proc. 2003-48, 2003-28 I.R.B. 86. Taxpayers can no longer obtain advance rulings on whether a transaction satisfies the business purpose requirement. However, the principles from the former ruling program (as articulated in Rev. Proc. 96-30 and predecessor guidance) remain highly instructive for self-assessment.
  • The sufficiency of business purpose is determined at the time of distribution. Post-distribution events generally do not invalidate a business purpose that was genuine at the time of distribution. (Rev. Rul. 2003-55, 2003-29 I.R.B. 79) (business purpose satisfied even if the purpose cannot be achieved due to unexpected circumstances after the distribution).
  • TRAP. In Olson v. Commissioner, 48 T.C. 855 (1967), the Tax Court originally held that containing labor difficulties and preventing the spread of union activity to a subsidiary was a valid business purpose. However, the IRS later withdrew its acquiescence in AOD CC-2004-01 (Jan. 22, 2004), stating that "it was not clear that the distribution could have achieved the taxpayer's stated business objective or that that objective could not have been achieved through means other than a distribution." Taxpayers should not rely on Olson for labor-related business purposes.

Step 6. Active Conduct of a Trade or Business

"Section 355(a)(1)(C) applies only if -- (A) the distributing corporation and the controlled corporation are each engaged immediately after the distribution in the active conduct of a trade or business, and (B) the trade or business has been actively conducted throughout the 5-year period ending on the date of distribution" (IRC § 355(b)(1))

• Dual active business requirement. Both distributing and controlled must each be engaged immediately after the distribution in the active conduct of a trade or business. This is tested at the snapshot moment immediately after the distribution. (Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794 (4th Cir. 1966), aff'g 42 T.C. 779 (1964)) (holding that the active business requirement is tested at the moment immediately after distribution, and subsequent reorganizations do not retroactively invalidate § 355 treatment). The requirement applies to spin-offs, split-offs, and split-ups. For split-ups, distributing must hold only stock and securities of controlled corporations immediately before distribution, and each controlled must independently satisfy the active business requirement.
  • § 355(b)(2)(A) provides two ways a corporation can be treated as engaged in the active conduct of a trade or business. First, it is itself engaged in the active conduct. Second, "substantially all of its assets consist of stock, or stock and securities," of one or more controlled corporations each engaged in an active business. The second prong is the subsidiary look-through rule.
  • The § 355(b)(3) separate affiliated group (SAG) rules, added by TIPRA 2005 and effective May 17, 2006, treat all members of a corporation's SAG as one corporation for the active business test. A SAG is determined under § 1504(a) principles as if the corporation were the common parent and § 1504(b) did not apply.
• The "trade or business" component. A corporation is treated as engaged in a trade or business if "a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such group include every operation that forms a part of, or a step in, the process of earning income or profit." Treas. Reg. § 1.355-3(b)(2)(ii). Such activities "ordinarily must include the collection of income and the payment of expenses."
  • The "ordinarily" qualifier leaves room for pre-revenue businesses. The Service suspended Rev. Rul. 57-464 and Rev. Rul. 57-492 in Rev. Rul. 2019-9, 2019-14 I.R.B. (March 21, 2019), to study whether entrepreneurial activities without current income can qualify. Since 2019, the IRS has issued favorable private letter rulings for pre-revenue life sciences companies with substantial R&D activities (PLR 202246008 (2022), PLR 202150004 (2021), PLR 202009002 (2020)). However, no final guidance has been published, and this area remains uncertain.
  • Passive activities do NOT constitute an active trade or business. Treas. Reg. § 1.355-3(b)(2)(iv). The active conduct of a trade or business does not include (A) the holding for investment purposes of stock, securities, land, or other property, or (B) the ownership and operation (including leasing) of real or personal property used in a trade or business, unless the owner performs significant services with respect to the operation and management of the property.
• The "active conduct" component. The determination is made from all facts and circumstances. "Generally, the corporation is required itself to perform active and substantial management and operational functions. Generally, activities performed by the corporation itself do not include activities performed by persons outside the corporation, including independent contractors." Treas. Reg. § 1.355-3(b)(2)(iii).
  • Activities performed by the corporation's officers and employees count toward active conduct. Activities of shareholders of closely held corporations may count. Activities of employees of affiliates may count if the corporation's officers perform active and substantial management. (Rev. Rul. 79-394, 1979-2 C.B. 141, amplified by Rev. Rul. 80-181, 1980-2 C.B. 121) (holding that controlled with no paid employees could satisfy the active business test through employees of a sister corporation where controlled's officers performed substantial management functions).
  • CAUTION. Activities of independent contractors do NOT count toward the active conduct requirement. (Rev. Rul. 86-125, 1986-2 C.B. 57) (holding that rental of an office building managed by an unrelated management company as independent contractor did not satisfy the active business test). (Rev. Rul. 86-126, 1986-1 C.B. 59) (holding that a farm corporation using tenant farmers as independent contractors for all operational work did not satisfy the active business test, distinguishing Rev. Rul. 73-234 where the corporation had its own employees).
  • (Rev. Rul. 73-234, 1973-1 C.B. 180) (holding that one managerial employee and one operating employee are sufficient to satisfy the active conduct requirement, establishing a minimum personnel standard for the active business test).
• Five-year lookback requirement. The trade or business relied upon must have been "actively conducted throughout the five-year period ending on the date of the distribution." § 355(b)(2)(B). The fact that a trade or business underwent change during the five-year period (by addition of new or dropping of old products, changes in production capacity, and the like) is disregarded, provided the changes are not of such character as to constitute the acquisition of a new or different business. Treas. Reg. § 1.355-3(b)(3)(ii).
  • The "same line of business" expansion doctrine. "If a corporation engaged in the active conduct of one trade or business during that five-year period purchased, created, or otherwise acquired another trade or business in the same line of business, then the acquisition of that other business is ordinarily treated as an expansion of the original business, all of which is treated as having been actively conducted during that five-year period." Treas. Reg. § 1.355-3(b)(3)(ii). (Rev. Rul. 2003-38, 2003-1 C.B. 811) (holding that a shoe store's creation of an Internet website selling the same shoes was an expansion, not a new business). (Rev. Rul. 2003-18, 2003-7 I.R.B. 467) (holding that an auto dealer acquiring a franchise for a different brand was an expansion because the products were similar, business activities were the same, and the new operation used existing know-how).
  • (Estate of Lockwood v. Commissioner, 350 F.2d 712 (8th Cir. 1965)) (holding that a division or branch operation within the distributing corporation can satisfy the 5-year requirement. The controlled corporation need not have existed as a separate entity for the full five-year period, because the 5-year test looks to continuity of the underlying business activity, not the corporate shell).
• Taxable acquisition prohibition. § 355(b)(2)(C) provides that the trade or business must not have been acquired by the corporation during the 5-year period "in a transaction in which gain or loss was recognized in whole or in part." § 355(b)(2)(D) similarly prohibits acquisition of control of a corporation conducting the trade or business in a taxable transaction during the 5-year period.
  • Tax-free acquisitions are permitted. If the acquisition was tax-free (for example, a § 351 transfer, § 332 liquidation, or reorganization), the business history tacks onto the acquiring corporation. (Rev. Rul. 74-79, 1974-1 C.B. 81) (holding that an active trade or business transferred to a distributing corporation in a § 332 liquidation satisfies § 355(b) because the business history tacks through the tax-free acquisition).
  • (Rev. Rul. 2002-49, 2002-2 C.B. 288) (holding that a corporation's acquisition of all remaining partnership interests, converting the LLC to a disregarded entity, constituted an expansion of the corporation's existing business, not a taxable acquisition of a new business).
  • TRAP. The prohibition applies to the trade or business itself, not just the corporate entity. If distributing acquired the assets of a business in a taxable purchase and then contributed those assets to a new subsidiary for distribution, neither distributing nor the new subsidiary can rely on the pre-acquisition history of that business for the 5-year requirement.
• Partnership and LLC interests. A corporation may be treated as engaged in the active conduct of a trade or business through its ownership of a partnership or LLC interest, but the standards vary based on ownership level and management involvement.
  • (Rev. Rul. 2007-42, 2007-2 C.B. 44) (establishing that a 33 1/3% interest in an LLC constitutes a "significant interest" sufficient to satisfy the active business test without the corporation performing management functions, but a 20% interest without management participation is not sufficient. A 20% interest coupled with active and substantial management functions -- a "meaningful interest" -- can also satisfy the test).
  • (Rev. Rul. 92-17, 1992-1 C.B. 142) (holding that a corporate general partner holding a 20% interest in a limited partnership was engaged in an active trade or business where its officers performed active and substantial management functions for the partnership, including significant business decision-making and supervision of partnership employees).
• Real property separations and careful scrutiny. Separations of real property all or substantially all of which is occupied prior to the distribution by distributing or controlled (or by any corporation controlled directly or indirectly by either) "will be carefully scrutinized with respect to the requirements of section 355(b)." Treas. Reg. § 1.355-3(b)(2)(iii). This applies to sale-leaseback and owner-occupied property transactions.
  • Treas. Reg. § 1.355-3(c), Example 13 illustrates a failing case. A bank owns a 2-story building, occupies 1.5 floors, and rents the remaining half-floor as storage with the tenant maintaining the building. The spun-off subsidiary fails the active business test because the landlord performs only minimal functions under a long-term net lease.
  • Treas. Reg. § 1.355-3(c), Example 12 provides a contrasting success. A bank that owns an office building and actively manages it (hiring maintenance, negotiating leases, collecting rents, paying expenses) satisfies the active conduct requirement.
• The 5% minimum active business assets threshold (proposed). The 2016 proposed regulations (Prop. Reg. § 1.355-9) would impose a 5% minimum of active business assets as a per se rule. As of 2025, these regulations have not been finalized. Historically, the Service applied a 5% minimum through its ruling practice (Rev. Proc. 96-30) but removed it in 2003 (Rev. Proc. 2003-48). The G.C.M. 34,238 (Dec. 15, 1969) concluded that a corporation having assets attributable to its active business equal to only 5% of net book value could still be engaged in the active conduct of a trade or business.
  • CAUTION. Even if the 5% threshold is satisfied, significant nonbusiness assets can still be evidence of a device under § 355(a)(1)(B). The proposed regulations would also create a safe harbor of no device if both distributing and controlled have 20% or less nonbusiness assets, or the difference is less than 10 percentage points. Conversely, evidence of device would exist if 2/3 of assets are nonbusiness or if disparity exceeds certain thresholds.
  • TRAP. § 355(g) provides a hard stop. If either distributing or controlled is a "disqualified investment corporation" -- meaning 2/3 or more of the fair market value of its assets (excluding stock of members of its separate affiliated group) consists of nonbusiness assets -- the distribution does not qualify under § 355. This operates independently of the device test and the active business requirement.

Step 7. The Five-Year Active Business Lookback

"The trade or business must have been actively conducted throughout the 5-year period ending on the date of the distribution." (IRC § 355(b)(2)(B))

• The five-year continuity test. § 355(b)(2)(B) requires that any trade or business relied upon to satisfy § 355(b) must have been actively conducted throughout the five-year period ending on the date of distribution. Treas. Reg. § 1.355-3(b)(3) restates this requirement and adds critical guidance on what changes during that period are permissible.
  • The test looks to the continuity of the underlying business activity, not the corporate form. In Estate of Lockwood v. Commissioner, 350 F.2d 712 (8th Cir. 1965), the Eighth Circuit reversed the Tax Court and held that a division or branch operation within the distributing corporation can satisfy the five-year requirement even though the controlled corporation did not exist as a separate entity for the full period. The Maine sales and service operations of a potato equipment manufacturer had been conducted continuously since 1949, and that business history tacked to the newly formed subsidiary.
  • In Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794 (4th Cir. 1966), the Fourth Circuit held that the active business requirement is tested at the snapshot moment "immediately after the distribution." Congress deliberately limited the post-distribution requirement to that specific instant, so subsequent reorganizations do not retroactively invalidate § 355 treatment.
  • TRAP. The five-year period is measured backward from the distribution date. A business begun four years and eleven months before the spin-off does not satisfy the requirement. Calendar the acquisition or commencement date precisely.
• Changes and expansions during the five-year period. Treas. Reg. § 1.355-3(b)(3)(ii) provides that changes in products, production capacity, or business methods during the five-year period are disregarded if they do not constitute the acquisition of a "new or different business." An acquisition in the same line of business is ordinarily treated as an expansion of the original business, which shares the original five-year history.
  • Rev. Rul. 2003-18, 2003-7 I.R.B. 467 (obsoleting Rev. Rul. 57-190) held that an automobile dealer acquiring a franchise for a different brand of automobiles engaged in an expansion of its existing business, not a new business, because the products were similar, the business activities were the same, and the new operation used existing experience and know-how.
  • Rev. Rul. 2003-38, 2003-1 C.B. 811 held that a shoe store's creation of an Internet website selling the same shoes was an expansion of the retail business, not a new business, because the product and principal business activities were the same and the website drew on existing experience, know-how, and goodwill.
  • The "same line of business" standard derives from Estate of Lockwood, where the Eighth Circuit asked whether the two post-distribution corporations were "doing the same type of work and using the same type of assets previously done and used." This remains the operative formulation.
• The taxable acquisition prohibition. § 355(b)(2)(C) bars relying on any trade or business acquired by the corporation during the five-year period "in a transaction in which gain or loss was recognized in whole or in part." § 355(b)(2)(D) similarly bars reliance where control of a corporation conducting the trade or business was acquired in a taxable transaction during that period.
  • Tax-free acquisitions tack the transferor's business history. Rev. Rul. 74-79, 1974-1 C.B. 81 held that an active trade or business transferred to a distributing corporation in a § 332 liquidation satisfies § 355(b) because the business history tacks through the tax-free acquisition.
  • Rev. Rul. 2002-49, 2002-2 C.B. 288 held that a corporation's acquisition of all remaining partnership interests (converting the LLC to a disregarded entity) constituted an expansion of the corporation's existing business, not a taxable acquisition of a new business.
  • CAUTION. A § 351 transfer of a business to a new subsidiary in exchange for stock does not trigger gain recognition and therefore does not violate § 355(b)(2)(C). But a taxable purchase of assets or stock followed by a spin-off within five years will disqualify the active business treatment for the acquired business.
• Controlled group attribution under the SAG rule. § 355(b)(3)(A) (added by TIPRA 2005, effective May 17, 2006) provides that all members of a corporation's separate affiliated group (SAG) are treated as one corporation for the active business test. A SAG is the affiliated group that would be determined under § 1504(a) if the corporation were the common parent and § 1504(b) did not apply. § 355(b)(3)(B).
  • The SAG rule requires 80% ownership (by voting power and value) of each affiliated corporation. This replaced the pre-2006 "substantially all" test for determining whether a parent holding company could satisfy the active business requirement through subsidiaries.
  • § 355(b)(3)(C) provides that if a corporation becomes a SAG member through one or more taxable transactions, any trade or business conducted by that corporation at the time it became a member is treated as acquired in a taxable transaction for purposes of § 355(b)(2). Proposed Regulation § 1.355-3(b)(1)(ii) provides that a transaction resulting in a corporation becoming a SAG member is treated as an asset acquisition, though an expansion in the same line of business may still qualify.

Step 8. D Reorganization Qualification

"A transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred." (IRC § 368(a)(1)(D))

• The divisive D reorganization structure. A tax-free spin-off, split-off, or split-up is frequently structured as both a § 355 distribution and a divisive D reorganization under § 368(a)(1)(D). In this structure, Distributing transfers part of its assets (a business line) to a controlled corporation and then distributes the Controlled stock to Distributing's shareholders pursuant to § 354, 355, or 356. The D reorganization overlay provides corporate-level nonrecognition under § 361 and enables certain transactional features (such as liability assumptions and boot distributions) that a pure § 355 distribution does not accommodate.
  • The statutory text requires a transfer of "all or a part" of the transferor's assets. This is less demanding than the acquisitive D reorganization, which requires "substantially all" assets under § 354(b)(1). For a divisive D, only a portion of the assets need be transferred.
  • Rev. Rul. 2003-79, 2003-29 I.R.B. 80 held that in a multi-step transaction, "steps (i) and (ii) together meet all the requirements of § 368(a)(1)(D), step (ii) meets all the requirements of § 355(a), and steps (iii) and (iv) together meet all the requirements of § 368(a)(1)(C)." This confirms that the distribution of Controlled stock in a divisive D is tested under § 355 while the upstream asset transfer is tested under § 368(a)(1)(D).
  • TRAP. A divisive D reorganization requires that stock or securities of Controlled received in the asset transfer be distributed in a transaction qualifying under § 354, 355, or 356. If the distribution fails § 355 for any reason (active business, device, etc.), the D reorganization also fails, and Distributing recognizes gain under § 311(b).
• The post-transfer control requirement. § 368(a)(1)(D) requires that the transferor or its shareholders (or both) control the transferee corporation "immediately after the transfer." For nondivisive D reorganizations, § 368(a)(2)(H) reduces this control standard to the § 304(c) level (more than 50% of voting power and more than 50% of value), not the § 368(c) 80% standard. For divisive D reorganizations that include a § 355 distribution, the 80% standard of § 368(c) applies to the pre-distribution control test, and the 50% standard applies to the post-transfer control test under § 368(a)(2)(H).
  • Rev. Rul. 2003-79 clarified that the 1997 Act did not change the requirement that Distributing must distribute 80% of the voting power and 80% of each other class of stock of Controlled under § 355(a)(1)(D). The 50% standard applies only to the post-transfer control analysis under § 368(a)(1)(D).
  • The § 354(b)(1) requirements for a nondivisive D (substantially all assets acquired, and complete distribution of received property) do not apply to divisive D reorganizations. Bloomberg Tax Portfolio No. 772, "Corporate Acquisitions - D Reorganizations."
• Interaction with § 361 nonrecognition. When a spin-off is structured as a divisive D reorganization, § 361(a) provides that Distributing recognizes no gain or loss on the transfer of assets to Controlled in exchange for Controlled stock. § 361(c) provides that Distributing recognizes no gain or loss on the distribution of Controlled stock to its shareholders.
  • If Distributing receives boot in the asset transfer, § 361(b)(1) generally provides nonrecognition if the boot is distributed to shareholders in pursuance of the plan. Under § 361(b)(3), a transfer of boot to creditors is treated as a distribution to shareholders, but gain is recognized to the extent the boot exceeds the aggregate adjusted basis of the transferred assets (net of liabilities assumed under § 357(c)).
  • CAUTION. § 357(c)(3)(A) excludes the § 357(c)(3) exception for deductible liabilities from applying to § 361 transfers. Accounts payable and other ordinary-course liabilities can therefore trigger § 357(c) gain in a divisive D reorganization even though they would not trigger gain in a § 351 transaction.
• Step-transaction risks in divisive D structures. The step-transaction doctrine remains a material risk in divisive D reorganizations despite Rev. Rul. 98-27, 1998-1 C.B. 1159 (limiting step-transaction application to the pre-distribution control test). The doctrine still applies to continuity of interest analysis, business purpose evaluation, and recharacterization of pre-distribution steps. FNMA v. Commissioner, 896 F.2d 580 (D.C. Cir. 1990), cert. denied, 499 U.S. 974 (1991) (a series of transactions designed as parts of a unitary plan will be viewed as a whole).
  • In Penrod v. Commissioner, 88 T.C. 1415 (1987), the Tax Court applied the step-transaction doctrine to collapse a series of related transactions in a § 355 context, finding all three tests (binding commitment, mutual interdependence, and end result) satisfied where the parties had entered into an agreement linking the distribution step to a subsequent exchange.
  • To minimize step-transaction risk, each step in a multi-step transaction should have independent economic significance and business purpose. Board resolutions, fairness opinions, and documented alternative pathways help demonstrate that each step stands on its own.

Step 9. Disqualified Stock

"If immediately after the distribution, any person holds disqualified stock in the distributing corporation or any controlled corporation which constitutes a 50 percent or greater interest in such corporation, then subsection (a) shall not apply to such distribution." (IRC § 355(d)(1)-(2))

• The disqualified distribution framework. § 355(d), enacted by OBRA 1990, requires the distributing corporation to recognize gain on a "disqualified distribution" where immediately after the distribution any person holds disqualified stock constituting a 50% or greater interest in Distributing or Controlled. The gain is measured as if Distributing sold the Controlled stock for its fair market value. This provision targets transactions in which recently purchased stock is used to extract value tax-free.
  • A "50 percent or greater interest" means stock possessing at least 50% of total combined voting power or at least 50% of total value of all classes of stock. § 355(d)(4). This is a lower threshold than the 80% control standard in § 368(c).
  • "Disqualified stock" includes (i) stock in Distributing acquired by purchase during the five-year period ending on the distribution date, and (ii) stock in Controlled acquired by purchase during that period or received in the distribution to the extent attributable to distributions on disqualified Distributing stock or securities. § 355(d)(3).
  • TRAP. The five-year period is suspended during any period in which the holder's risk of loss is substantially diminished by an option, short sale, special class of stock, or other device. § 355(d)(6). Do not assume the five years run continuously.
• Definition of "purchase." § 355(d)(5) defines "purchase" as any acquisition of stock where (1) the basis of the stock is not determined by reference to the transferor's adjusted basis (i.e., not a transferred basis transaction), and (2) the stock is not acquired in an exchange to which § 351, 354, 355, or 356 applies. This definition sweeps in taxable stock acquisitions, gifts (where basis is FMV under § 1015), and certain deathtime transfers.
  • Tax-free reorganizations, § 351 transfers, and § 355 distributions themselves do not constitute purchases. Stock acquired in a tax-free reorganization tacks the transferor's holding period and is not disqualified stock.
  • Related persons are treated as one person for purposes of applying the 50% threshold, and constructive ownership rules apply under § 318(a) principles with modifications. § 355(d)(7)-(8).
  • Treas. Reg. § 1.355-6(b)(4) authorizes the Commissioner to treat any distribution as a disqualified distribution if the distribution or another transaction is structured with a principal purpose to avoid the purposes of § 355(d). This is a backstop anti-avoidance rule.
• The purposes exception. § 355(d) does not apply if the distribution and related transactions do not violate the purposes of the provision. The Conference Report (H.R. Rep. No. 101-964, at 1093 (1990)) states that the purposes are "not generally violated if there is a distribution of a controlled corporation within 5 years of an acquisition by purchase and the effect of the distribution is neither (1) to increase ownership in the distributing corporation or any controlled corporation by persons who have directly or indirectly acquired stock within the prior five years, nor (2) to provide a basis step-up with respect to the stock of any controlled corporation."
  • Treas. Reg. § 1.355-6 codifies this purposes exception. If neither the disqualified person nor any related person increases ownership in Distributing or Controlled as a result of the distribution, and no basis step-up is obtained, the purposes exception may apply.
  • CAUTION. The purposes exception is an exception, not a safe harbor. The burden of establishing that the purposes of § 355(d) are not violated rests with the taxpayer. Document the ownership percentages before and after the distribution carefully.
• Coordination with § 355(e). § 355(e)(2)(D) provides that § 355(e) does not apply to any distribution to which § 355(d) applies. There is no double application of these anti-abuse provisions. If § 355(d) applies, Distributing recognizes gain under § 355(d) and § 355(e) is inapplicable. If § 355(d) does not apply but § 355(e) does, Distributing recognizes gain under § 355(e).
  • The § 355(d) gain is treated as long-term capital gain. § 355(d)(1). Controlled receives no basis step-up in its assets despite Distributing's gain recognition. This is a harsh result because the corporate-level gain is phantom gain from Distributing's perspective (no cash is received).
  • Unlike § 355(e), which has detailed safe harbors in Treas. Reg. § 1.355-7, § 355(d) provides fewer safe harbors and relies more heavily on the purposes exception and the detailed definition of "disqualified stock." Practitioners should model both provisions separately.

Step 10. Plan Requirement and Anti-Morris Trust Rule

"If a distribution is part of a plan (or series of related transactions) pursuant to which 1 or more persons acquire directly or indirectly stock representing a 50-percent or greater interest in the distributing corporation or in any controlled corporation, then subsections (b) and (c) of section 355 shall not apply." (IRC § 355(e)(2)(A))

• The anti-Morris Trust statute. § 355(e), enacted by the Taxpayer Relief Act of 1997, is the statutory codification of the anti-Morris Trust rule. It requires Distributing to recognize gain if a § 355 distribution is part of a plan (or series of related transactions) pursuant which one or more persons acquire a 50% or greater interest in Distributing or any Controlled corporation. Unlike § 355(d), which targets purchased stock, § 355(e) targets planned acquisitions regardless of how the acquirer's stock was obtained.
  • The gain is measured as the excess of the fair market value of Controlled stock on the distribution date over Distributing's adjusted basis in that stock. § 355(e)(1). Only Distributing recognizes gain. Shareholders do not recognize gain. The character is long-term capital gain. Controlled receives no basis step-up.
  • The statute was enacted to prevent leveraged Morris Trust transactions in which Distributing transferred core operations to a subsidiary, borrowed substantial funds, distributed the subsidiary stock tax-free, and then was acquired, leaving the shareholders with cash-equivalent value and no corporate-level tax. Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794 (4th Cir. 1966) (the original Morris Trust transaction, which Congress determined had become abusive in leveraged form).
  • TRAP. § 355(e) applies to acquisitions of Distributing as well as acquisitions of Controlled. A post-distribution acquisition of Distributing by a third party can trigger § 355(e) gain even if Controlled remains independent.
• The rebuttable presumption. § 355(e)(2)(B) creates a rebuttable presumption that an acquisition is pursuant to a plan if a 50% or greater interest is acquired during the four-year period beginning two years before the distribution date. This creates a six-year window (two years before through two years after the distribution) in which acquisitions are presumed to be part of a plan.
  • Acquisitions more than two years before or more than two years after the distribution are outside the presumption window but can still be treated as part of a plan if the facts support it.
  • Treas. Reg. § 1.355-7 provides the regulatory framework for determining whether a distribution and acquisition are part of a "plan." The regulations adopt a "super safe harbor" under which a post-distribution acquisition can only be part of a plan if there was an agreement, understanding, arrangement, or substantial negotiations regarding the acquisition between Distributing, Controlled, or their controlling shareholders during the two-year period ending on the distribution date.
  • The regulations provide several specific safe harbors. Safe Harbor I applies to post-distribution acquisitions not involving public offerings where no discussions of significant economic terms occurred between certain parties during the relevant period. Treas. Reg. § 1.355-7(c).
• The affiliated group exception. § 355(e)(2)(C) provides that a plan is not treated as described in § 355(e)(2)(A) if immediately after completion of all transactions, Distributing and all Controlled corporations are members of a single affiliated group (as defined in § 1504 without regard to § 1504(b)). This exception permits tax-free internal reorganizations within a consolidated group.
  • This exception is critical for corporate groups that restructure operations through spin-offs followed by acquisitions that keep the entities within the same affiliated group. The § 1504 definition requires 80% ownership by vote and value.
  • CAUTION. If any Controlled corporation ceases to be a member of the affiliated group as part of the plan, the exception is lost. Model the post-transaction ownership structure carefully.
• Reverse Morris Trust transactions. A Reverse Morris Trust (RMT) is a structure in which Distributing separates a business line via a § 355 spin-off, and the spun-off business (Controlled) then merges with a third-party acquirer in a transaction in which Distributing's shareholders receive more than 50% of the combined company. If the distribution and subsequent merger are not part of a "plan," § 355(e) does not apply.
  • The RMT structure requires that former Distributing shareholders own more than 50% of the combined company immediately after the merger. This is the § 368(a)(2)(H) control standard, not the 80% § 368(c) standard.
  • Each step must have independent business significance. The step-transaction doctrine can collapse the steps if they are prearranged parts of a single plan. King Enterprises, Inc. v. United States, 418 F.2d 511 (Ct. Cl. 1969) (steps prearranged from the outset to reach an ultimate result may be stepped together under the end result test).
  • EXAMPLE. Distributing operates a pharmaceutical business and a medical device business. It spins off the device business into Controlled and distributes Controlled stock pro rata. Six months later, Controlled merges with Acquirer in a tax-free A reorganization. Distributing's shareholders receive 55% of the combined company's stock. If the spin-off and merger were not part of a plan (no pre-spin negotiations or agreements), § 355(e) does not apply and the spin-off remains tax-free.
• § 355(f) and intragroup transactions. § 355(f) provides that if a distribution is part of a Morris Trust transaction described in § 355(e), § 355 does not apply at all to distributions from one member of an affiliated group to another member. This means both corporate-level and shareholder-level tax consequences apply to intragroup distributions that are part of a prohibited plan.
  • § 355(f) is narrower than § 355(e) because it applies only to intragroup distributions. It effectively prevents affiliated groups from using intra-group spin-offs to avoid the corporate-level gain recognition that § 355(e) would otherwise impose.
  • Treas. Reg. § 1.355-7(h) provides guidance on the interaction between § 355(e) and § 355(f). In general, if a distribution is described in both provisions, § 355(f) controls and § 355 does not apply.

Step 11. Basis Allocation in the Distribution

"In the case of an exchange to which section 355 (or so much of section 356 as relates to section 355) applies, then in making the allocation under paragraph (1) of this subsection, there shall be taken into account not only the property so permitted to be received without the recognition of gain or loss, but also the stock or securities (if any) of the distributing corporation which are retained, and the allocation of basis shall be made among all such properties." (IRC § 358(b)(2))

• The carryover basis framework. § 358(a)(1) provides the general rule that the basis of property received in a nonrecognition exchange equals the basis of the property exchanged, decreased by the fair market value of any boot received and increased by any gain recognized. In a pure § 355 spin-off with no boot, the shareholder's aggregate basis in Distributing stock carries over unchanged to the combined holdings of Distributing and Controlled stock.
  • § 358(c) provides the mechanism by which this framework operates for § 355 distributions. It states that "a distribution to which section 355 applies shall be treated as an exchange, and for such purposes the stock and securities of the distributing corporation which are retained shall be treated as surrendered, and received back, in the exchange." This fictional exchange treatment is necessary because a pro rata spin-off involves no actual surrender of Distributing stock.
  • Treas. Reg. § 1.358-2(a)(2)(iv) implements the statutory framework by providing that "the basis of each share of stock or security of the distributing corporation... shall be allocated between the share of stock or security of the distributing corporation with respect to which the distribution is made and the share or shares of stock or security or securities (or allocable portions thereof) received with respect to the share of stock or security of the distributing corporation in proportion to their fair market values."
• FMV proportionate allocation. § 358(b)(2) mandates that the shareholder's pre-distribution aggregate basis in Distributing stock be allocated between the retained Distributing stock and the received Controlled stock in proportion to their respective fair market values immediately after the distribution. This is the core operative rule for all § 355 basis allocations.
  • EXAMPLE. A shareholder owns 100 shares of Distributing Corp with an aggregate basis of $10,000. Distributing spins off Controlled Corp pro rata. Immediately after the spin-off, the fair market value of the shareholder's Distributing stock is $800,000 and the fair market value of the Controlled stock received is $200,000 (total post-spin value of $1,000,000). The $10,000 aggregate basis is allocated as follows. Distributing stock receives $8,000 ($10,000 multiplied by $800,000/$1,000,000). Controlled stock receives $2,000 ($10,000 multiplied by $200,000/$1,000,000). The shareholder's combined basis in all post-spin stock equals the pre-spin basis in Distributing.
  • When a shareholder holds multiple blocks of Distributing stock acquired at different times or prices, the allocation is performed separately for each block. Treas. Reg. § 1.358-2(a)(2)(vi) provides that shares received with respect to multiple blocks are divided into segments based on the relative fair market values of the surrendered shares, and each segment has a separate basis and corresponding holding period.
  • CAUTION. The allocation depends on accurate fair market value determinations. If the post-distribution FMVs are not supportable, the basis allocation may be challenged. Obtain a qualified appraisal or valuation opinion for both Distributing and Controlled immediately after the distribution.
• Holding period tacking. § 1223(1)(B) provides that "a distribution to which section 355 (or so much of section 356 as relates to section 355) applies shall be treated as an exchange" for holding period purposes. The shareholder's holding period in Controlled stock includes the holding period of the Distributing stock with respect to which the distribution was made, provided the Distributing stock was a capital asset or § 1231 property.
  • Treas. Reg. § 1.1223-1(a)(2) confirms this rule, providing that "the period for which the taxpayer has held the stock of the controlled corporation shall include the period for which he held the stock of the distributing corporation with respect to which such distribution was made."
  • Boot received in the distribution does not take a tacked holding period. The holding period for boot begins on the date of distribution. § 1223(1) (tacking applies only to property with substituted basis).
  • § 1223(2) provides a separate holding period tacking rule for Controlled's holding period in assets received from Distributing in a divisive D reorganization. Controlled's holding period in received assets includes Distributing's holding period because the assets have the same basis in Controlled's hands as they had in Distributing's hands.
• Boot and gain recognition adjustments. When boot is received in a § 355 transaction, the basis allocation computation is modified. Under § 356(a)(1), gain is recognized to the extent of the sum of money and the fair market value of other property received, but not in excess of the shareholder's realized gain. Under § 356(a)(2), if the exchange has "the effect of the distribution of a dividend," the recognized gain is treated as a dividend to the extent of the shareholder's ratable share of earnings and profits.
  • The basis computation proceeds as follows. Start with the pre-distribution basis in Distributing stock. Decrease by the fair market value of boot received under § 358(a)(1)(A)(ii). Increase by any gain recognized under § 358(a)(1)(B)(ii). Allocate the resulting adjusted basis between Distributing and Controlled stock in proportion to their respective FMVs. Boot takes a fair market value basis under § 358(a)(2).
  • EXAMPLE. Same facts as the prior example, but the shareholder also receives $5,000 cash boot. Realized gain is $195,000 (value of Distributing plus Controlled plus cash minus $10,000 basis). Gain recognized is $5,000 (lesser of realized gain or boot). The basis computation is $10,000 starting basis, decreased by $5,000 boot to $5,000, increased by $5,000 gain recognized back to $10,000. The net adjusted basis of $10,000 is then allocated as before ($8,000 to Distributing, $2,000 to Controlled). The $5,000 cash has a basis of $5,000 (its FMV).
  • TRAP. In a pro rata spin-off, boot is generally treated as a § 301 dividend to the extent of E&P because the distribution is pro rata and has the effect of a dividend under § 356(a)(2). In a split-off (non-pro rata exchange), boot may be treated as redemption proceeds potentially qualifying for capital gain treatment under § 302(a).
• Earnings and profits allocation. § 312(h)(1) authorizes the Secretary to prescribe regulations for allocating earnings and profits between Distributing and Controlled in a § 355 transaction. Treas. Reg. § 1.312-10 provides the operative rules.
  • For a divisive D reorganization, Treas. Reg. § 1.312-10(a) provides that E&P is allocated between Distributing and Controlled "in proportion to the fair market value of the business or businesses (and interests in any other properties) retained by the distributing corporation and the business or businesses (and interests in any other properties) of the controlled corporation immediately after the transaction."
  • For a spin-off or split-off that is not a divisive D reorganization, Treas. Reg. § 1.312-10(b) limits the decrease in Distributing's E&P to the lesser of (i) the amount that would have been allocated in a hypothetical divisive D reorganization, or (ii) the net worth of Controlled (the sum of the basis of all properties plus cash minus all liabilities). No deficit of Distributing is allocated to Controlled. § 1.312-10(c).
  • The E&P allocation is critical because it determines the character of future distributions from each corporation. A higher E&P allocation to Controlled means more future distributions from Controlled may be taxable as dividends. The E&P allocation operates alongside the basis allocation to determine the complete tax picture for the separated entities.

Step 12. Shareholder Gain Recognition and Boot

"If ... section 355 would apply to an exchange but for the fact that the property received in the exchange consists not only of property permitted by such section to be received without the recognition of gain, but also of other property or money, then -- the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property" (§ 356(a)(1)).

"If ... the exchange has the effect of the distribution of a dividend, then there shall be treated as a dividend to each distribute such an amount of the gain recognized ... as is not in excess of his ratable share of the undistributed earnings and profits of the corporation accumulated after February 28, 1913" (§ 356(a)(2)).

• Boot at the shareholder level under § 356(a)(1). When a shareholder receives property other than stock or securities of Controlled ("boot") in a § 355 transaction, gain is recognized to the lesser of realized gain or the fair market value of boot plus money received.
  • No loss is recognized under § 356(a) even if boot is received in a loss position. The boot-within-gain limitation caps recognition at the taxpayer's realized gain.
  • EXAMPLE. A shareholder with $10 basis in Distributing stock receives Controlled stock worth $100 plus $15 cash boot. Realized gain is $105. Gain recognized is $15 (the boot amount, which is less than realized gain). If the same shareholder's basis were $120, realized gain would be negative and no gain would be recognized despite the cash received.
  • Boot takes a fair market value basis under § 358(a)(2) and does NOT receive a tacked holding period under § 1223(1). The holding period for boot begins on the date of distribution.
• Dividend equivalence under § 356(a)(2). Gain recognized on receipt of boot is treated as dividend income to the extent of the shareholder's ratable share of undistributed earnings and profits.
  • In a pro rata spin-off, boot is generally treated as a § 301 dividend to the extent of E&P because the shareholder's proportionate interest in Distributing is unchanged. In a split-off, boot is treated as redemption proceeds and may qualify for capital gain treatment under § 302(a) if the exchange is "substantially disproportionate."
  • TRAP. The E&P taint analysis under § 356(a)(2) applies to the gain recognized, not the full boot amount. If boot exceeds realized gain, only the recognized portion (capped at realized gain) is subject to the dividend equivalence test.
• Corporate-level boot gain under § 355(c)(2). If Distributing distributes property other than qualified property (stock or securities in Controlled), and the FMV of that property exceeds its adjusted basis in Distributing's hands, gain is recognized as if Distributing sold the property at FMV.
  • "Qualified property" for this purpose means only stock or securities of Controlled. Any other property triggers corporate-level gain.
  • CAUTION. The § 355(c)(2) gain is computed at the corporate level and is separate from any shareholder-level gain under § 356(a)(1). Both can apply simultaneously to the same transaction.

Step 13. COBE and COI Requirements

"Section 355 applies to a separation that effects only a readjustment of continuing interests in the property of the distributing and controlled corporations. In this regard section 355 requires that one or more persons who, directly or indirectly, were the owners of the enterprise prior to the distribution or exchange own, in the aggregate, an amount of stock establishing a continuity of interest in each of the modified corporate forms in which the enterprise is conducted after the separation" (Treas. Reg. § 1.355-2(c)(1)).

"Section 355 contemplates the continued operation of the business or businesses existing prior to the separation" (Treas. Reg. § 1.355-2(b)(2)).

• Continuity of interest thresholds. The regulations establish a spectrum for COI through four examples in Treas. Reg. § 1.355-2(c)(2).
  • 20% aggregate continuity is INSUFFICIENT. Example 3 demonstrates that when historic shareholders retain only 20% of the equity in the separated enterprises, the readjustment of continuing interests requirement is not met.
  • 50% aggregate continuity is SUFFICIENT. Example 4 confirms that when historic shareholders retain 50% or more of the equity in the separated enterprises, COI is established. The continuing shareholders in one corporation need not be the same as those in the other (as in a split-off where different shareholder groups take different corporations).
  • The 40% range remains uncertain. By analogy to Treas. Reg. § 1.368-1(e)(1) (where 40% continuity is generally sufficient for acquisitive reorganizations), many practitioners treat 40% as the practical floor, but no § 355 regulation or ruling directly confirms this.
• Continuity of business enterprise for both corporations. COBE requires that both Distributing and Controlled continue their historic business activities after the spin-off.
  • Treas. Reg. § 1.368-1(d) principles inform the COBE analysis. The issuing corporation must continue the target's historic business or use a significant portion of the target's historic business assets in a business. Treas. Reg. § 1.368-1(d)(2)(ii). If a corporation has multiple lines of business, continuity requires only that a "significant line of business" continue.
  • Rev. Rul. 2003-79, 2003-2 C.B. 80 blesses "born-to-die" transactions where Controlled is liquidated or merged after the spin-off. The subsequent disappearance of Controlled does not retroactively disqualify the § 355 distribution if the business continues through another entity. This ruling builds on Rev. Rul. 98-27, 1998-1 C.B. 1159, which eliminated step-transaction concerns for pre-arranged post-spin acquisitions of Controlled.
• Post-distribution acquisitions and the Morris Trust lineage. The seminal case of Commissioner v. Mary Archer W. Morris Trust, 367 F.2d 794 (4th Cir. 1966), affirming 42 T.C. 779 (1964), held that a spin-off followed by a tax-free merger of Distributing qualified under § 355 where historic shareholders retained 54% of the merged entity. The IRS acquiesced in Rev. Rul. 68-603, 1968-2 C.B. 148.
  • Penrod v. Commissioner, 88 T.C. 1415 (1987), held that a post-reorganization sale of stock within nine months did NOT violate COI where the sale was not contemplated at the time of the reorganization and shareholders had unfettered discretion to retain or sell. This contrasts with McDonald's Restaurants of Illinois, Inc. v. Commissioner, 688 F.2d 520 (7th Cir. 1982), where the Seventh Circuit reversed the Tax Court and held COI was NOT satisfied because target shareholders had a binding plan to sell acquiring corporation stock immediately after the merger, making the stock interest transitory.
  • CAUTION. § 355(e) now imposes corporate-level gain recognition on distributions that are part of a plan involving a 50% or greater acquisition. The COI analysis and § 355(e) analysis operate independently. A transaction can satisfy COI but still trigger § 355(e) gain if a qualifying acquisition is part of a plan.
• § 355(g) limitation on disqualified investment corporations. § 355(g) denies tax-free treatment to any distribution where either Distributing or Controlled is a "disqualified investment corporation" and any person acquires a 50% or greater interest who did not previously hold such interest.
  • A "disqualified investment corporation" means any corporation the FMV of whose investment assets is two-thirds or more of the FMV of all assets. Investment assets include cash, stock, securities, partnership interests, debt instruments, options, derivatives, and foreign currency. § 355(g)(2).
  • TRAP. § 355(g) does NOT apply to pro rata distributions (spin-offs) because no "new" person acquires a 50% interest. It primarily threatens split-offs where one shareholder group exchanges Distributing stock for Controlled stock and Controlled holds significant investment assets.

Step 14. Anti-Abuse Doctrines

"Simply an operation having no business or corporate purpose -- a mere device which put on the form of a corporate reorganization as a disguise for concealing its real character, and the sole object and accomplishment of which was the consummation of a preconceived plan, not to reorganize a business or any part of a business, but to transfer a parcel of corporate shares to the petitioner" (Gregory v. Helvering, 293 U.S. 465, 469-70 (1935), holding that a transaction literally complying with the reorganization statute was denied tax-free treatment for lack of business purpose).

• Step-transaction doctrine. Courts apply three alternative tests to collapse a series of formally separate but related transactions into a single integrated transaction. A transaction need satisfy only one test for the doctrine to apply. Penrod v. Commissioner, 88 T.C. 1415, 1428 (1987).
  • The binding commitment test (narrowest) integrates steps only if, at the time the first step commences, there is a binding legal commitment to undertake the subsequent step(s). Commissioner v. Gordon, 391 U.S. 83, 96 (1968) (addressing Pacific Telephone spin-off of Northwest Bell assets). Most courts consider this test alone too rigid and have supplemented it with broader formulations.
  • The mutual interdependence test (intermediate) collapses steps that are "so interdependent that the legal relations created by one transaction would have been fruitless without completion of the series." Redding v. Commissioner, 630 F.2d 1169, 1177 (7th Cir. 1980), cert. denied, 450 U.S. 913 (1981). If individual steps have "reasoned economic justification standing alone," the test does not apply.
  • The end result test (broadest) integrates steps that are "really prearranged parts of a single transaction intended from the outset to reach the ultimate result." King Enterprises, Inc. v. United States, 418 F.2d 511, 516 (Ct. Cl. 1969).
  • TRAP. Rev. Rul. 98-27, 1998-1 C.B. 1159 eliminated step-transaction application to the control-immediately-before-distribution requirement. But the doctrine still applies to COI analysis, business purpose evaluation, and whether § 355(e) applies. McDonald's Restaurants of Illinois, Inc. v. Commissioner, 688 F.2d 520 (7th Cir. 1982) (applying step-transaction to integrate merger and immediate stock sale, denying reorganization treatment).
• Economic substance doctrine under § 7701(o). For transactions entered into on or after March 31, 2010, a conjunctive two-prong test applies. Both prongs must be satisfied. Notice 2010-62.
  • Prong 1 (objective) requires that the transaction change in a meaningful way (apart from federal income tax effects) the taxpayer's economic position. § 7701(o)(1)(A).
  • Prong 2 (subjective) requires that the taxpayer have a substantial purpose (apart from federal income tax effects) for entering into the transaction. § 7701(o)(1)(B).
  • The reasonable cause defense under § 6664(c) does NOT apply to transactions lacking economic substance. Penalties are 20% under § 6662(b)(6) or 40% under § 6662(i) for nondisclosed transactions.
• § 355(e) anti-Morris Trust rule. If a § 355 distribution is part of a "plan (or series of related transactions)" pursuant to which one or more persons acquire a 50% or greater interest in Distributing or Controlled, Distributing must recognize gain as if it sold the Controlled stock for FMV. § 355(e)(1).
  • Acquisitions within two years before or after the distribution are presumed part of a plan. § 355(e)(2). The presumption is rebuttable.
  • The "super safe harbor" in Treas. Reg. § 1.355-7 provides that a post-distribution acquisition can only be part of a plan if there was an agreement, understanding, arrangement, or substantial negotiations regarding the acquisition during the two-year period ending on the distribution date.
  • Only Distributing recognizes gain. Shareholders do not recognize gain under § 355(e). Controlled receives no basis step-up despite Distributing's gain recognition.
• § 355(d) disqualified distributions and § 269. § 355(d) requires Distributing to recognize gain on a "disqualified distribution" where any person holds a 50% or greater interest attributable to "disqualified stock" (stock purchased within five years). Treas. Reg. § 1.355-6 provides a purpose exception where the disqualified person does not increase ownership or obtain a purchased basis in Controlled stock.
  • § 269(a) grants the Secretary discretion to disallow deductions, credits, or other allowances where the principal purpose of an acquisition of control was tax evasion or avoidance. "Control" for this purpose means 50% of voting power or value. Borge v. Commissioner, 405 F.2d 673 (2d Cir. 1968) (applying § 269 to deny benefits where a corporation was formed solely to secure tax advantages).
• Post-Loper Bright litigation landscape. Loper Bright Enterprises v. Raimondo, 603 U.S. ___ (2024), overruled Chevron U.S.A. v. Natural Resources Defense Council, 467 U.S. 837 (1984). Courts must now exercise independent judgment on agency statutory interpretations rather than deferring to reasonable regulatory positions.
  • Treasury regulations under § 355 are more vulnerable to judicial challenge. Already in Memorial Hermann Care Org. v. Commissioner, 120 F.4th 215 (5th Cir. 2024), the Fifth Circuit cited Loper Bright to reject a Treasury interpretation.
  • The January 2025 proposed regulations (REG-112261-24) imposing a 12-month boot purge requirement and other restrictions were withdrawn on September 29, 2025 following critical public comments. Rev. Proc. 2025-30 reinstated the prior ruling framework.

Step 15. CAMT and Corporate-Level Considerations

"In the case of a distribution or exchange to which section 355 (or so much of section 356 as relates to section 355) applies, proper allocation with respect to the earnings and profits of the distributing corporation and the controlled corporation (or corporations) shall be made under regulations prescribed by the Secretary" (§ 312(h)(1)).

• CAMT treatment of § 355 transactions under Notice 2023-7. The Inflation Reduction Act enacted a 15% Corporate Alternative Minimum Tax effective for taxable years beginning after December 31, 2022. Notice 2023-7, 2023-1 I.R.B. 610 provides parity between regular tax and CAMT for spin-off transactions.
  • A § 355 spin-off (pro rata distribution) generally does not result in financial statement gain or loss. Therefore, no AFSI impact from the distribution itself. A § 355 split-off may result in financial statement gain or loss, but Notice 2023-7, § 3.03 excludes such gain or loss from AFSI.
  • Increases or decreases to financial accounting basis of property from "covered nonrecognition transactions" are disregarded for AFSI. The pre-transaction financial accounting basis is preserved solely for future AFSI calculations.
  • When a spin-off or split-off occurs, Controlled is allocated a portion of the distributing group's AFSI for the prior three-taxable-year testing period. This allocation does NOT decrease Distributing's AFSI for any year in the testing period. Any reasonable method may be used for the allocation until proposed regulations provide a mandatory method.
  • TRAP. An applicable corporation with average annual AFSI exceeding $1 billion must now maintain parallel accounting tracks (GAAP, regular tax, and CAMT/AFSI) through and after a spin-off transaction.
• Earnings and profits allocation under § 312(h) and Treas. Reg. § 1.312-10. The E&P allocation framework determines the amount of future distributions that may be taxable as dividends.
  • For a divisive D reorganization, Treas. Reg. § 1.312-10(a) allocates E&P proportionately to the FMV of the business retained by Distributing and the business transferred to Controlled immediately after the transaction. In a "proper case," allocation may be made by net basis (basis of assets less liabilities) or by another appropriate method.
  • For a spin-off or split-off that is NOT a divisive D reorganization, Treas. Reg. § 1.312-10(b) limits the decrease in Distributing's E&P to the lesser of (i) the hypothetical amount that would have been allocated in a divisive D reorganization, or (ii) the net worth of Controlled (basis of all properties plus cash minus all liabilities).
  • Treas. Reg. § 1.312-10(c) prohibits allocation of any deficit of Distributing to Controlled. A Distributing corporation with negative E&P cannot offload that deficit onto a newly spun Controlled.
• § 355(f) intragroup transactions and § 355(h) REIT limitations. § 355(f) denies tax-free treatment entirely when a distribution is from one affiliated group member to another and is part of a Morris Trust transaction involving a 50% acquisition. Both corporate-level and shareholder-level tax consequences apply.
  • § 355(h), added by the PATH Act of 2015 (effective for distributions on or after December 7, 2015), denies § 355 treatment if either Distributing or Controlled is a REIT. Two exceptions apply. First, the prohibition does not apply if both Distributing and Controlled are REITs immediately after the distribution. Second, a distributing REIT may spin off a taxable REIT subsidiary (TRS) if the REIT status and TRS relationship existed throughout the three-year period before distribution and control (80% voting and value) was maintained throughout.
  • § 856(c)(8) prevents any non-REIT that was a Distributing or Controlled corporation in a § 355 transaction from making a REIT election for ten years. Treas. Reg. § 1.337(d)-7 imposes built-in gains tax on C corporations that convert to REITs within ten years of a § 355 transaction.
• S corporation spin-off considerations. An S corporation can engage in a tax-free spin-off under § 355 subject to limitations. A QSub spin-off terminates the QSub election, and the former QSub is treated as a new corporation acquiring all assets and liabilities from the S corporation immediately before the spin-off. § 1361(b)(3). After a spin-off, both Distributing and Controlled may separately elect S status provided each satisfies the 100-shareholder limit, single-class-of-stock requirement, and eligible shareholder restrictions under § 1361(b).

Step 16. Documentation and Reporting Obligations

"Every corporation which -- (1) within 30 days after the adoption by the corporation of a resolution or plan for the dissolution of the corporation or the liquidation of the whole or any part of its capital stock, or (2) at any time thereinafter ... shall file ... a return" (§ 6043(a)).

• Form 8937 and § 6045B basis reporting. An issuer of specified securities undertaking an organizational action affecting basis must file Form 8937, Report of Organizational Actions Affecting Basis of Securities, by the earlier of 45 days after the organizational action or January 15 of the following year. § 6045B. Treas. Reg. § 1.6045B-1(a)(2).
  • The form must describe the organizational action, state the quantitative effect on basis per share or as a percentage of old basis, describe the calculation methodology, identify the applicable Code sections (e.g., § 355, § 368(a)(1)(D)), and include any other information necessary to implement the adjustment.
  • Issuers may satisfy the filing obligation by posting the completed Form 8937 on a publicly accessible website by the deadline and maintaining it for ten years. This public posting option is the most commonly used method for publicly traded corporations.
  • Penalties for failure to file or furnish correct information apply under §§ 6721 and 6722 on a tiered structure. Reasonable cause relief is available.
  • CAUTION. The issuer's Form 8937 provides the official basis allocation methodology that brokers use to adjust cost basis reporting on Form 1099-B. An error or omission on Form 8937 can trigger cascading incorrect basis reporting across thousands of shareholder accounts.
• E&P allocation documentation. Because Treas. Reg. § 1.312-10 governs how E&P is divided between Distributing and Controlled, the parties should maintain contemporaneous documentation supporting the allocation methodology.
  • For divisive D reorganizations, the FMV-based allocation under Treas. Reg. § 1.312-10(a) requires reliable valuations of the retained and transferred businesses. Obtain independent valuation opinions for the business lines of both Distributing and Controlled as of the transaction date.
  • If net basis is used as an alternative allocation method under the "proper case" exception, maintain detailed asset and liability schedules showing the net basis computation for both the retained and transferred businesses.
• Form 966 and § 6043 considerations for split-ups. A § 355 spin-off or split-off that does not involve Distributing's liquidation does NOT trigger § 6043(a) Form 966 reporting. § 6043(a) applies only upon adoption of a plan for dissolution or liquidation of capital stock.
  • A split-up (complete liquidation of Distributing through distribution of multiple Controlled corporations) DOES trigger § 6043(a). Distributing must file Form 966 within 30 days after adopting the liquidation plan.
  • Treas. Reg. § 1.6043-2 provides an exception. Distributions for which information is required under Treas. Reg. § 1.368-3(a) (reorganization statement requirements) do not also require Forms 1096/1099 under § 1.6043-2.
• Form 1099-DIV implications. A qualifying § 355 distribution does NOT trigger Form 1099-DIV reporting. § 312(d)(1) provides that a distribution of stock or securities in a transaction to which § 355 applies is not considered a distribution of earnings and profits if no gain to the distributee was recognized.
  • If the distribution fails to qualify under § 355, it is treated as a § 301 distribution and the shareholder has dividend income to the extent of Distributing's E&P. In that case, Form 1099-DIV is required with the FMV of Controlled stock as the distribution amount.
  • If boot is received in a qualifying § 355 transaction, the boot portion is taxable under § 356 and should be reported appropriately. The character of the boot (dividend vs. capital gain) depends on whether the distribution is pro rata (spin-off) or non-pro rata (split-off).
• Shareholder basis tracking and the § 368(a)(1)(D) reorganization statement. Treas. Reg. § 1.368-3(a) requires that every corporation that is a party to a reorganization file a statement with its return for the taxable year of the reorganization setting forth certain information.
  • The statement must include the date of the reorganization, the identities of the parties, the assets and stock transferred, the basis of property transferred, and the Code section under which the reorganization is claimed.
  • Distributing and Controlled should each retain complete records of the transaction for at least the statute of limitations period. Shareholders should be provided with detailed basis allocation information reflecting the proportionate FMV allocation under § 358(b)(2) and Treas. Reg. § 1.358-2(a)(2)(iv), including per-share or percentage allocation ratios.
  • For shareholders with multiple blocks of Distributing stock acquired at different dates or prices, Treas. Reg. § 1.358-2(a)(2)(vi) requires segmented allocation. Each segment of Controlled stock receives a basis and holding period corresponding to the Distributing share with respect to which it was received. If the shareholder cannot identify which Controlled share was received with respect to which Distributing share, a designation may be made before the basis becomes relevant (i.e., before sale).