IRS approves tax-free treatment for an S corporation business spin-off

Plain-English summary

An S corporation separated one business from another by forming a controlled subsidiary, making a qualified subchapter S subsidiary election, contributing partnership interests to the subsidiary, and distributing all of its stock pro rata to shareholders. The IRS ruled that the contribution and distribution together qualified as a Section 368(a)(1)(D) reorganization and that neither corporation nor the shareholders recognized gain or loss on the covered steps. The controlled corporation took carryover bases and holding periods, while shareholders allocated their existing stock basis between the two corporations according to relative fair market value. Earnings and profits and the accumulated adjustments account were also allocated between the corporations. The controlled corporation's brief ownership by the distributing corporation did not itself prevent a first-year S election effective immediately after the subsidiary election terminated.

Ruling snapshot

• Question: What federal tax consequences followed from the S corporation's contribution of partnership interests and pro rata spin-off of its controlled subsidiary?
• Outcome: Approved. The covered contribution and distribution received tax-free reorganization and spin-off treatment, subject to the stated representations and caveats.
• Key authorities: IRC §§ 355, 361, 362, 368(a)(1)(D), 1032, 1223, 1361, 1362; Rev. Proc. 2017-52

Full text (IRS public release)

Internal Revenue Service Department of the Treasury
Washington, DC 20224

Number: 202132006 Third Party Communication: None
Release Date: 8/13/2021 Date of Communication: Not Applicable
Index Number: 355.00-00, 355.01-00,
355.03-00, 368.00-00, Person To Contact:
368.04-00 ----------------------------,
ID No. -----------------
--------------------------------------- Telephone Number:
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-------------------------------- Refer Reply To:
CC:CORP:B2
---------------------- PLR-126886-20
----------------------------------------------------------- Date:
May 20, 2021

                                                Legend

Distributing = ------------------------------------------------------------------------------------
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Controlled = ------------------------------------------------------------------------------------
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Sub 1 = ------------------------------------------------------------------------------------
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PRS 1 = ------------------------------------------------------------------------------------
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PRS 2 = ------------------------------------------------------------------------------------
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PRS 3 = ------------------------------------------------------------------------------------
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PRS 4 = ------------------------------------------------------------------------------------
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PLR-126886-20 2

DRE 1 = ------------------------------------------------------------------------------------
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DRE 2 = ------------------------------------------------------------------------------------
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DRE 3 = ------------------------------------------------------------------------------------
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DRE 4 = ------------------------------------------------------------------------------------
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DRE 5 = ------------------------------------------------------------------------------------
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Individual A = ---------------

Business A = ------------------------------------------------------------------------------------
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Business B = ------------------------------------------------------------------------------------
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a = -----------

b = --------

c = -----------

d = -----------

e = -----------

f = ---

g = ---

h = --
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Date 1 = -----------------------

Date 2 = --------------------------

Date 3 = -----------------------

Transition = ------------------------------------------------------------------------------------
Agreement ------------------------------------------------------------------------------------
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Employee = ------------------------------------------------------------------------------------
Transfer ------------------------------------------------------------------------------------
Agreement ------------------------------------------------------------------------------------
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Dear -----------:

This letter responds to your authorized representatives’ letter dated October 26, 2020,
as supplemented by subsequent information and documentation, requesting rulings on
certain federal tax consequences of a series of transactions (the “Completed
Transaction,” as defined below). The material information submitted in that letter and
subsequent correspondence is summarized below.

This letter is issued pursuant to Rev. Proc. 2017-52, 2017-41 I.R.B. 283, regarding one
or more “Covered Transactions” under sections 355 and 368 of the Internal Revenue
Code (the “Code”). This Office expresses no opinion as to any issue not specifically
addressed by the rulings below.

The rulings contained in this letter are based upon facts and representations submitted
by the taxpayer and accompanied by a penalties of perjury statement executed by an
appropriate party. This Office has not verified any of the material submitted in support of
the request for rulings. Verification of the information, representations, and other data
may be required as part of the audit process.

This Office has made no determination regarding whether the Distribution (defined
below): (i) satisfies the business purpose requirement of Treas. Reg. § 1.355-2(b); (ii) is
used principally as a device for the distribution of the earnings and profits of the
distributing corporation or the controlled corporation or both (see section 355(a)(1)(B)
and Treas. Reg. § 1.355-2(d)); or (iii) is part of a plan (or series of related transactions)
pursuant to which one or more persons will acquire directly or indirectly stock
representing a 50-percent or greater interest in the distributing corporation or the
PLR-126886-20 4

controlled corporation, or any predecessor or successor of the distributing corporation
or the controlled corporation, within the meaning of Treas. Reg. § 1.355-8 (see
section 355(e)(2)(A)(ii) and Treas. Reg. § 1.355-7).

                               Summary of Facts

Distributing is a subchapter S corporation. Individual A owns a% of the stock of
Distributing; unrelated shareholders own the remaining stock of Distributing. Individual A
also owns b% of the stock of Sub 1, a domestic corporation; unrelated shareholders
own the remaining stock of Sub 1.

Distributing and an unrelated person (as limited partners) respectively own c% (an
amount greater than 33 1/3%) and d% of the interests in PRS1, a domestic eligible
entity (within the meaning of Treas. Reg. § 301.7701-3(a)) that is classified as a
partnership for federal income tax purposes (an “eligible entity classified as a
partnership”). Sub 1 (as a general partner) owns the remaining interest in PRS 1.

PRS 1 owns all of the interests in DRE 1, a domestic eligible entity that is disregarded
as separate from its owner for federal income tax purposes (a “disregarded entity”).
DRE 1 (as a limited partner) owns an e% interest in PRS 2, a domestic eligible entity
classified as a partnership; Sub 1 (as a general partner) owns the remaining interest in
PRS 2.

PRS 1 also owns all of the interests in DRE 2, a domestic disregarded entity. DRE 2
owns a f% interest in PRS 3, a domestic eligible entity classified as a partnership;
unrelated shareholders own the remaining interests in PRS 3. PRS 3 owns all the
interests in DRE 3, a domestic disregarded entity. DRE 3 owns all the interests in DRE
4, a foreign disregarded entity.

Prior to Date 2, PRS 1 owned an e% interest in PRS 4, a domestic eligible entity
classified as a partnership (an amount resulting in Distributing indirectly owning a
greater than 33 1/3% interest in PRS 4); Sub 1 owned the remaining interest in PRS 4.
PRS 4 owns all the interests in DRE 5, a domestic disregarded entity.

Through its direct and indirect ownership of PRS 1 and PRS 4, Distributing is engaged
in Business A and Business B. PRS 1 is engaged in Business A through PRS 2, PRS 3,
DRE 1, DRE 2, DRE 3, and DRE 4. PRS 4 is engaged in Business B through DRE 5.

Financial information has been submitted in accordance with Rev. Proc. 2017-52
indicating that each of Business A and Business B has had gross receipts and operating
expenses representing the active conduct of a trade or business for each of the past
five years.

                            Completed Transaction

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For what are represented to be valid corporate business purposes, Distributing
undertook the Completed Transaction to separate Business A from Business B.

The steps of the Completed Transaction are set forth below:

(i) Distributing formed Controlled, effective Date 1.

(ii) Distributing filed an election under section 1361(b)(3)(B) of the Code to treat
Controlled as a qualified subchapter S subsidiary for federal income tax purposes
(the “QSub election”), effective Date 1.

(iii) On Date 2, PRS 1 distributed all of its interests in PRS 4 pro rata to Distributing and
its other partners in a distribution that qualified under section 731(a) and (b) of the
Code.

(iv) On Date 2, Distributing contributed all of its interests in PRS 4 to Controlled (the
“Contribution”).

(v) On Date 2, Distributing distributed all the stock of Controlled pro rata to its
shareholders (the “Distribution”).

(vi) On Date 3, Controlled elected under section 1362(a) of the Code to be treated as a
subchapter S corporation for federal income tax purposes effective immediately
following the termination of the QSub election.

In connection with the Completed Transaction, Distributing and Controlled entered into
certain business arrangements, including a Transition Services Agreement and an
Employee Transfer Agreement (collectively, the “Continuing Relationships”). The
Transition Services Agreement is expected to terminate within g months of the
Distribution, whereas the Employee Transfer Agreement is expected to terminate within
h months of the Distribution.

                                 Representations

With respect to the Distribution, except as otherwise set forth below, Distributing has
made all the representations in section 3 of the Appendix to Rev. Proc. 2017-52.

Distributing has made the following alternative representations:

   Representations 3(a), 8(a), 11(a) (except as noted in the Continuing
   Relationships), 15(a), 22(a), 31(a), and 41(b).

Distributing has not made the following representations, which do not apply to the
Distribution:
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   Representations 7, 17, 19, 20, 24, 25, 35, 36, 37, 38, 39, 40, and 43.

Additionally, Distributing has represented that the pro rata distribution by PRS 1 of all of
its interests in PRS 4 to Distributing and its other partners qualified under section 731(a)
and (b) of the Code.

                                     Rulings

Based on the information submitted and the representations set forth above, we rule as
follows regarding the Completed Transaction:

1. The Distribution caused a termination of Controlled’s QSub election because
   Controlled ceased to be a wholly owned subsidiary of an S corporation. For
   federal income tax purposes, Controlled will be treated as a new corporation
   acquiring all of Distributing’s PRS 4 equity from Distributing immediately before
   the termination of Controlled’s QSub election in exchange for the stock of
   Controlled (i.e., the Contribution). Treas. Reg. § 1.1361-5(b)(1)(i) (section
   1361(b)(3)(B) and (C)).

2. The Contribution and the Distribution, together, will be a “reorganization” within
   the meaning of section 368(a)(1)(D). Distributing and Controlled will each be “a
   party to a reorganization” within the meaning of section 368(b).

3. Distributing will not recognize gain or loss on the Contribution. Sections 361(a)
   and 357(a).

4. Controlled will not recognize gain or loss on the Contribution. Section 1032(a).

5. Controlled’s basis in each asset received in the Contribution will be the same as
   the basis of such asset in the hands of Distributing immediately before the
   Contribution. Section 362(b).

6. Controlled’s holding period in each asset received in the Contribution will include
   the period during which Distributing held the asset. Section 1223(2).

7. Distributing will not recognize gain or loss on the Distribution. Section 361(c).

8. Distributing’s shareholders will not recognize gain or loss (and no amount will be
   includable in income) upon receipt of Controlled stock in the Distribution. Section
   355(a).

9. The aggregate basis of the Controlled stock and the Distributing stock in the
   hands of each shareholder immediately after the Distribution will equal the
   aggregate basis of the Distributing stock held by the shareholder immediately
   before the Distribution, allocated between the stock of Controlled and Distributing
   PLR-126886-20 7

   in proportion to the fair market value of each immediately following the
   Distribution in accordance with Treas. Reg. § 1.358-2(a). Section 358(a)(1) and
   (b).

10. Each shareholder’s holding period in the Controlled stock received in the
    Distribution will include the holding period of the Distributing stock, provided that
    the Distributing stock is held as a capital asset on the date of the Distribution.
    Section 1223(1).

11. Earnings and profits, if any, will be allocated between Distributing and Controlled
    in accordance with section 312(h) and Treas. Reg. § 1.312-10(a).

12. Distributing’s accumulated adjustments account will be allocated between
    Distributing and Controlled in a manner similar to the manner in which the
    earnings and profits of Distributing would be allocated under section 312(h) in
    accordance with Treas. Reg. § 1.1368-2(d)(3).

13. Distributing’s momentary ownership of the stock of Controlled, as part of the
    reorganization under section 368(a)(1)(D), did not cause Controlled to have an
    ineligible shareholder for any portion of its first taxable year under section
    1361(b)(1)(B), and did not, in itself, render Controlled ineligible to elect to be an S
    corporation for its first taxable year. If Controlled otherwise meets the
    requirements of a small business corporation under section 1361, Controlled will
    be permitted to make a subchapter S election under section 1362(a) for its first
    taxable year, provided that such election is made effective immediately following
    the termination of the QSub election.

                                      Caveats
    

Except as expressly provided herein, no opinion is expressed or implied concerning the
tax consequences of any aspect of any transaction or item discussed or referenced in
this letter.

                             Procedural Statements

This ruling is directed only to the taxpayer requesting it. Section 6110(k)(3) of the Code
provides that it may not be used or cited as precedent.

A copy of this letter must be attached to any income tax return to which it is relevant.
Alternatively, taxpayers filing their returns electronically may satisfy this requirement by
attaching a statement to their return that provides the date and control number of the
letter ruling.
PLR-126886-20 8

In accordance with the power of attorney on file with this Office, a copy of this letter is
being sent to your authorized representatives.

                                   Sincerely,



                                   _Susan E. Massey________
                                   Susan E. Massey
                                   Branch Chief, Branch 3
                                   Office of Associate Chief Counsel (Corporate)

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