Section 355 Revisited: Time for a Major Overhaul?

Abstract

Section 355 of the Internal Revenue Code permits a corporation that conducts multiple active businesses to distribute controlling stock ownership interests in one or more of such businesses to all or some of its shareholders on a tax-free basis, provided that various statutory and non-statutory requirements are met. Commonly known as “spin-offs”, “split-offs” and “split-ups”, qualifying section 355 distributions are often preceded by a transfer of assets (and sometimes liabilities) into the distributed controlled corporation, as part of an overall type “D” divisive “reorganization” described in section 368(a)(1)(D). Non-recognition treatment for at least some forms of corporate separations dates back to the Revenue Act of 1918. The 1954 Code iteration of section 355, which continues to provide the basic statutory framework for tax-free treatment, has been amended several times in order to tighten various qualification requirements and, in certain instances, to impose a corporate level tax on the distributing corporation (via sections 355(d) and (e)) even through the transaction still generates tax –free treatment at the shareholder level. In general, however, the primary distinguishing tax feature of section 355 transactions is that they permit tax-free treatment at both the shareholder and corporate levels, thus constituting the principal exception to the statutory repeal of the so-called General Utilities doctrine during the mid-1980s. The main premise of this article is that section 355 is due for a major overhaul. Following an Introduction in Part I, Part II of the article discusses the core principles that commonly underlie non-recognition treatment for both acquisitive and divisive reorganizations. Part III traces the evolution of section 355 and its statutory predecessors, including (i) the impact of the seminal Supreme Court decision in Gregory v. Helvering; (ii) the several sets of Treasury regulations under section 355 that have been promulgated, amended and proposed over the years; and (iii) the frequently changing and critically important IRS ruling policies with respect to section 355 transactions. Part IV suggests possible reform measures (summarized in Part IV.A) that would streamline and better objectify the statutory and non-statutory requirements of section 355 by (i) eliminating certain overlaps and discontinuities between such requirements; (ii) imposing specific restrictions and limitations regarding post-distribution stock and asset dispositions; and (iii) repealing or combining existing sections 355(d) and (e). Part V, the Conclusion of the article, capsulizes the main thrust of any ultimate section 355 overhaul -- namely, to implement changes that (i) limit the application of section 355 to corporate separation transactions in which primarily active business assets of the distributing corporation are shifted into stand-alone corporations that continue to be owned primarily by the distributing corporation’s shareholders; (ii) deny nonrecognition treatment where substantial amounts of nonbusiness assets change hands and a substantial complement of new shareholders enters the picture; and (iii) preserve the integrity of General Utilities repeal.