In Episode 24 of How Tax Works, Matt Foreman discusses how to divide two businesses into separate entities, focusing on the legal requirements and best practices.

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How Tax Works, hosted by FRB Partner Matthew E. Foreman, Esq., LL.M., delves into the intricacies of taxation, breaking down complex concepts for a clearer understanding of how tax laws impact your financial decisions. Through this, listeners are treated to a comprehensive breakdown of entity structures, from the robust shield of C corporations to the flexibility of partnerships and LLCs. Foreman navigates through the maze of tax considerations, shedding light on entity-level taxation, shareholder responsibilities, and nuanced tax strategies. Foreman shares valuable insights and practical advice, emphasizing the need for informed decision-making and consultation with tax professionals. From qualified small business stock to state and local tax considerations, no stone is left unturned in this illuminating exploration of tax law and entity selection.

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Transcript:

**This transcript has been prepared automatically by AI and may contain inaccuracies**

Matthew Foreman [00:00:00]:
Hello and welcome to the 24th episode of How Tax Works. I’m Matt Forman. This episode I will discuss tax free, really? Tax Deferred divisive reorganizations under 368A, 1D and 355, the Internal Revenue Code, or as they’re commonly known, D reorgs. How Tax Works is meant for informational and entertainment purposes only. This may be attorney advertising and it is not legal advice. Please hire your own attorney. How Tax Works is intended to help listeners navigate the intricacies and complexities of tax law, regulations, case law, and guidance to demystify how taxes shape the financial and business choices we all make.

Matthew Foreman [00:00:47]:
Before I get started, new episodes every two weeks. The next episode is going to talk about partnership divisions which are fraught with opportunities to mess up. I know I’ve. I’ve seen a few in my time. And if you have any questions, comments or constructive criticism, you can email me at my FRB email address, which you can find via your favorite search engine. Upcoming speaking gauges, webinars, et cetera, et cetera, et cetera are on the How Tax Works page on the FRB website. Now it’s time to talk about divisive reorganizations. Before we talk, before I start, one thing I want to note this is for C Corps and S Corps.

Matthew Foreman [00:01:21]:
Partnerships don’t go under this scheme em at all. We’re in subchapter C of the code. And so if you want to do anything with partnerships, you’re going to wait two weeks and listen to that bad boy right there. But that’s C and S corpse. If you’re doing trust, that’s different too. But I’m probably not going to talk about that because I don’t think most people really worry about that sort of stuff. So anyway, divisive reorganizations, okay, so there’s a number of requirements, you know, mechanical, legal, et cetera. You know, can be a bit, you know, can it can’t be a tax device, blah blah, blah.

Matthew Foreman [00:01:52]:
The first requirement that I always talk about with D reorgs is what I call the 9070 rule. I suspect I’m not the only person who uses that. But as part of it, you must transfer at least 90% of the net assets, which are, you know, assets minus liabilities, and at least 70% of the gross assets, which are the assets in ignoring liabilities. Right. And that’s really important to know that that’s sort of a starting point for what you’re doing. It’s also somewhat important word, somewhat, kind of loosely but to, to think like, what are you trying to do, right? You’re dividing it. So immediately after, right, you have the, the two companies and they’re owned by the same people in the same proportion. So if you two shareholders that own 50% of a company, they’re splitting.

Matthew Foreman [00:02:40]:
It has two businesses. I’ll get into that in a second. You can’t have it after, like I say, the company’s worth a hundred dollars. The two together afterwards, if they own 50, 50 before, they have to own 50, 50 in value after. You can’t change that. So some people are like, oh, what if we change how this works? We change how that works. No, no, no, no, no, no, don’t do it, don’t do it. It has to be the same thing, right? So that’s really important to do.

Matthew Foreman [00:03:02]:
One other thing I do want to point out before I get into it is, is really there, there’s straight W, but there’s three different variations on what can be a divisive reorganization under section 355. All right? And they’re spin offs, split offs and split ups. And I will tell you that I mix up the term all the time. And the way I get around that is by calling them divisive reorganizations or splits, right? Not really accurate, but that’s how I get around it. If you want a technical on a spin off is basically as follows. Common fact pattern is two people own it or one person, whatever. This one you can do is just one shareholder. And the businesses just make sense for business reasons to split them up.

Matthew Foreman [00:03:45]:
One interferes with the other. You want to get financing, you want to do certain things, et cetera. So what you have is two shareholders. This is going to be the fact pattern for all of them. Two shareholders, A&D own 50, 50 and you basically one corp with two divisions, two different businesses. Afterwards you have two corps and a and B each own half. So they own the same part. You just have corporation one, corporation two, right? So they each own half.

Matthew Foreman [00:04:10]:
The next one is a split off. Pretty common one. When the bi. They just, the owners disagree on the direction of the business. Owners disagree on a variety of things, right? So A and B, 50, 50 again. And then afterwards A owns 100% of X and B owns 100% of Y. Again, that’s assuming that the two lines of business, X and Y are equal in value. If they’re not, we need to have a conversation.

Matthew Foreman [00:04:32]:
You need to figure that out beforehand. Okay? Third one, split up. Split up is what happens when the partners hate each Other and can’t decide who gets the name. So what happens is instead of, you know, let’s say the current corporation is X Corp. What happens is A then owns Y Corp and B owns Z Corp. No one keeps X Corp. I don’t know. Kind of stupid, yes, me.

Matthew Foreman [00:04:52]:
But you know, so are a lot of business divorces, you know, if you really get into it. So it’s probably for the better that you don’t do it. And that’s, that’s how that works out. Right. So now you know there’s a number of requirements under section three. 55. I go so far as to say there’s seven. Cause that’s what my list and my notes say.

Matthew Foreman [00:05:08]:
And I think it’s important to go through all of them in order. All right, so first and foremost, the first one is that you’re having a distribution of a controlled corp. In the context of 368A 1D and 355, the two corporations as they’re split are called controlled and distributed. Right. Pretty obvious. The idea is basically that it allows you to make a tax free distribution of a corporation. Okay, and that’s it. Someone once asked me, if you do a tax redistribution of a S Corp, can you then elect to be a C? Yes.

Matthew Foreman [00:05:42]:
What if there’s two Cs? Can you be an S? Yeah, I think so. But you have these sort of weird issues of E and P and things like that. And I’ll get into why that deals with the device, which is much different later. But in terms of the two corporations, the first requirement is the distribution of the control Corp, where 80% of the vote and 80% of the value of each class of stock, you know, gets split up somehow. Right. So you really can’t, you know, do too much in terms of, you know, some people say, oh well, we’re going to do this and we’re going to split it six ways. And you know, everyone has to get involved in it. All the shareholders do.

Matthew Foreman [00:06:15]:
So you need, you need to vote. Number two is not a device. Okay, what is a device? A device is something that can distribute earnings and profits from a corporation whether it’s distributing or controlled without taxes. So what they don’t want is for you to split up two corps in a way that all the EMPs in one and not the other. And so it allows you, okay, section 301, if my recollection serves it correctly, through 1C, C1, 2 and 3. The way the rule works is if you have ENP and you make a distribution, it’s a dividend. If you don’t have ENP that it becomes a recovery. But you have basis, it becomes a recovery of basis.

Matthew Foreman [00:06:51]:
If you don’t have ENP and you don’t have basis, then it’s a taxable distribution after that. Okay. What they don’t want is to shift the E and p to 1, but leave the cash in the other so you can distribute it and take your basis back. They don’t want that. That would be considered a device. There are a number of factors that are considered not a device and are a device. They’re under 1 point Treasure AG 1.355 dash 2D 2D 3D5. The main ones that you know would say that the device factors.

Matthew Foreman [00:07:23]:
First one, you know, a pro rata distribution. So you know, dividends tend to be pro rata. Right. Second one is subsequent seller exchange of stock. That that really suggests you have a device that’s problematic. As a general rule, you actually don’t want to sell any either of them for a couple years because by not selling for a couple years it suggests it’s not a device. You know, two years, five years. I put in my documents that no one’s allowed to sell for two years at least as a general rule, just so they don’t deal with it.

Matthew Foreman [00:07:51]:
The third one is the nature and use of assets. So if you’re using it to distribute, you know, one has is a core business. It was a core business, but it’s smaller and you just kind of pack assets in it that could be considered a device because you know, if one has a lot of cash, that’s a way to sort of distribute out by lowering the E and P amount or, or shifting the NP otherwise. So I think it’s really important, you know, not to over. You know, sometimes tax goes one or cash goes one way or the other to even up the asset value, the total asset value or some other factor. But you know, don’t, don’t jam it one way or the other. If you have a lot of cash, you know, distribute the cash before, use it as a partial liquidation and then do it over. People say oh, that’s taxable.

Matthew Foreman [00:08:30]:
I’m sorry, you know, sucks for you. The next one, you know, number of factors that are not devices. Right. Publicly traded. If one, if the company’s publicly traded, they’re spinning it off. Really hard to do this kind of tax planning on publicly traded companies. Just, just tough to do. They would they really watch out for closely held companies.

Matthew Foreman [00:08:47]:
You know that there’s a corporate Business purpose, if you have a real purpose for doing it. I’ve seen a number of times where, you know, they’ll have three pieces of real property and they just want to split them up because they want to use it to, you know, leverage up one piece of property or they want to do different things with them and they just think having this one is. Or, you know, let’s say there’s an environmental risk with one, so they want to just shelter the other two. And they’re like, well, you know, that’s not a great one. That’s really not a great one. But it’s something like that, right? The next one is a distribution to corporate shareholders, you know, not likely to be a device because like corporate shareholders all pay 21%. There’s no capital gains, there’s no ordinary income. So the fact that there’s not, you know, really a huge disparate between dividends or near income for a corporate shareholder suggests it’s not a big deal.

Matthew Foreman [00:09:35]:
You know, transaction one, if there’s no E and P, not an issue, things like that. There’s also one for 302 transactions. Not going to talk about that. But that’s really brother, sister or parent, sibling corps. They become brother sisters, have the same one. So if you still have same ownership after, probably not a huge issue. But you know, a lot of device factors, right? Active trader business is, is the third one. But I’m going to take a quick, quick break break and I’ll give you some music and I’ll be back in a moment.

Matthew Foreman [00:10:10]:
So I’m back. Let’s talk about the active trader business requirement under 355. So you need either the distributing and controlled must be engaged in an active trader business immediately after the transaction, right? Or you need what’s called the holding company rule. So this is important for the active trader business. You only need one active trader business to start. You need two afterward. So what happens is, let’s say you own two supermarkets, right? You just want to split them up, you know, one’s doing well. There’s different kinds of business.

Matthew Foreman [00:10:39]:
Shareholders want to do different things with it. You know, just different. Whatever business reason for splitting them up, it’s only one trader business, most likely for one supermarket. For two supermarkets, split them up, each have one after. That’s fine. You don’t need to have two separate lines of business. You don’t need to have a car dealership at a car wash, right? Doesn’t need to be the same, doesn’t need to be a different business before, right? Then what’s called the holding company rule 355B1 cat B. Right is immediately before the distribution distributing court had no assets other than the stock or securities of the controlled corp.

Matthew Foreman [00:11:12]:
And immediately after the distribution each controlled corp is engaging in the active COD perpetrator business. Kind of like a fear 2 but basically you have a C corp that owns 2 corps underneath and they distribute both out. Right? So you kind of get rid of the holding corp. That’s generally fine for the active trader business requirement. Not an issue. The important thing is you must have an active trader business for five years before the acquisition. At least five years. If, if, if you acquired it in, in and this is important if you acquired it within five years.

Matthew Foreman [00:11:42]:
The trader business within five years it must have been acquired in a completely tax free acquisition. Type A 351 et cetera, et cetera. Whatever it is, if it’s not tax free then you don’t do it. You can’t use 355. What they don’t want is people to buy businesses and then you know, use it to buy a business with cash to spin off another business. And then what happens is. Then what happens is you have, you know you’ve, you’ve basically bought a business. You get a step up in basis.

Matthew Foreman [00:12:09]:
You can use that to shift that emp, use that, shift that basis. Not great. Right? So that’s tough. You have rules with, you know, you acquired as a creeping acquisition and that’s fine, right? One year ago, not great. You know. But if you acquired it slowly over a long period of time. It depends. Right? Really interesting one.

Matthew Foreman [00:12:29]:
What if 95% of the voting stock was four years ago and then cash for the last 5%. You know, control. The key is it’s not necessarily 100% but control has to be acquired tax free. I always feel more comfortable if you did a hundred percent tax free. But you know there’s some regs that deal with it, deal with different timeframes and things like that. They just don’t want someone to buy a corp and use that to spin them off. Basically every, you know, use free cash from a business to buy something that device of reorganization to basically not say give but have an exiting shareholder take the business and walk away. Right? Different.

Matthew Foreman [00:13:05]:
So number four, no retention through 55A1 cap D. So the distributing corp must distribute everything or the distributing corp must distribute an amount that constitutes control and a non avoidance of the tax purpose. So basically distributing corp has to distribute all of the controlled corp. There are situations where Distributing Corp. Actually retains some ownership in the controlled. That does happen but you need to get control out. Generally speaking you probably, you know, for DRD and tax efficiency reasons you want to completely push it out. But it depends.

Matthew Foreman [00:13:36]:
5. Business purpose. Business purpose which is a purpose independent of the actual split. There’s a couple rev procs. There’s a Rev Proc of 9630 and Revenue Ruling 2004 Dash 23 that talk about it. They give examples, right? Key employee easier to give equity. They only want equity in one company. Don’t do tracking.

Matthew Foreman [00:13:55]:
Stock a stock offering. Make it so you divide. You divide and then you do a stock offering to raise money for one business. They, you know, you can’t raise money if you have sort of another business in there. Facilitate borrowings, cost savings. You know, sometimes there’s just savings on insurance borrowing costs. By getting rid of a business that may be struggling a bit. Fit and focus.

Matthew Foreman [00:14:14]:
You have multiple businesses that create and they create inefficiencies, disagreements on how to manage the business because of that competition, you know you’re going to decrease costs, increase sales by split, splitting stuff out. Facilitating an acquisition of the distributing corp. Or by distributing or controlled. So basically, you know, look like we can’t, you know, sell one of them or do another merger or something like that without the division or we can’t make an acquisition without a division. Right. Those are reasons. And also each company has more valuable stock. So you know, just generally like it’s accretive to split them.

Matthew Foreman [00:14:49]:
Believe it or not, it’s a good reason. 6. Continuity of interest right? Both contributing controlled. Must be at least half owned after the transaction by the prior shareholders. So what happens is, you know, you split it and new people come in, you know, not great. If you split it then they end up only owning 30 or whatever. So you have to sort of watch out for it. If you’re doing multiple D reorgs in one shot, you know, each one must be, you know, greater than 50 own.

Matthew Foreman [00:15:17]:
So I think that’s important. These are all at the shareholder level. There is some math that goes into it. Really good, really good. Example in the regs example 4 under 1.3552 C2 I’m not going to go through it. I don’t think it’s worth it. But I think that that’s really something you want, you know, you want to watch out for. And finally the last requirement is the continuity of business enterprise.

Matthew Foreman [00:15:41]:
So you must continue the businesses that were conducted after the transaction. There’s no time frame for this. So, you know, some people say, oh, well, you know, this business, I’m going to shut it down in six months. Don’t necessarily have that plan in place. Right. But you might split off and say, look like one’s going to continue for 30 years. One, it’s got five year, five year run. We’ll see where it is at the end of five years.

Matthew Foreman [00:16:00]:
That’s fine. You’re continuing it. You’re going to try to earn money and continue the business. It might, just might not work. You know, people always say, okay, you know, so what does this mean? Right? I got to tell you that there is an underrated complexity here. That’s two things. One, the basis that goes with each. So you’re going to have basis in the stock.

Matthew Foreman [00:16:18]:
How does that basis track for the new corpse? And two, how do you split up the E and P earnings and profits of the company? Which is a huge issue. Right. You have to do that properly. So basis generally fair market value of the company after. And the ENP gets allocated in proportion which with the fair market value of the assets transferred and retained. Right. With the assets that go each way, section 312H and 1.3 1210 a deal with that. And I think that’s really important to know, you know, what’s going on there.

Matthew Foreman [00:16:51]:
Okay. Before I bring it on home, let’s take another quick break and I’ll be back in just a moment to finish this bad boy up. All right, we’re back. So what happens if you mess up? Right? You don’t do this properly. Not great. Right? You’re going to trigger 3 11B and it’s as if you distributed an appreciated asset which causes tax to the corporation S or C. And then if it’s a C, you’re going to have a tax on the distribution itself as well. If it’s S, you won’t, you know, because there’s only one layer of tax.

Matthew Foreman [00:17:30]:
So not, not great. You know, it’s commonly referred to as a disguise sale. 355D. So I think that’s really important. You know, that’s there’s a lot of ways to do it. You just don’t do it. Right. There’s not enough ownership in either of the companies, et cetera, et cetera.

Matthew Foreman [00:17:45]:
And you know, again, the stock was acquired the taxable transaction within five years prior to the distribution. We actually had a client wanted to do a D reorg spinoff to go to IPO and couldn’t because that would have caused the spinoff to be taxable and no one really wanted that so had to sort of think through another, another issue. One point, you know, this is a real short, short episode for me. One point I want to make is 355 Ian Morris Trust. For those who’ve never heard of Morris Trust, basically the idea was that you would spin off one business and merge another, right? And Morris Trust had sort of a step transaction in it. And I’m not going to go into Morris Trust because it took a little more effort than it’s going to go to. And without pictures I don’t think I can do it justice. And I’m not going to create a handout for this one.

Matthew Foreman [00:18:37]:
But you know, Google 355 Morris Trust, it’ll talk about it. People lean into Morris Trust transactions. It’s a common one. If you, if people in the reorg space, they’ll talk about, well, isn’t that a Morris Trust? And answers, you know, sometimes yes, and that can be fine. This is a point that I make with some frequency. But if you know the tax consequences sometimes, you know, creating tax is not necessarily a bad thing. You just have to really think through is this the right way to do it? And that’s the important thing, right? Divisive reorganizations. Whole idea is tax free, really tax deferred.

Matthew Foreman [00:19:10]:
Sometimes, you know, it can be a not terrible thing to, to trigger some tax. You know, you may have a, you know, especially for an S corp, you may have a shareholder who has, you know, an NOL or they have something else that’s going on and they’re able to use that gain to offset otherwise. So I think that’s important, right? So finally. All right, that was the 24th episode of how tax works. I hope you learned something. We’ll be back two weeks, 25th episode where I’m going to talk about partnership divisions. Now some music to bring it all home.