In a private letter ruling (PLR), IRS has held that a series of proposed transactions by three related corporations in order to separate two lines of business will be treated as tax-free recapitalizations and spin-offs. Accordingly, no gain or loss will be recognized by any of the corporations or their shareholders as a result of the transactions.
Background. A Type E reorganization is a recapitalization or change in the capital structure of a single corporation. (Code Sec. 368(a)(1)(E)) A recapitalization may be achieved through an exchange of stock for stock, bonds for bonds, stock for bonds, or bonds for stock.
A corporate division may be accomplished on a tax-free basis in the form of a spin-off, i.e., a pro rata distribution of a controlled corporation's stock to the distributing corporation's shareholders without requiring the shareholders to surrender any of their distributing corporation stock. A number of requirements must be satisfied in order to qualify for tax-free treatment. (Code Sec. 355)
Facts. Parent, a State A corporation formed in Year 1, is the common parent of an affiliated group of corporations that files a consolidated federal income tax return. Parent is a holding company with one class of stock outstanding. The stock of Parent is owned by a number of shareholders, two of which (Shareholders 1 and 2) own more than 5%.
Sub, a corporation from State B, is a wholly-owned subsidiary of Parent and a member of Parent's group. Sub has been engaged in Business A for an undisclosed number of years.
Controlled, a State A corporation, was a member of Parent's group until Date 1. Controlled has been engaged in Business B since Year 2. Controlled currently has outstanding one class of voting common stock (Class A) and one of class of nonvoting common stock (Class B).
Sub acquired Controlled in Year 3 and owned all of its issued and outstanding stock until Date 1, when Shareholder 3 paid an undisclosed amount to Controlled for the issuance of a number of shares of voting stock. Shareholder also made a payment to Sub for a 3-year option to acquire additional shares in Controlled.
Sub, Shareholder 3, and Controlled entered into a stockholders' agreement as of Date 1 that currently remains in effect. The agreement provides that Controlled's board of directors be comprised of a number of members who are designated by Sub, a number of members who are designated by Shareholder 3, and a number of whom must serve as an executive officer of Controlled and be reasonably acceptable to Sub and Shareholder 3. The agreement was subsequently amended to increase the exercise price of Shareholder 3's option and provide that, if the option expires unexercised on Date 4, Controlled would issue shares of nonparticipating preferred stock to Sub. The option was not exercised, entitling Sub to be issued preferred stock.
On Date 2, Controlled issued a number of shares of Class B stock to certain of its current and former employees. This stock may be converted by Controlled into shares of voting common stock upon a shareholder vote and may be redeemed at any time for fair market value (FMV). On Date 5, Controlled issued additional Class B shares to certain employees, and it repurchased shares from an employee who left the company on Date 6.
The senior managements of Parent, Sub, and Controlled have concluded that a separation of Businesses A and B would enhance the successful operation of both businesses, citing among other reasons the fundamental differences between the two businesses and the lack of synergies from their combination. Notably, separating the businesses would allow each to pursue tailored growth strategies, allow Controlled to improve the terms of the contracts with current suppliers and possibly provide access to new suppliers, allow Controlled to tailor compensation programs and issue equity-based compensation to its employees, and promote efficiency.
Proposed transactions. Parent, Sub, and Controlled propose engaging in the following transactions in order to separate Businesses A and B:
1. Controlled will redeem all of the Preferred Stock, or distribute such stock together with the Class A stock in Step (5).
2. Controlled's charter will be amended to: (i) provide each share of nonvoting common stock with a vote, including for the election of directors (Recapitalization 1); (ii) expand the board of directors, with Sub appointing the additional directors and replacing the Controlled directors that are also officers or directors of Sub; and (iii) create a new class of stock (Class C) with special voting rights for which Shareholder 3 will exchange its Class A stock (Recapitalization 2).
3. Through a stock split, recapitalize all of the outstanding Class A Stock, Class B Stock and Class C Stock to increase the total number of shares of each class to a number determined appropriate (Recapitalization 3).
4. Sub, Shareholder, and Controlled will amend the stockholders' agreement to eliminate Shareholder 3's current rights to designate directors.
5. Sub will distribute to Parent (i) all of its Class A Stock representing at least 80% of the voting power of Controlled's outstanding stock, and (ii) to the extent not previously redeemed or settled, all of its outstanding preferred stock, representing 100% of the only nonvoting class of Controlled's outstanding stock (the Class A stock together with any preferred stock distributed—collectively, “Controlled stock”) (“Spin-Off 1”).
6. Sub will distribute all of its Controlled stock to the shareholders of Parent on a pro rata basis (“Spin-Off 2”). Neither Sub nor Parent will retain any Controlled Stock following the Spin-Offs.
7. Immediately following the Spin-Offs, the stockholders' agreement will be further amended to add Shareholder 1 as a party with respect to certain provisions and remove Sub. Also, following the Spin-Offs, the board of Controlled might (but is under no obligation to do so) propose a shareholder vote to convert the Class A, B, and C stock into a single class of common stock, or propose to convert the Class B stock into Class A stock.
Various representations were made in association with each of the transactions.
Favorable rulings. The PLR concluded that Recapitalizations 1, 2, and 3 will each be treated as a reorganization within the meaning of Code Sec. 368(a)(1)(E), with no gain or loss recognized respectively by the Class B Shareholders, by Shareholder 3, or by Sub, Shareholder 3, or the Class B shareholders as a result. (Code Sec. 368(a)(1)(E); Code Sec. 354(a)(1))
IRS further held that no gain or loss will be recognized by Parent or Sub upon their respective receipt and distribution of the shares of Controlled stock as a result of Spin-Off 1, and no gain or loss will be recognized by Parent shareholders or Sub upon their respective receipt and distribution of shares of Controlled Stock as a result of Spin-Off 2. (Code Sec. 355(a)(1); Code Sec. 355(c))
The aggregate basis of the Controlled Stock and the Parent stock in the hands of Parent's shareholders will be the same as the basis in the Parent stock held immediately prior to Spin-Off 2, allocated in proportion to the FMVs of the Controlled stock and the Parent stock. (Code Sec. 358(a)(1); Code Sec. 358(b); Reg. §1.358-2(a)(2)) The holding period of the Controlled stock received by Parent's shareholders in Spin-Off 2 will include the holding period of the Parent stock with regard to which Spin-Off 2 will be made, provided that such stock is held as a capital asset on the date of Spin-Off 2. (Code Sec. 1223(1))
References: For recapitalizations, see FTC 2d/FIN ¶F-3000; United States Tax Reporter ¶3564.05; TaxDesk ¶235,001; TG ¶5163. For spin-offs, see FTC 2d/FIN ¶F-4600; United States Tax Reporter ¶3554; TaxDesk ¶235,601; TG ¶5168.