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Today in Tax: Spin-off Structures in Mergers & Acquisitions



Brief commentary on the past week’s cases, rulings, notices, and related federal tax guidance.

Corporations Permitted to Rely on Public Shareholder Data to Confirm Qualification for Tax-Free Spin-off and Subsequent Merger

Tax free spin-off transactions are subject to strict rules relating to how and when they may be used in conjunction with a subsequent sale or divestiture. This latest ruling from the IRS provides guidance on how to apply permissible methodology to help determine if a pre-sale spin-off will qualify for tax-free treatment. There is a high cost for failing to qualify a spin-off transaction as tax-free, so there is value in obtaining rulings to support the proposed qualification.

In a recent ruling (PLR 202145020) the IRS addressed a proposed spin-off transaction where the spun-off subsidiary would be immediately acquired by a third party in a reverse triangular merger. In this situation, the subsidiary corporation would be expected to be separated from its parent corporation by virtue of the parent corporation distributing to its shareholders all of the subsidiary corporation stock held by the parent. If qualified as a tax-free spin-off, this distribution would not cause the parent or the shareholders to recognize taxable gain. In the event the spin-off transaction did not qualify for tax-free treatment, then the distribution of subsidiary stock would be taxable. Because the subsequent acquisition is also intended to be a tax-free transaction, a taxable spin-off would be an unwanted surprise for the shareholders who might have otherwise expected not to recognize taxable income in the transaction.

The crux of the ruling lies in a particular restriction on using a tax-free reorganization to transfer ownership of a corporation to a third party. Specifically, a spinoff that results (either directly or through a series of transactions) in a change in greater than 50 percent ownership of the parent or subsidiary corporations’ stock (measured by vote and value) will be treated as a taxable dividend, rather than a tax-free reorganization. There is, however, a special computation rule that allows the taxpayer to disregard any stock ownership that does not decrease (for example, stock owned by a minority owner that, post-acquisition, would hold a larger share of the combined entity than in the acquired corporation would not be included in the calculation to determine whether a 50 percent ownership change has occurred (this is called the “net decrease methodology”)).

To establish that the proposed spin-off and subsequent merger have not resulted in a 50 percent ownership shift based on the net decrease methodology, the taxpayer proposed identifying the ultimate beneficial owners based on the actual knowledge of key personnel within the corporations and on any publicly available information reported in securities filings and investor or investment advisor websites. In this instance, the IRS agreed with this approach. This is a bit of an expansion in the sense that in prior rulings (for example, PLR 201603005), the IRS approved the application of the net decrease methodology but did not go so far as to approve any particular method of identifying the affected shareholders (likely because the taxpayer in that ruling did not ask for such a ruling).

Reorganization on Heels of Business Sale Satisfies Certain Continuity Requirements for Tax-Free Treatment

There is a great deal of detail we don’t know about the taxpayer in this ruling and what options were available to them. Nonetheless, this ruling illustrates that although there are many statutory and regulatory constraints on tax-free reorganizations in connection with a sale transaction, there are usually several options at your disposal. Competent tax counsel can often find creative ways to achieve client goals. This ruling also clarifies that an earlier deconsolidation or sale of a line of business is not incompatible with subsequent tax-free reorganization planning.

On November 12, 2021, the IRS issued Private Letter Ruling 202145025 (PLR 202145025), in which the requesting taxpayer intended to undertake a series of transactions to deconstruct its organizational structure and sell off one of its lines of business. The overall divisive goal of this transaction often lends itself to a tax-free spin-off (for example, as discussed in PLR 202145020 above), but there were likely factors undisclosed in the ruling that precluded such an approach. Instead, the organization essentially collapsed its two lines of business into a lower-tier parent corporation and a subsidiary corporation. The lower-tier parent merged into a newly formed LLC, with the LLC surviving. The resulting LLC made a tax-free distribution of the stock of the subsidiary to an upper-tier parent owner, and was thereafter sold in what we expect was a taxable equity sale. The final step to this transaction involved the creation of a subsidiary LLC, wholly owned by the subsidiary corporation, into which the upper-tier parent corporation would be merged in a downstream merger. When the dust settled, this would leave the ultimate owner as the sole owner of the subsidiary corporation, with no loose ends.

One of the issues addressed in this ruling is whether the final downstream merger would qualify as a tax-free reorganization, given the deconsolidation of the original taxpayer’s consolidated filing group and the sale of a significant line of business. One of the requirements for a tax-free reorganization is that there must be “continuity of business enterprise”—that is, the historic business and assets of the organization must be preserved in whatever form results from the planned reorganization. Because of this requirement, the deconsolidation and sale of business lines could be fatal to tax-free treatment in certain circumstances. Although the IRS ruled in favor of the taxpayer, the ruling doesn’t make it entirely clear why. Presumably it is because the taxpayer ultimately retained an entire historic line of business without alteration (other than capital structure).

As an interesting counterpoint, the continuity of business enterprise requirements are not generally applied in the divisive reorganization and spin-off contexts. Specifically, the Preamble to TD 8760 indicates the IRS hasn’t extended regulations governing continuity of business enterprise “D” reorganizations, “F” reorganizations, or Section 355 transactions, as further study is required to determine if such requirements are warranted. So, there may be cases where, facts permitting, a spin-off transaction could be a preferable approach.

Access last week's installment here.

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