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When Risk Reduction Yields Tax Deductions

The IRS seems to change its mind on how to tax small-company spin-offs.
Robert Willens, CFO.com | US
May 23, 2011

Under previous interpretations of tax law, certain kinds of companies looking to spin off subsidiaries for the purpose of shedding risks would be taxed on the costs of distributing shares as part of the transaction. But the Internal Revenue Service may have changed its mind, suggests a recent ruling in which risk reduction justified a deduction.

To grasp the IRS's previous thinking, let's look at an example from the literature of tax regulation: a company named X Corp. makes and sells toys and candy. X's shareholders want to protect the candy business from the risks and vicissitudes of the toy business. Accordingly, X transfers the toy business to a spin-off, Newco, and distributes the stock of Newco to its shareholders.

Under what the IRS saw then as existing tax law, the
spin-off didn't qualify for a deduction because it wasn't driven by a "business purpose" that couldn't be achieved in some other way. The purpose of protecting the candy business from the risks of the toy business was achieved as soon as X transferred the toy business to Newco. Thus, X's distribution of shares wasn't carried out for a corporate business purpose because the purpose could have been achieved through a nontaxable transaction (the contribution of the risky business to Newco) not involving a distribution. The purpose could have been achieved simply by setting up the new company, the reasoning went. Hence, the expense involved in the spin-off was taxable to both the corporation and the new shareholders.

But the law (or the IRS's version of it) appears to have changed, the March 12 letter ruling (LTR 201010023) suggests. The question was brought by an "S corporation," which we'll call Distributor Corp. (S corporations, which are limited to 100 shareholders, pass corporate income, losses, deductions, and credit through to their shareholders for federal tax purposes. The shareholders report the flow-through of the corporation's income and losses on their personal tax returns and are assessed tax at their individual income-tax rates.)

Distributor Corp., which makes a product we'll call Widget A, owns all the stock of a subsidiary dubbed Controlled Corp. For its part, Controlled owns all the shares of CS, another firm. Both Controlled and CS are "qualified subchapter S subsidiaries" (QSUBs), meaning they're not treated as separate from Distributor. Further, all their assets and liabilities are treated as assets and liabilities of Distributor, which owns 100% of their stock.

Controlled and CS, however, make Widget B, which exposes Distributor to pollution liabilities and potential cleanup costs. Protecting its Widget A business from the environmental risks involved in manufacturing Widget B was one of three key reasons for the plan submitted to the IRS by Distributor to spin off Controlled and CS.

The second reason Distributor wanted to proceed with the spin-off was to provide retention incentives to key employees of Controlled by increasing their equity interest in Controlled. Distributor's third reason was to create a capital structure that would allow key employees to have voting control of Controlled after the death of that company's majority shareholders.

Under the spin-off, Distributor planned to dole out the stock of Controlled to certain shareholders in exchange for some or all of their stock in Distributor. Controlled would elect to be treated as an S corporation immediately after the distribution.

The IRS concluded that the transaction would end Controlled's status as a QSUB, since it would no longer be wholly-owned by an S corporation. The distribution would be treated as if Controlled were a new corporation acquiring all the assets (and assuming all the liabilities) of Controlled and CS from Distributor. In essence, the IRS found that the spin-off expenses claimed by the participants as a deduction from their taxable income served a genuine business purpose, rather than representing an attempt to avoid taxes.

Could that purpose be achieved through another tax-free transaction, not involving the spin-off? Apparently not, the IRS ruled. It may have once thought differently.

Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for CFO.com.




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