IRS Reverses Longstanding Rule Regarding Spin-offs

Lehman Brothers tax expert Robert Willens explains how it affects companies with substantial real estate assets.
Robert WillensJune 12, 2001

In order for a spin-off to qualify for tax-free treatment, both the distributing corporation and the controlled (the spun-off) corporation must be seen as engaged in the “active conduct” of a trade or business.

This business, in addition, must have been actively conducted throughout the five-year period ending on the date of distribution and not acquired within that period in a transaction in which gain or loss was recognized in whole or in part. For this purpose, a corporation is treated as “actively” conducting a trade or business only if, in connection with such business, it (the corporation itself through its employees) performs “active and substantial” management and operational functions.

Although the activities of others, outside the corporation, such as independent contractors, are not counted for this purpose, a corporation can, still, satisfy the test even though some activities are performed by such outsiders. (See Rev. Rul. 73-234.)

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In Rev. Rul. 73-236, the IRS ruled, in effect, that a REIT was conclusively barred from participating in a tax-free spin-off. There, a corporation effected a spin-off and, immediately after the spin-off, and as part of the plan, converted itself into a REIT.

The question was whether the corporation, while qualifying as a REIT, was also engaged in the active conduct of a trade or business. It was not. Under the law then existing, a REIT’s income had to consist primarily of “rents from real property.”

At the time, Sec. 856(d)(3) excluded from that term amounts received (for the use of the REIT’s property) if the REIT rendered services to tenants or managed or operated such property. Thus, rental activities, conducted as a REIT, precluded the corporation from directly performing active and substantial management and operational activities and, consequently, the corporation was not seen, for purposes of the spin-off rules, as engaged in the active conduct of a trade or business.

However, since 1973, the law regarding permissible REIT activities has been liberalized. Under the statute, as amended, amounts that would qualify as “rents”, under Sec. 512(b)(3), which deals with permissible activities of certain tax-exempt organizations, will also qualify as “rents from real property” for purposes of the REIT rules.

Significantly, for this purpose, rental income received by an organization will so qualify even if it furnishes certain services to its tenants. Accordingly, in light of the change in the law governing REITs, the IRS. was forced (in newly-issued Rev. Rul. 2001-29) to admit that, now, a REIT is permitted to perform activities that can, within the meaning of the spin-off rules, constitute active and substantial management and operational functions.

As a result, a corporation that plans, in connection with a spin-off, to convert itself into a REIT will find that, assuming the other conditions for a tax-free spin-off are met, such spin-off can, for the first time, qualify for tax-free treatment. Thus, Rev. Rul. 2001-29 revokes, after its 28 year reign, Rev. Rul. 73-236.

This concession opens up some interesting possibilities for corporations that possess substantial real estate assets that would like to separate those assets, in a tax-efficient manner, from the operating business in which that realty is employed.

Presumably, the corporation can now, safely, “drop” the real estate into a new corporation the stock of which can be distributed to the corporation’s shareholders on a tax-free basis. The spun-off corporation can, promptly, convert itself into a REIT (in which posture it will be free of corporate taxes) and enter into appropriate leasing arrangements with the parent corporation. Such parent, which now only conducts its operating business, and which has shed its real estate assets, may well experience higher returns on assets and equity and, as a result, enjoy a higher stock price.

At the same time, the shareholders of the corporation, who now own the REIT’s stock in the same proportions that they own the parent’s stock, will own an income-producing vehicle that should, presumably, be assigned an appropriate valuation in the markets. One would think, therefore, that the sum of the parts should exceed the whole; the goal of most spin-offs.

On a micro basis, this ruling should pave the way for the IRS. to rule favorably with respect to the pending merger between The Timber Group and Plum Creek (a REIT). That transaction, which will be preceded by a spin-off of The Timber Group, by Georgia-Pacific, was conditioned on the IRS ruling that the preliminary spin-off was tax-free.

In light of Rev. Rul. 73-236, there was fear that the IRS would not so rule because, as part of the plan, The Timber Group was converting itself (via merger) into a REIT. Now, with the issuance of Rev. Rul. 2001-29, which, as indicated, stands for the proposition that a REIT can satisfy the active business test imposed with respect to spin-offs, the impediment that existed, regarding the ability to secure the I.R.S.’s blessing for this transaction, should no longer be present.

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