Monday, January 16, 2017
Last week I posted on the accumulated earnings tax and the personal holding company tax. Those two taxes are possible in the C corporation context, and there could be more C corporations formed in the future if the corporate tax rate is cut as proposed.
Another issue related to C corporation is the opposite side of the coin. What if C corporate shareholders want out of the C corporate form? Perhaps there is hostility among the shareholders, or the C corporation no longer fits with the estate and succession planning desires of the family. Or maybe there is some other reason to change the structure of the business.
Well, when it comes to getting out of the C corporate structure, most of the options aren’t good from a tax standpoint. But, a “Type D” divisive reorganization can be a tax-favored way to get out of the C corporation and also satisfy the family’s estate and business planning objectives. The Type D divisive reorganization is the most widely used type of corporate reorganization for farming and ranching operations and is carried out in three steps. First, a subsidiary corporation is formed. Then, an exchange of property for stock occurs by carving out the machinery, livestock and land that is to be transferred to the new subsidiary. Finally, the new owners of the subsidiary give up the stock in the parent corporation for all of the stock in the subsidiary. At this point, the subsidiary is cut loose from the parent corporation. If the reorganization is conducted properly, it should be tax-free. However, a corporate division will not be tax-free unless it is carried out for a legitimate business purpose and there is an active trade or business. Those two requirements are the focus of today’s post.
Tax-free Reorganization Basics
A separation of business interests through a divisive reorganization in accordance with I.R.C. §368 and §355 is the only tax-free method of separating a corporation’s business. There are various types of reorganizations in the Code but, as noted above, a " Type D" reorganization is governed by I.R.C. §368(a)(1)(D) which requires that after the transfer of assets to a newly created subsidiary corporation in exchange for stock in that entity, the original corporation must distribute the stock of the new corporation to its shareholders in a transaction qualifying under I.R.C. §355.
Business Purpose Requirement
In order for I.R.C. §355 to apply to the distribution of the newly-formed entity’s stock, the distribution cannot principally be a device for the distribution of earnings and profits of either or both corporations. I.R.C. §355(a)(1)(B). The reorganization must be motivated, in whole or substantial part, by a corporate business purpose rather than a shareholder purpose. That’s a determination that is based on all of the facts and circumstances surrounding the transaction.
So, what qualifies as an acceptable business purpose? Clearly, if the sole purpose of a transaction is to minimize federal income taxes, the transaction is likely doomed. See, e.g., Wortham Machinery Co. v. United States, 521 F.2d 160 (10th Cir. 1975). But, serious shareholder disagreements that could negatively affect the efficient operation of the corporation’s business qualify as a legitimate reason to divide the business tax-free. See Athanasios v. Comr., T.C. Memo. 1995-72; Treas. Reg. §1.355-2(b). That is good news for farming and ranching operations where there is family disharmony that could threaten the future of the operation. See also Priv. Ltr. Rul. 9713020 (Dec. 30, 1996). The corporation might be able to be divided tax-free with one shareholder or shareholder group being separated from another shareholder or group.
But, there doesn’t necessarily have to be family problems for a corporate division to qualify as tax-free. The IRS has ruled that a family farming operation can be divided and the business purpose requirement of Treas. Reg. § 1.355-2(b) satisfied even though the distribution is intended, in part, to further estate planning goals and family harmony. This is similar to Treas. Reg. §1.355-2(b)(5) which says that a valid business purpose can exist even though the shareholder split is amicable rather than hostile where the reason for the split is different shareholder business interests. In the IRS ruling, Rev. Rul, 2003-52, 2003-1 C.B. 960, the IRS ruled that the reorganization was motivated by substantial nontax business reasons, and accordingly met the I.R.C. §355 tax-free divisive reorganization rules. Although the reorganization advanced the personal estate planning goals of the parents and promoted family harmony, substantial business reasons were associated with the separation of the two children from the single business activity that the corporation used to conduct.
Active Business Requirement
I.R.C. §355 requires that after the distribution of the subsidiary corporation’s stock, both corporations must be engaged in the “active conduct of a trade or business.” I.R.C. §355(b)(1)(A). The Code does not define “active trade or business,” but the regulations state that, “A corporation shall be treated as engaged in a trade or business…if a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such group include every operation which forms a part of, or a step in, the process of earning income or profit. Such group of activities ordinarily must include the collection of income and the payment of expenses.” Treas. Reg. §1.355-3(b)(2)(ii). A rental activity is not considered an active business for this purpose “unless the owner performs significant services.”
A Type D reorganization can be complicated when the farm or ranch operation has an existing lease or leases with respect to its land. For various reasons, it is fairly common for farm and ranch corporations to operate its business activity on certain tracts of land and lease other tracts to others – either unrelated tenants or shareholders. In these situations, it is common for the shareholders to want to transfer the leased ground (and perhaps some equipment) to the newly created corporation so that the departing shareholder(s) can operate that ground separately. But, this can create the potential for a fully taxable corporate separation if the IRS determines that the property transferred to the newly created subsidiary (the leased land) has not been used in the active conduct of a trade or business. Treas. Reg. §1.355-3(b)(2)(iii).
This all means that the type of lease matters, as does the involvement of the corporation with that leased land. As noted earlier, the leasing of land generally does not constitute the active conduct of a trade or business. Treas. Reg. §1.355-3(b)(2)(iv)(B). Thus, If the primary asset to be transferred to the newly-created corporation is land leased to tenant farmers or to a shareholder, the corporate division may be unable to meet the requirement that both corporations are engaged in an active trade of business with a five-year history (another requirement not discussed in this post).
A standard cash lease arrangement would fail the active trade or business requirement. Under the regulations, a corporation conducts an active business only when the corporation itself performs, “active and substantial management and operational functions. In the case of a farm or ranch corporation leasing property under a crop-share arrangement, the degree of involvement of the officers and employees of the original corporation in the management and operational functions relating to the leased property will determine whether the corporate division can be accomplished tax-free.
Instructive on the leasing issue for farming operations are two IRS rulings. Practitioners should compare Revenue Ruling 73-234, 1973-1 C.B. 180 with Rev. Rul. 86-126, 1986-2 CB 58. What those ruling instruct is that merely leasing agricultural land under a crop-share arrangement, by itself, will not be treated as an active business within the meaning of I.R.C. §355. A corporation leasing agricultural land will have to demonstrate more than a moderate degree of involvement in the managerial decisions relating to the farm or ranch activity. This seems to indicate that a lease that meets the definition of a material participation crop-share lease for I.R.C. §1402 purposes is necessary. In addition, the corporation must perform substantial managerial and operational activities. Such things as hiring seasonal workers; supplying and maintaining equipment, arranging financing, planning crop rotation, planting and harvesting, selling crops and accounting to the tenant farmers are all helpful in meeting the standard.
Documenting a Type-D Reorganization
Over a decade ago, the IRS said it would no longer issue rulings on whether a proposed transaction qualified as a Type D reorganization. While that’s still the case for the overall transaction, the IRS will now issue a letter ruling, upon request, on whether a distribution has a corporate business purpose or is a device for purposes of I.R.C. §355, but only when a legal issue is present and the matter is not entirely factual. Rev. Proc. 2016-45, 2016-37 I.R.B. 344. So, it’s still necessary to document in detail how a transaction meets all the requirements of a divisive reorganization, including the business purpose and active trade or business tests.
We’ve just scratched the surface of the details involved when a Type D corporate reorganization transaction is utilized. But, for some farm and ranch operations, it is an option that can work well to facilitate estate and business planning goals when a C corporation is involved.