Active Trade or Business Requirements in a Section 355(b) Split Transaction

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Generally, a transaction must satisfy two sets of requirements to qualify as a tax-free transaction pursuant section 355, IRC.  First, the transaction must satisfy the statutory requirements in section 355 itself (i) control; (ii) device; (iii) active trade or business; and (iv) distribution. Second, the transaction must satisfy certain non-statutory requirements that have developed through case law (i) business purpose; (ii) continuity of interest; and (iii) continuity of business enterprise.  

Here, we want to dig deeper into the non-statutory requirements of business purpose, continuity of interest, or continuity of business enterprise, and therefore this we shall limit our discussion to the “active trade or business” statutory requirement, and more specifically, the following issues:

1) The amount of time the company had to be engaged in an active trade or business prior to the distribution or settlement; and

2) The amount of time both companies had to or have to be engaged in an active trade or business after the distribution. 

Five-Year Active Trade or Business Requirement:

The trade or business must have been actively conducted for the five-year period preceding the distribution.[1]  If the business has been acquired in a tax-free acquisition, the predecessor’s business history is tacked in computing whether the business has been actively conducted for a five-year period.[2] 

The regulations provide a broad definition of what activities constitute a trade or business, primarily focusing on whether the purpose of the activities is to generate a profit.  Although the issue is largely factual, the following guidelines are contained in the regulations:

1) The activities must include all steps in the process of earning income, specifically including the collection of income and the payment of expenses[3];

2) The corporation itself must perform active and substantial management and operational functions (one managerial employee and one operating employee are sufficient)[4];

3) Activities of independent contractors or others outside the corporation are not taken into account[5];

4) Active conduct of a trade or business does not include holding stock, securities, land, or other property for investment purposes, owning and/or leasing real or personal property, unless significant, or holding non-operating assets for use by a related corporation[6];

5) The fact that during such period the trade or business underwent a change such as the addition of new, or the dropping of old, product lines or a change in production capacity is disregarded as long as the change is not of such a character as to constitute the acquisition of a new or different business[7];

6) The expansion of an existing business generally constitutes the continuation of the existing business rather than the beginning of a new business.[8] 

Moreover, the requirements of section 355 are “detailed and specific, and must be applied with precision.”  In other words, the five-year requirement is not merely a guideline, but a requirement.[9] 

Immediately After Requirement:

The companies also must be engaged in an active trade or business immediately after the distribution.  The active trade or business requirement of section 355 clearly contemplates that the business be operated as a going concern intended to be operated indefinitely, even though subsequent events might force its liquidation.[10]  The requirement is not satisfied by a “business” intended to be operated only so long as it takes to achieve its own liquidation.[11]

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[1] Treas. Reg. Sec. 1.355-3(b)(2).

[2] Atlee V. Commissioner, 67 T.C. 395, 405 n.17 (1976)

[3] Treas. Reg. Section 1,355-3(b)(2)(ii)

[4] Treas. Reg. Section 1.355-3(b)(2)(iii); Rev. Rul. 86-126, 1986-2 C.B. 58.

[5] Treas. Re. Section1.355-3(b)(2)(iii)

[6] Treas. Re. Section1.355-3(b)(2)(iv(A); (B)

[7] Treas. Re. Section1.355-3(b)(3)(ii)

[8] Id.

[9] Commissioner of Internal Revenue v. Gordon, 1968, 391 U.S. 83, 92, 88 S. Ct. 1517, 20 L. Ed. 2d 448.

[10] Hanson v. USA, 338 F. Supp. 602, U.S. Dist. Court (1971). 

[11] Id.