The Section 355 Transaction: Waving Goodbye to Your Business Partner With Money in Your Pocket

A business is constantly changing and almost everyone wants to see their businesses evolve and grow.

However, when businesses have multiple owners, business relationships may sour due to both personal and professional conflicts. These conflicts can often lead to the dissolution and liquidation of a business if owners cannot find common ground, which often results in large amounts of realized income and capital gains tax. If you have almost or already reached such an impasse and you desire to continue operating the business, rather than dissolving your business, consider splitting your business via a Section 355 nonrecognition transaction (a Section 355 transaction can be used for both corporations and limited liability companies that have elected to be taxed as a corporation).

A Section 355 transaction in its most basic form generally involves a parent company and a subsidiary company. Though all requirements are the same within Section 355, there are three variations of the Section 355 fact pattern: 1) a spin-off, 2) a split-up and 3) a split-off.

1. A spin-off involves the distribution of subsidiary company stock from parent company to the shareholders of the parent, without the surrendering of any parent stock.
2. A split-up involves the distribution of two or more subsidiaries from the parent company to the shareholders of the parent company in complete liquidation of the parent company. The distribution of subsidiary stock can either be pro-rata to the parent company shareholders or each shareholder can acquire a separate subsidiary.
3. A split-off involves the distribution of subsidiary to some or all of the parent’s shareholders in exchange for some or all of their stock in parent.

Regardless of the type of split, there are a number of requirements that must be satisfied to ensure the transaction qualifies for nonrecognition treatment. Though a number of the requirements are relatively straightforward, the requirement most prone to challenge is the business purpose requirement. The reason for this is because even if the transaction satisfies all other requirements, if no legitimate business purpose exists, the transaction will lose its nonrecognition treatment and the shareholders and company will be subject to tax.

Though what constitutes a business purpose is not clearly defined within Section 355, or the corresponding regulations, a legitimate business purpose has previously been found in the following situations:

1. when there are two owners and they desire to split because the owners have interest in different business activities;
2. when a parent company surrendered all outstanding stock in its subsidiary due to serious disputes between owners; and
3. when a distribution was completed in order to increase the amount of commercial credit.

Nevertheless, it is important to note that simply because a business purpose has previously been found in the transactions, each transaction is independently reviewed and a business purpose that satisfied the requirement for one transaction may not satisfy the requirement for another.

Given the intricate requirements involved in properly structuring a Section 355 transaction to ensure nonrecognition treatment, it is important that you consult with competent legal counsel. If you have any questions about how a Section 355 transaction can help your business, the attorneys of Vandenack Weaver can assist you.

VW Contributor: Justin A. Sheldon
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