Section 355 Transactions: A Corporate Division Breakdown

A corporate division under Section 355 of the Internal Revenue Code allows a parent corporation to distribute a subsidiary’s stock to its shareholders without an immediate tax event. This provision facilitates the separation of one or more businesses from the main corporate group, a process that can unlock value, streamline operations, or resolve internal conflicts. These transactions are known as a “spin-off,” “split-off,” or “split-up.”

In a spin-off, subsidiary shares are distributed pro-rata to all parent company shareholders. In a split-off, some shareholders exchange their parent stock for subsidiary stock, while a split-up involves the parent company distributing stock in multiple subsidiaries before liquidating.

Qualifying for Tax-Free Treatment

For a corporate division to receive tax-free status under Section 355, it must meet several strict statutory and judicial requirements. These rules are designed to ensure that the transaction is a genuine reorganization of business assets and not a disguised method for distributing corporate earnings to shareholders at a lower tax rate. The primary requirements cover control, active business operations, business purpose, device limitation, and continuity of shareholder interest.

Control

The distributing corporation must have “control” of the subsidiary corporation immediately before the distribution. The Internal Revenue Code defines control as owning stock with at least 80 percent of the total combined voting power and at least 80 percent of the total shares of all other classes of stock.

Following the distribution, the distributing corporation must distribute all the stock and securities it holds in the controlled corporation. A corporation may retain a small portion of the stock only if it proves to the IRS that the retention was not part of a tax avoidance plan.

Active Trade or Business

The Active Trade or Business (ATB) requirement mandates that both the distributing and controlled corporations engage in an active trade or business immediately after the distribution. This ensures that the transaction separates viable, operating businesses, not just passive investments or liquid assets. The trade or business that each corporation operates must have been actively conducted throughout the five-year period ending on the date of the distribution.

Furthermore, the business must not have been acquired within that five-year period in a transaction where gain or loss was recognized. The active conduct of a business requires the corporation to perform substantial management and operational functions itself. To provide a benchmark, proposed regulations have introduced a safe harbor where the ATB requirement is met if the fair market value of the business’s gross assets is at least five percent of the total fair market value of the corporation’s gross assets.

Device Limitation

A Section 355 transaction cannot be used principally as a “device” for distributing the earnings and profits of either corporation. This rule prevents shareholders from receiving what is economically a dividend and treating it as a tax-free transaction. The IRS examines all facts and circumstances, and a pre-arranged sale of a large percentage of stock after the distribution is strong evidence of a device. The presence of a strong corporate business purpose is evidence that the transaction was not primarily a device.

Business Purpose

Every Section 355 transaction must be motivated by a substantial non-federal tax corporate business purpose. A shareholder’s personal reasons, such as estate planning, are not sufficient. The purpose must be related to the business of the distributing corporation, the controlled corporation, or their affiliated group.

Valid corporate business purposes include resolving shareholder disputes, enhancing borrowing capacity, meeting regulatory requirements, or improving cost efficiencies. The corporation must also demonstrate that the distribution was necessary to achieve the stated purpose and that no simpler, non-taxable alternative was available.

Continuity of Interest

The Continuity of Interest doctrine requires that the original shareholders of the distributing corporation maintain a sufficient continuing ownership interest in both corporations after the division. This ensures the transaction is a readjustment of continuing interests in a modified corporate form. To satisfy this, owners of the distributing corporation must hold stock establishing continuity in each of the separated businesses.

While no specific percentage is mandated, a common benchmark for IRS ruling purposes is that historic shareholders as a group retain at least 50% of the value of each corporation’s stock for a period of time after the transaction.

Tax Treatment for Shareholders and Corporations

When a corporate division meets all Section 355 requirements, the tax consequences are favorable. Shareholders can receive stock in the new subsidiary without recognizing immediate gain, loss, or dividend income. The principle is that shareholders have not cashed out their investment but have merely altered the form in which they hold it across separate corporate entities.

For Shareholders

Shareholders who receive only stock of the controlled corporation in a qualifying transaction do not recognize income. Their original basis in the parent corporation’s stock is allocated between the parent stock they retain and the new subsidiary stock they receive, in proportion to the fair market values of each corporation’s stock.

If a shareholder receives other property or cash, known as “boot,” the transaction may be partially taxable. The recognized gain is the lesser of the total gain realized or the fair market value of the boot received, and this gain is often treated as a dividend. For example, if a shareholder’s stock in the parent company has a basis of $10,000 and they receive new subsidiary stock worth $15,000 plus $2,000 in cash, their total realized gain is $7,000. Because they received $2,000 in boot, they must recognize a gain of $2,000, while the remaining $5,000 of gain is deferred.

For the Distributing Corporation

A qualifying Section 355 transaction also benefits the distributing corporation, which does not recognize any taxable gain or loss on the distribution of the subsidiary’s stock. This is an exception to the rule that a corporation recognizes gain when distributing appreciated property. Without this non-recognition, the tax on the subsidiary’s built-in gain could make the transaction too expensive. The tax attributes of the distributing corporation, such as earnings and profits, are allocated between the two corporations.

Consequences of a Failed Transaction

If a corporate division fails to meet the Section 355 requirements, the tax consequences are severe for both the shareholders and the distributing corporation. The transaction is treated as a taxable distribution rather than a tax-free reorganization. This can result in a significant and unexpected tax liability at both the corporate and shareholder levels.

Treatment for Shareholders

If a transaction fails, shareholders are treated as receiving a taxable distribution. The full fair market value of the subsidiary stock and any other property received is generally treated as a dividend, to the extent of the distributing corporation’s earnings and profits. Any amount exceeding the earnings and profits is treated as a non-taxable return of capital that reduces the shareholder’s stock basis. Any further excess is taxed as a capital gain.

Treatment for the Distributing Corporation

For the distributing corporation, a failed transaction triggers a corporate-level tax. The corporation must recognize gain as if it had sold the subsidiary’s stock to its shareholders at fair market value. This means the difference between the stock’s fair market value and the parent’s basis in that stock becomes taxable gain. The combination of a corporate-level tax and a shareholder-level tax creates two layers of taxation, which Section 355 is designed to prevent.

Required Information and Disclosures

To validate the tax-free status of a corporate division, the distributing corporation and its shareholders must attach detailed statements to their federal income tax returns for the year of the distribution. This documentation provides the IRS with a comprehensive overview of the transaction to verify its legitimacy. The distributing corporation’s statement must include:

• The names and employer identification numbers (EINs) of the distributing and controlled corporations.
• A detailed description of the stock and securities of the controlled corporation that were distributed.
• A thorough explanation of the corporate business purpose for the distribution.
• An affirmation that the transaction was not used principally as a device to distribute earnings.
• Balance sheets for both corporations as of the date of the separation.
• Information substantiating that the Active Trade or Business (ATB) requirement has been met.
• The aggregate fair market value and tax basis of the distributed stock and property.

Shareholders who receive stock must file a similar statement with their personal tax returns. In January 2025, the Treasury and IRS released proposed regulations that would expand these reporting requirements. If finalized, these rules would require the corporations and significant shareholders to file a new form, “Form 7216, Multi-Year Reporting Related to Section 355 Transactions,” with their tax returns to provide more detailed information over several years.