People are often surprised to learn that tax planning can be an aid in solving closely held business problems. Over time, families and closely held business owners have differences. Sometimes the best way to handle the problem is to have the business be divided. The question is whether or not it can be done tax free?
This article focuses on borrowing devices from the business planning world to solve “people planning” objectives. Certainly in the larger business world, tax-free corporate divisions and reorganizations play an important and commonplace role as the needs, purposes and operations of a business change over time.
Congress has facilitated these changes in business entities by permitting many of these corporate reorganizations to occur on a tax-deferred basis. Let me give you an example from an article written by Bradford N. Dewan who discusses using tax planning to solve people problems. The balance of this article is from his article.
Family Business Example. “Business A,” had been operated in two different locations, “Location A” and “Location B” within a single corporate entity, “Distributing.” The stock of the Distributing was held 50% by Mother and 25% each by Brother A and Brother B (children of Mother).
Importantly, as noted below, Business A had been operated at each of the two locations for more than five years. The management of Distributing (probably Mother and the two Brothers) had concluded that splitting up Business A into two separately operated businesses, one operated at each of the two current locations, would enable Distributing to eliminate “serious conflicts that are preventing Distributing from developing a cohesive strategic business plan.
Fortunately for this family, Business A was operated at two different locations and, apparently, each location ran, or could run, Business A independent of the other location. Having these two locations certainly enabled the “spinoff” strategy in a way that might not have been possible if Business A were operated from just a single location.
The Spinoff Strategy. The “spinoff” strategy involved the formation of a new corporation, “Controlled,” which initially would be a wholly-owned subsidiary of Distributing. In return for the common stock of Controlled, Distributing would contribute all the assets of Business A at Location B into Controlled, and Controlled would assume all of the liabilities related to the operations at Location B.
Once the above was completed, Distributing would then distribute to Mother and Brother B all of the stock of Controlled in exchange for their surrender of stock in Distributing.
In this exchange, Mother would exchange only one-half of her Distributing stock for 50% of the Controlled stock.
However, Brother B would surrender all of his Distributing stock in exchange for the other 50% of the Controlled stock. So, at the end of the day, Distributing would be held 50% each by Mother and Brother A, and Controlled would be held 50% each by Mother and Brother B.
Tax-Free Treatment. Importantly, this transaction, since it complied with Section 355, triggered no current income tax. (Compare this with the typical distribution of funds or assets by a corporation to its shareholders: Such a distribution is treated as a dividend and taxed as ordinary income.)
The Brothers, with Mother’s concurrence, were able to divide the Family Business, allowing each Brother to implement his own view of the Business A in connection with that location that he received control over, without having to pay any federal income tax.
Without the use of Code Section 355, income taxes might be imposed at such a level that the Brothers would be forced to stay working together in a very unpleasant environment until one died or one Brother bought out the other. Neither scenario would have been attractive.
Business Purpose Caveat. The above planning can only be successful if there is a proper “business purpose” for the planning. Avoiding income taxes or even estate planning objectives cannot satisfy the business purpose test.
Active Trade Or Business Requirement. Lastly, the spinoff requires that the business be an active one as part of the IRS regulation.
Conclusion. The IRS has various guidelines that can be used by the family and business owners to develop a successful spinoff. Both the business purpose and active trade requirements must be complied with in order to be successful.