IRS request for information regarding the active trade or business requirement for section 355 separations of entrepreneurial ventures

May 6, 2019

The Department of the Treasury (Treasury Department) and the Internal Revenue Service (IRS) have been studying whether, and to what extent, corporations may utilize the tax-free separation rules of section 355 of the Internal Revenue Code to separate established businesses from newer entrepreneurial ventures that have not collected income but have engaged in substantial research and development (R&D) and other activities.  The study is also considering the extent to which section 355 could apply to a separation of two or more R&D segments of a stand-alone entrepreneurial venture from each other in a tax-free manner.  The IRS requests information regarding the activities of these types of ventures to facilitate this continuing study.

Section 355 separations

In general, section 355 allows a corporation (Parent) to distribute or exchange the stock and securities of a controlled subsidiary corporation (Spinco) to Parent’s shareholders or security-holders without taxable gain to Parent, Spinco, or their shareholders or security-holders.  Such a tax-free separation is available only if the separation accomplishes a corporate business purpose (as opposed to a purely shareholder business purpose).  Examples of valid corporate business purposes include enabling separate management teams to better concentrate on two or more different businesses, shielding assets of one business from risks of another business, allowing lenders or investors to participate in one business but not the other, and creating Parent or Spinco stock that can be used in acquisitions or as employee compensation.

Active trade or business requirement

To qualify for tax-free treatment, various requirements must be satisfied, including the requirement that Parent and Spinco each be “engaged in the active conduct of a trade or business” (ATB).  A qualifying ATB generally requires a five-year track record of active and substantial managerial and operational activities by the business’s employees (as opposed to independent contractors).  During the five-year period, qualifying ATBs may naturally evolve and expand, organically or through acquisitions.

Application of “collection of income” requirement to entrepreneurial ventures

Regulations provide that an ATB’s activities “ordinarily must include the collection of income.”  Generally, in the absence of exceptional circumstances beyond the business’s control (such as drought, fire, financial distress, or seasonal downtime), the IRS historically has required a qualifying ATB to have collected income continuously for at least five years.

In recent years, the IRS has observed a significant increase in entrepreneurial ventures that collect little or no income during lengthy and expensive R&D phases, particularly pharmaceutical and technology ventures.  However, these types of ventures often use the R&D phase to develop new products that will generate income in the future but do not collect income during that phase.  If a corporation wishes to achieve a corporate-level business purpose by separating one R&D segment from an established business or from another R&D segment, the IRS’s historical application of the income collection requirement likely would present a challenge for section 355 qualification.

In response to the emergence of a greater number of these entrepreneurial ventures, the IRS announced in September 2018 that it would entertain requests for private letter rulings regarding the ATB qualification of corporations that have not collected income, and that, with the Treasury Department, it was commencing this study.  See IRS statement regarding the active trade or business requirement for section 355 distributions, dated September 25, 2018, available at the Statements from Office of the Chief Counsel page.  In March 2019, the IRS facilitated this study by suspending two 1957 revenue rulings that could have been interpreted as requiring income generation for a business to qualify as an ATB.  Rev. Rul. 2019-09, 2019-14 I.R.B. 925.

Request for information

The IRS requests information to assist in identifying what types of entrepreneurial ventures should qualify as ATBs absent a five-year track record of income collection.  For example:

  • In what industries or industry segments do the types of R&D ventures described above, as well as in the September 2018 IRS statement, exist?
  • How are these ventures created?
  • If no income is collected for extended periods, how are these ventures funded?
  • In what circumstances do these ventures typically receive grants or similar funding?  What types of organizations make these grants and on what terms?
  • Is it common for investments in, or grants to, these ventures to include rights to acquire interests in potential products of the research, rights to use such products, or similar rights?
  • What types of managerial and operational activities of these ventures generally are conducted by employees?  What types of activities generally are conducted by independent contractors or their employees?
  • What proportion of these ventures’ managerial and operational activities is conducted by employees, as compared to independent contractors (for example, based on personnel number, hours spent, or amounts of expenditures)?
  • What steps are necessary to obtain regulatory approval of products developed in the R&D phase of these ventures, and how do these steps vary by industry?
  • Is it possible to generalize about the amounts of time necessary to accomplish these regulatory approval steps?
  • Is it possible to generalize about the nature of activities and the levels of activity required to accomplish these regulatory approval steps (for example, based on numbers of hours spent by managerial and operational employees, asset values, or expenditure amounts)?
  • What types of opportunities exist to collect income from the results of research before any marketable product is developed?  Do markets (or recognized communities of investors, joint venturers, or customers) exist with respect to these opportunities?  If so, do these opportunities vary by industry?
  • Do opportunities to collect income from these sources increase as a result of preliminary approval by a regulator or accomplishment of particular steps toward final regulatory approval?  If so, do these opportunities vary by industry?
  • Is it possible to describe situations in which, either before or after a corporate separation, activities of a separated R&D venture could be interrupted or could cease permanently due to an inability to raise capital or for any other reason?
  • Is it possible to generalize as to amounts of expenditures, or amounts of time spent, at which, in various industries, a decision is likely to be made whether to continue R&D on a particular project?
  • In what situations might an R&D venture benefit from separating part of its activities?
  • Following such a separation, how likely is it for Spinco to provide services to Parent or vice versa, or that other business relationships between Parent and Spinco continue?
  • What types of entrepreneurial ventures, in addition to R&D, potentially would satisfy the ATB requirement in the absence of income collection?

Contact information

Representatives of the IRS will be pleased to review written information or discuss these matters.  To arrange to submit written information or to schedule such a discussion, please call Lisa A. Fuller, Deputy Associate Chief Counsel (Corporate), at 202-317-7700.