IRS Statement on Trade or Business Requirement
IRS has issued a statement indicating that it is contemplating issuing guidance on the active trade or business (ATB) requirement under Code Sec. 355(b). Specifically, IRS notes that certain entrepreneurial ventures whose activities consist of long period of research and development often collect little income (ordinarily a requirement in determining an ATB), yet nonetheless incur significant expenses and perform the day-to-day operational and managerial functions historically associated with an “active” business. IRS also requests comments and indicates that it will entertain requests for private letter rulings on these matters.
Background. Under Code Sec. 355(a), if certain requirements are satisfied, a distributing corporation may distribute the stock (or stock and securities) of a controlled corporation to its shareholders and security holders without the distributing corporation, its shareholders, or its security holders recognizing income, gain, or loss on the distribution. A “controlled corporation” is defined by reference to Code Sec. 368(c), which defines control as ownership of stock possessing at least 80% of the total combined voting power of all classes of stock entitled to vote and at least 80% of the total number of shares of all other classes of stock of the corporation.
One such requirement is the ATB requirement of Code Sec. 355(b), which requires that:
…each corporation is engaged, immediately after the distribution, in the active conduct of a trade or business;
…each trade or business was actively conducted throughout the 5-year period ending on the date of the distribution; and
…neither trade or business was acquired in a transaction in which gain or loss was recognized, in whole or in part, within the 5-year period.
A corporation is treated as engaged in a trade or business immediately after the distribution if a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such group include every operation that forms a part of, or a step in, the process of earning income or profit. Such group of activities ordinarily must include the collection of income and the payment of expenses. (Reg § 1.355-3(b)(2)(ii))
IRS statement. IRS has observed a significant rise in entrepreneurial ventures whose activities consist of research and development in lengthy phases. During these phases, the ventures often collect no income or negligible income but nonetheless incur significant financial expenditures and perform day-to-day operational and managerial functions that historically have evidenced an “active” business.
For instance, a venture in the pharmaceutical or technology field might engage in research to develop new products with the purpose of earning income in the future from sales or licenses. The venture might even forgo current income opportunities to obtain increased future income by developing products on its own. The nature and duration of the research phases is often dictated by regulatory agencies, which require complex review processes that can span multiple years and cost millions of dollars.
Due to the emergence of these ventures, IRS is considering guidance to address whether a business can qualify as an ATB if entrepreneurial activities, as opposed to investment or other non-business activities, take place with the purpose of earning income in the future, but no income has yet been collected.
IRS requests comments on all aspects of the requirement that an ATB ordinarily must include the collection of income, including:
- the scope of the requirement under current law and administrative guidance,
- whether any applicable administrative guidance should be withdrawn, revoked, modified, or declared obsolete, and
- whether the requirement should be modified, for example, whether an exception should apply to any particular business model due to its unique characteristics.
IRS states that it is not contemplating industry-specific guidance. Pending completion of its study, IRS will entertain requests for private letter rulings on the ATB qualification of corporations that have not collected income.
Taxpayers and their advisers are encouraged to request pre-submission conferences to discuss requests for rulings on these matters.
References: For requirements for tax-free stock distributions, see FTC 2d/FIN ¶F-4602; United States Tax Reporter ¶3554.01. For requirements that an active trade or business ordinarily must include the collection of income, see FTC 2d/FIN ¶F-4804; United States Tax Reporter ¶3554.021.
