Proposed Regs on Tax-Free Reorgs and Spinoffs

On Jan. 13, the U.S. Department of the Treasury and the IRS issued two sets of proposed regulations that would add several new requirements for transactions to qualify as a tax-free reorganization or a tax-free spinoff under Section 355. The proposed regulations follow Notice 2024-38 and Revenue Procedure 2024-24, which tightened the rules under existing regulations for qualifying as a tax-free reorganization or a spinoff under Section 355.

In a related news release, the IRS released a draft version of proposed Form 7216, “Multi-Year Reporting Related to Section 355 Transactions,” which under the proposed regulations is required to be filed annually for five years following a Section 355 transaction.

Background

Sections 355 and 368 govern corporate separations and reorganizations, respectively, and have long been instrumental in facilitating corporate restructurings on a tax-free basis for qualifying transactions. Section 355 permits the tax-free distribution of stock of a controlled corporation to shareholders, enabling companies to separate business units without immediate tax consequences. Section 368 defines various types of tax-free corporate reorganizations, recapitalizations, and certain types of corporate acquisitions, providing mechanisms for corporations to restructure operations or ownership on a tax-free basis. The recently issued proposed regulations have the potential to significantly alter the rules for Section 355 and Section 368 transactions.

Key provisions of the proposed regulations

Following are highlights of key provisions of the proposed regulations:

• Plan of reorganization. The proposed regulations would significantly update guidance on what constitutes a plan of reorganization and would require the taxpayer to file a single plan document that includes detailed information for each transaction step with its income tax return for the year of the transaction. The proposed regulations permit amendments to the plan that was originally filed only if there are identifiable, unexpected, and material changes in market or business conditions.

Crowe observation

The proposed regulations would meaningfully increase the breadth of information required for plan documentation and potentially introduce significant added compliance time and cost for taxpayers to meet the requirements for a valid plan of reorganization.

• Assumption of liabilities. The proposed regulations would add substantive requirements for the assumption of liabilities by a controlled corporation in a spinoff transaction to be respected and not treated as money or other property received (boot) by the distributing corporation. Additionally, taxpayers would be required to specifically identify liabilities assumed in the plan document required to be filed with tax return.
• Stock retention and delayed distribution in spinoff transactions. Currently, there is a distinction between a delayed distribution of 12 months or less of controlled corporation stock, which is considered part of the tax-free spinoff transaction, and retention of controlled corporation stock, which is subject to more scrutiny and could be treated as outside the tax-free spinoff transaction and therefore subject to tax. The proposed regulations eliminate this practical distinction and treat both situations as a retention of stock.
  
  Additionally, the proposed regulations add an antiavoidance rule that treats a stock retention as part of the tax-free spinoff transaction if the taxpayer satisfies a safe harbor test or a facts-and-circumstances test. Both tests are quite burdensome and complex, involving a multistep analysis that focuses heavily on business purpose; the overlap of officers, directors, and employees; and the nature and terms of any continuing arrangements between the distributing and controlled corporations. Furthermore, tax-free treatment requires that the plan document filed with the taxpayer’s return for the transaction year detail a definite intent to dispose of all retained stock.

Crowe observation

The proposed regulations do permit a level of contingency planning that does not exist under current guidance by allowing taxpayers to identify a primary disposition method with specified alternative disposition methods.

• Transfers to creditors of the distributing corporation. Under the current rules, no gain or loss is recognized by the distributing corporation on the use of certain consideration to repay debt as part of a spinoff transaction. For purposes of qualifying as a tax-free spinoff, the proposed regulations provide rules for who is considered a qualified creditor of the distributing corporation, the specific debt that is eligible to be treated as distributing corporation debt, and which transactions are considered qualifying debt-elimination transactions.
• Enhanced reporting for spinoffs. The proposed regulations would significantly expand reporting requirements by requiring corporations and significant shareholders involved in a spinoff transaction to file Form 7216 for five years following a tax-free spinoff transaction. For purposes of these rules, a significant shareholder generally is a shareholder that owns at least 5% of a corporation involved in the transaction. Form 7216 requires filers to provide details about the transaction, including information demonstrating compliance with each requirement under Section 355 and related provisions, solvency of the distributing and controlled corporations, continuing relationships, and transaction costs.

Looking ahead

Comments on the proposed regulations are due March 17. A public hearing will be scheduled if requested. A sizable number of public comments are expected as the proposed regulations add significant new reporting and compliance burdens. Comments are likely to request considerable modification of the proposed rules.

It is unclear how the current administration’s regulatory freeze and review of proposed regulations could impact these rules. Because of this uncertainty, taxpayers contemplating a tax-free reorganization or a tax-free spinoff should consult their tax advisers about the potential impact of these regulations.