Rev. Rul. 98-27 - additional but limited flexibility for spin-offs.

One of the requirements of a tax-free spin-off under Sec. 355 is that the parent must distribute control of the subsidiary. For this purpose, "control" is defined under Sec. 368(c) as 80% of the voting stock and 80% of all other classes of stock. Prior to the Taxpayer Relief Act of 1997 (TRA '97), the IRS applied the step-transaction doctrine to determine whether a post-spin-off acquisition of a controlled corporation affected the 80% control requirement.

Rev. Rul 96-30 explained the application of the step-transaction doctrine. A controlled corporation was merged into an unrelated corporation shortly after the spin-off. The Service held that the taxation of the transaction depended on whether the distributing corporation had entered into negotiations with the acquiring company before the spin-off. If it had, under the step-transaction doctrine, control would be measured as if the distributing corporation had disposed of the controlled corporation's stock before the spin-off; consequently, the 80% control test would not be met. This result is based on Court Holding Co., 324 US 331 (1945), which held that a sale of property by a corporation's shareholders after receipt of the property as a liquidating distribution was taxable to the corporation when the corporation had in fact conducted all the negotiations and the terms had been agreed on prior to the distribution.

Similarly, the IRS applied the step-transaction doctrine to a post-spin-off disposition in Rev. Ruls. 70-225 and 75-406. In these rulings and in Rev. Rul. 96-30, satisfaction of the 80% control test depended on whether the subsequent disposition of the con trolled corporation's stock was pursuant to a prearranged plan.

The TRA '97 added Sec. 355(e), which generally provides for the recognition of gain to the distributing corporation when, as part of a plan, one or more persons acquire a 50% or greater interest (measured by vote or value) in either the distributing corporation or the controlled corporation. If an acquisition of such an interest actually occurs during the four-year period beginning two years before the distribution, the acquisition is presumed to be pursuant to a plan.

According to Rev. Rul. 98-27, the Service intends to permit post-spin-off restructurings that meet the Sec. 355(e) requirements, and will not apply the Court Holding doctrine to a prearranged reorganization or sale for purposes of determining whether the distributing corporation distributes the requisite 80% control of the subsidiary.

Nevertheless, a prearranged sale or other restructuring may affect the other Sec. 355 spin-off requirements, such as the continuity-of-interest requirement, and the Sec. 355(a)(1)(B) "device" test. Consequently, it appears that the IRS's position in Rev. Rul. 98-27 on prearranged transactions involving the post-spin-off sale or disposition of the stock of the controlled corporation may be beneficial only when the stock of the controlled corporation is exchanged pursuant to a Sec. 368 taxfree reorganization.

From Louis A. Panoutsos, CPA, Oak Brook, IL