Spinoff to permit employee stock purchases.

If a key employee threatens to leave and start a competing company, one way to deal with the situation is to allow him or her to purchase an ownership interest in the existing business. However, if the business is large or has multiple divisions or locations, selling the employee an ownership interest sufficient to prevent defection may not be practical. It may be possible, though, in some cases, to spin off part of the business tax-free and sell some of the distributed stock to the employee.

Clark Pulliam owns a corporation that runs several funeral homes. When the manager of one quit because he wanted to open a competing funeral home, Pulliam tried to head off the competition by having his corporation establish a new subsidiary to own the funeral home the employee had previously managed. The corporation distributed the stock to Pulliam in a transaction he reported as a nontaxable spinoff. Pulliam sold 49% of the distributed Stock to his former employee, who had agreed to return and manage the funeral home. The IRS argued that the transaction in which the stock was distributed to Pulliam was a taxable dividend distribution. He disagreed, and appealed.

Result. For the taxpayer. To qualify as a tax-free spinoff, a transaction must satisfy four basic requirements:

1. Only stock or securities of the controlled corporation can be distributed.

2. All the stock of the controlled corporation (or an amount constituting control) must be distributed.

3. The distribution must not be a device for distributing earnings.

4. The business must meet the active business requirement.

The regulations also require the transaction to have a corporate business purpose. The IRS argued that Pulliam failed both the business purpose and device tests. The regulations further say there must be a corporate purpose for both a business separation and a stock distribution. Pulliam argued the need to rehire the employee and prevent competition justified the business separation. He believed that, under state law, funeral homes must be owned by licensed funeral directors and that, therefore, the controlled corporation stock had to be distributed to him rather than be owned by the original corporation. The Tax Court agreed there was a corporate business purpose for both the division and the distribution--in part because it found reasonable Pulliam's belief that individuals must own funeral home stock.

Under the regulations, the sale of distributed stock is evidence of a device to distribute earnings; a prearranged sale is strong evidence of a device. This evidence can be overcome, however, by--among other things--the significance of the transaction's business purpose. The Tax Court concluded that the business purpose of the transaction Pulliam undertook was sufficient to overcome the presumption of a device to distribute earnings.

The IRS recently published a notice of nonacquiescence to the Tax Court decision, saying it intends to object to all tax-free spinoffs in which the stock is sold shortly after distribution. Although, under current law, the distributing corporation must recognize gain if the recipient shareholders dispose of control of the distributed (controlled) corporation, the IRS has not changed its interpretation of the device test. A sale of distributed stock is a device. In the future, taxpayers attempting to duplicate Pulliam's success may be forced to prove in court that a spinoff is tax-free.

* Clark D. Pulliam v. Commissioner, TC Memo 1997-274.

Prepared by Edward J. Schnee, CPA, PhD, Joe Lane Professor of Accounting and director, MTA program, Culverhouse School of Accountancy, University of Alabama, Tuscaloosa.