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Spin-off of transaction division of S corporation tax save state sales and use tax.

One of the criteria for qualification as an S corporation is that the corporation cannot, at any time during the tax year, be a member of an affiliated group of corporations as defined in Sec. 1504, without regard to the exceptions enumerated in Sec. 1504(b).

Due to this prohibition, multifunctional and operational businesses that elect S status are forced to operate as multiple divisions within the single entity, while non-S businesses can utilize subsidiary structures to segregate activities. S corporations with transportation activities (e.g., a trucking division) may have an opportunity to spin off those operations under recently issued Letter Ruling 9441024.

In many states, corporate owned trucks, whether purchase or leased, that are used in the distribution of a product, are not exempt from state sales or us tax. Exemption from sales or us tax is available, however, for trucks used "exclusively" for common or contract carriage Under the state law applicable to the taxpayer in the letter ruling (but also common to many stat laws), "exclusively" was define as the use for "hauling goods of others for hire."

Under the facts in the ruling, Distribution (D), an S corporation, manufactured furniture products which it sold throughout the United States. The trucking division, which was actively conducted for five years, provided distribution services to both the furniture division and to third parties.

On Nov. 8, 1993, D formed Controlled (C) by transferring $500 in cash in exchange for one share of stock. In addition, D loaned C cash in exchange for a demand note. C then applied for regulatory and insurance licenses with the proceeds of the loan.

On Jan. 1, 1994, D transferred the operating assets and liabilities of the transportation division to C for stock followed immediately by a pro rata distribution of the C stock to the D shareholders. On the same date, C redeemed the single share of stock held by D for $500 and repaid the demand note.

C continued to operate the transportation business by carrying freight for both D and other customers. In addition, C elected S status for its first tax year beginning Jan. 1, 1994.

The IRS ruled that, for valid business reasons (the elimination of state sales and use tax), the transfer by D of the trucking division property to C in exchange for stock, followed immediately by a distribution of the stock to the D shareholders, was a reorganization within the meaning of Sec. 368(a)(1)(D) and that no gain or loss was recognized to the D shareholders under Sec. 355(a)(1) or to D under Sec. 361(c)(1). in addition, the Service ruled that the "momentary" affiliation of D and S would neither -terminate D's S election, nor -bar C from electing S status for its first tax year.

While not specifically addressed in the ruling (unless "momentary" includes the period from Nov. 8, 1993 through Jan. 1, 1994), the period of C's existence prior to Jan. 1, 1994, during which C's sole activity consisted of the application for regulatory and insurance licenses, appears to have been disregarded for the purpose of applying the affiliated group test to D for 1993.

The ruling provides a potential tax planning opportunity for S corporations with trucking operations to save state sales and use taxes and to move those assets into a separate corporation without jeopardizing their S elections. Taxpayers should, however, examine other issues, such as regulatory requirements under the state public utility commission, cost of obtaining and maintaining licenses, and other legal matters. Also, consideration should be given to obtaining a ruling from the Service before proceeding with a transaction of this nature. From Robert E. Kempke, CPA, J.D., Cleveland, Ohio
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Author:Kempke, Robert E.
Publication:The Tax Adviser
Date:Mar 1, 1995
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