IRS suspends 1957 revenue rulings on active trade or business requirement

The Internal Revenue Service is temporarily suspending a pair of revenue rulings dating back to 1957 on the tax requirement for corporate spinoffs until it finishes a new study analyzing the 62-year-old requirements.

IRS building sign

The IRS issued Revenue Ruling 2019-09 Thursday, which suspends the two 1957 revenue rulings until a study is completed on the active conduct of a trade or business requirement under sections 355(a)(1)(C) and (b)) of the tax code. In one of the old revenue rulings, Rev. Rul. 57-464, the IRS considered the section 355 qualification of a company’s separation of a manufacturing business from a group of real estate assets that included an old factory building used for storage, along with four other buildings. One of them was a duplex apartment building that had been rented to some of the corporation’s own employees. Another was a small office building rented to a single tenant. The other two were houses, one of which was occupied by a sister-in-law of the corporation’s president. The use of the old factory building for storage “was not in itself the active operation of a business as defined in the regulations,” according to the old revenue ruling, and the rental activities “produced only a nominal rental.” There was “negligible” net income, and the properties “were acquired either as an investment or as a convenience to employees of the manufacturing business.” Back in 1957, the IRS said the separation didn’t satisfy the active trade or business, or ATB, requirement.

In the other old revenue ruling, Rev. Rul. 57-492, a petroleum refining, marketing and transport company started a separate operation to explore for oil and produce it. While the exploration and production operation incurred substantial expenses, it “did not include any income producing activity or any source of income” until less than five years before it was spun off from the main refining, transportation and marketing operation. The IRS ruled in 1957 that the exploration and production operation didn’t qualify as an active trade or business because, “[b]efore oil was discovered in commercial quantities …, the venture … did not include any income producing activity or any source of income.”

Section 355(a)(1) of the tax code says that, if certain requirements are met, a corporation can distribute stock and securities of a controlled corporation to its shareholders and security holders without recognition of gain or loss or income to the recipient shareholders or security holders. Among those requirements, both the distributing corporation and the controlled corporation need to be engaged in an ATB immediately after the distribution. Each trade or business needs to have been actively conducted throughout the five-year period ending on the date of the distribution. The “trade or business” is supposed to be “a specific group of activities [that] 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.” In particular, “[s]uch group of activities ordinarily must include the collection of income and the payment of expenses.”

The study that the Treasury and the IRS are conducting will determine, for purposes of section 355 of the tax code, “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.”

The IRS pointed to a statement from last September from the IRS Office of the Chief Counsel informing taxpayers and their advisors about the study they were conducting regarding the active trade or business requirement under section 355(b) of the tax code, asking for comments, and to indicate the IRS would entertain requests for private letter rulings.

In general, the IRS noted, section 355 allows a corporation to distribute to its shareholders or security holders the stock and securities of a controlled subsidiary without recognition of gain to itself, its shareholders, or its security-holders. To qualify for tax-free treatment, various requirements must be satisfied, including the requirement under section 355(b) that the distributing corporation and the controlled corporation each be engaged in an ATB. The regulations under section 355(b) provide that an ATB “ordinarily must include the collection of income and the payment of expenses.”

The IRS said it 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,” said the IRS. “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.”

Because of the emergence of these ventures, the IRS and the Treasury said they are 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.

In the meantime, the IRS is suspending the two 1957 revenue rulings. Ed Zollars, CPA, of Kaplan Financial Education noted in an email to clients that it’s “relatively rare” for the IRS to suspend earlier revenue rulings. “Suspended is used only in rare situations to show that previously published guidance will not be applied pending some future action, such as the issuance of new or amended regulations, the outcome of cases in litigation, or the outcome of a Service study,” he wrote. “Thus, suspension is not a revocation of the rulings. Presumably this leaves the door open for the IRS to determine that one or both rulings will be put back in force unchanged at the end of the study. But, more likely, the agency doesn’t want to imply that both of the situations describe cases where it will be held there clearly is an active trade or business once the study is complete.”


Michael Cohn