TO: Senior Partner
FROM: Team Number ______
DATE: November 10, 2003
SUBJECT: 2003 Law Student Tax Challenge Problem
Summary of the proposed transaction: LandCo will contribute the eastern 160 acres of
land to NewCo, a new C corporation in exchange for all its stock, making NewCo a wholly
owned subsidiary of LandCo. Then, in exchange for 200 shares of LandCo stock that Colona
holds, LandCo will distribute to her all the shares of NewCo. The end result is that LandCo, still
an S corporation, owns the western 160 acres of land and leases it to G& S. Furthermore,
NewCo, a C corporation (Colona could elect S corporation status for NewCo), controls the
eastern 160 acres of land and leases it to TFC. If the transaction satisfies the requirements of
I.R.C. § 355, it should be tax-free to LandCo, NewCo and their shareholders.
As the following analysis will demonstrate, although the proposed transaction is not a
reportable transaction under Treas. Reg. §§ 1.6011-4 and §301.6112-1, LandCo will mostly
likely be found by the I.R.S. as not engaged in an active trade and business for purposes of I.R.C.
§ 355 during the five-year period prior to the transaction and there are uncertainties concerning
the underlying business purpose of the transaction. Thus, it would not be prudent to undertake
the transaction as proposed. We provide an alternative transaction to achieve the same goals.
II. Five-Year Active Trade and Business Requirement
A. The Standard for “Active Trade or Business” Under § 355(b)
In order to facilitate a tax-free separation of a controlled corporation both the distributing
and controlled corporation must be engaged in an “active business” immediately after the
distribution. I.R.C. § 355(b). Furthermore, this active trade or business must have been
conducted for five years prior to the date of distribution. IRC § 355(b) (2) (B). The question in
our case is whether LandCo’s business is active. Leasing is not considered an active trade or
business unless the owner performs “significant services with respect to the operation and
management of the property.” Treas. Reg. § 1.355-3(b) (2) (iv). There is no concrete or
steadfast rule for determining what is “significant” but Rev. Rul. 79-394, 1979-2 C.B. 141,
provides some guidance. It discusses several activities that indicate an active real estate business,
such as: (1) seeking, acquiring, or renovating new properties; (2) advertising for and
investigating tenants and negotiated leases; (3) made payments for utilities, insurance, and taxes;
and (4) providing maintenance and repairs. Furthermore, it states that having no salaried
employees did not preclude the business from being active if the officers performed considerable
day-to-day management and operational activities. Importantly though, in a “net lease” situation
(i.e., the tenant is responsible for most or all of the operational and maintenance activities), then
the IRS will tend to view the rent as passive income. Treas. Reg. § 1.355-3(c), Example (13).
However, in King v. Commissioner, 458 F.2d 245 (6th Cir. 1972), the court declared that a real
estate business was active even though the rents were collected under a “net lease.” The fact that
the businesses purchased land, negotiated with contractors for improving the land, and obtained
insurance was sufficient to establish an active trade or business. Conversely, in Rafferty v.
Commissioner, 452 F.2d 767 (1st Cir. 1971), cert. denied, 408 US 922 (1972), the court found
that a net lease was not sufficient to constitute an active trade or business when the only
activities were collecting rent, paying taxes, and keeping separate books. The court emphasized
the general requirement that “a corporation must engage in entrepreneurial endeavors of such a
nature and to such an extent as to qualitatively distinguish its operations from mere investments.”
Id at 772. Taken together, this implies that “significant services” that show more than just
investment type passive activity are the key. While net leases are an indication of a failure to
meet this active business requirement, they only do so because they usually lack the “significant
services” that are required in proving that the business is active. As the regulations point out,
“the determination of whether a trade or business is actively conducted will be made from all of
the facts and circumstances.” Treas. Reg. §1.355-3(b) (2) (iii).
B. The “Active Trade or Business” Standard of § 355(b) Applied to This Transaction
Although leasing does not entirely defeat a claim by LandCo that it is engaged in an
active business, the requirement of proving that “significant services” must be performed might
be difficult to fulfill. Specifically, the fact that the leases are on a triple net lease basis certainly
does not add to the claim that LandCo is engaged in an active business. However, there are some
plausible and authoritatively supported arguments that indeed LandCo is so engaged.
First, LandCo employs a president (Colona) secretary (Fermier) a treasurer (Mimi), and
has two directors (Fermier and Colona). Both Fermier and Colona are salaried officers. The
court in Rafferty considered the presence of employees as a factor tending to prove that rental
activities are sufficiently active under § 355(b). Still, this is but one factor and combined with
the fact that Fermier, Colona, and Mimi only work 100 hours per year each and receive relatively
little compensation, more will be needed to establish an “active” trade.
Secondly, there are other objective factors that show that qualitatively speaking,
LandCo’s activities distinguish it from a mere passive investment. Such activities include
maintaining the road, spraying for weeds, and keeping the books. The argument is strengthened
if these activities require considerable day-to-day management and if they are performed directly
by LandCo (through its officers and employees) rather than through independent contractors. See
Rev. Rul. 86-126, 1986-2 C.B. 59.
Ultimately, however, we do not find it likely that these arguments will sway either the
Service or the courts in determining that LandCo is engaged in an “active” business.
C. S Corporation Issues
The purpose of this memorandum is not to determine whether LandCo’s operations
satisfy the S corporation passive income limitation requirement under § 1362(d) (3). Still, it
must be noted that since LandCo has accumulated subchapter C e&p it is indeed subject to the
passive income limitation rule of § 1362(d)(3) unless its business is deemed “active.” Since
LandCo’s leases are “triple net leases” and it has a minimal amount of activities and employees
(factors which tend to show that rental activities are indeed passive, see Treas. Reg. § 1.1362-
2(c)(5)(ii)(B)(2)), then their S corporation status may have terminated in 1986 (the three year test
begins counting after 1982, see I.R.C. § 1362(d)(3)(A)(iii)). Furthermore, if LandCo’s activities
have been deemed “active” for S corporation purposes, then that would strengthen the argument
(II. B. above) that they are engaged in an active business for § 355(b) purposes. However, if the
IRS did approve of LandCo’s activities for S corporation purposes, a spin-off that changes the
structure of LandCo may put that approval in jeopardy. Yet, given the similar requirements of
Treas. Reg. § 1.1362(d) (3)(A)(iii) and I.R.C. § 355(b), and our analysis that the “active”
business requirement is not met under § 355(b), we find this unlikely and recommend further
inquiry into this matter.
III. Business Purpose
To qualify for tax-free treatment under I.R.C § 355, the transaction must have a business
purpose. Treas. Reg. § 1.355-2(b) (2). Here, there must be a valid business purpose for both
separating the eastern and western parts of the land and distributing the eastern 160 acres to
Colona. See Treas. Reg. 1.355-2(b) (3).
The motivation for making the current division originates from the shareholders’
different plans and visions for the future of LandCo. Fermier wants to cash in on the
appreciation of the land owned by LandCo in the near future (5 years) while Colona plans to
hold on to the land much longer. This creates conflicts among the shareholders, which have
potentially disrupting effects on the continuing operation of the corporation.
The I.R.S. and courts haven long recognized that shareholder conflicts as a legitimate
business purpose for § 355 transactions. See Badanes v. Comm’r, 39 T.C. 410 (1962);
Athanasios v. Comm’r, 69 T.C.M. 1902 (1995). Using “shareholder conflict” as the business
purpose for the instant transaction, however, has some drawbacks. First, none of the
shareholders has any immediate plans for the company. Though they certainly have different
long-term goals in mind, the real divergence will not occur until 5 or 6 years later. It could be
considered to be only “an envisaged possibility of a future debilitating nepotism”, Rafferty v.
Comm’r, 452 F.2d 767, 770 (1st Cir., 1971), rather than “a seemingly irreconcilable falling-out
between the owners of a business”, Id. Secondly, there is only one single business within
LandCo: land-leasing. Even after the division, each separated corporation will be engaging in the
same business. Therefore, it does not have the “fit and focus” purpose, as is often used as a
justification for separating conflicting shareholder. See Rev. Proc. 96-30, 1996-1 C.B. 696,
Appendix A, § 2.05.
Colona wishes to compensate certain employees of TFC with stocks of a smaller
corporation than LandCo. Splitting a corporation to enable some key employees to hold some
equity interest in a smaller one has also been a legitimate business purpose in § 355 transactions.
See Rev. Rul. 88-34, 1988-1 C.B. 115; Rev. Rul. 85-127, 1985-2 C.B. 119. Rev. Proc. 96-30
also acknowledged this as a valid business purpose but with certain conditions. Id., Appendix A,
One requirement is that “the taxpayer must state why the same objective cannot be
accomplished by an alternative nontaxable transaction that is neither impractical nor unduly
expensive.” Id. Here, arguably, the same objective could be achieved through setting up a
subsidiary, especially since the employees expressed a willingness to take stock in a LandCo
subsidiary. However, there is a counterargument of “undue burden.” Since only Colona’s
employees would be getting equity, then Colona and Fermier would have to undergo a complex
process of recapitalization. That is, Colona will have diluted her ownership (compared to
Fermier) because Fermier probably will not accept a dilution of his shares in order to appease
A more powerful challenge to the “key employee” business purpose is that those
employees are TFC’s, not LandCo’s. Since TFC is wholly owned by Colona, the employee
compensation is actually a shareholder purpose, which is usually not acceptable as the corporate
business purpose unless it is “so nearly coextensive with a corporate business purpose as to
preclude any distinction between them.” Treas. Reg. § 1.355-2(b) (2). Arguments could be made
that the shareholder purpose here is coextensive with the corporate business purpose. First,
Colona is a 50% shareholder of LandCo and she owns 100% of TCF, which combined with S
corporation pass-through status of LandCo makes the connection between LandCo and TFC
stronger than one which normally exists between two corporations commonly controlled by
certain shareholders. Secondly, TFC is a major customer of LandCo and contributes half of its
revenue; therefore, the success of TFC is important to the business of LandCo. These are
plausible arguments, but explicit authoritative support for them cannot be found.
In 2003, the IRS announced that for ruling requests filed after August 8, 2003, it will not
rule on whether the §355 business purpose requirement is satisfied. Rev. Pro. 2003-48, §4.01,
2003-29 I.R.B. 86. This new development makes it riskier to carry out a § 355 transaction
without a clearly-defined business purpose. Now shareholders must proceed with the transaction
at their own risk without the blessing of the Service in the form of private lettering rulings.
In conclusion, there are uncertainties surrounding both shareholder conflict and key
employee compensation as the business purposes for the underlying transaction. In light of the
recent IRS procedural changes in § 355 transaction ruling area, it would be too risky to carry out
the transaction as proposed.
IV. Alternative Transaction
There may be a way to accomplish the objectives of Fermier and Colona through an
alternative transaction. This transaction would involve Fermier and Colona contributing
ownership interests in their respective LLCs to LandCo. This would be a non-taxable transaction
under I.R.C. § 351. LandCo would then contribute G&S and 160 acres into new subsidiary
NewCo. NewCo would then be spun-off to Colona in a § 355 transaction in exchange for all her
shares of LandCo. This could solve the “active trade or business” problem because LandCo and
NewCo will have an active trade or business within it (i.e., TCF and G&S respectively). It will
also help resolve the “key employee” business purpose problem discussed earlier because G&S’s
employees will be LandCo’s employees after Colona contributes her TFC interest to LandCo.
This transaction finds support in the case of Badanes v. Commissioner, 39 T.C. 410
(1962). Badanes and a partner each owned 50% of an active bottling company and 50% of a
realty company. The realty company leased its real estate to the bottling company. Badane and
his partner had a disagreement about the future of the bottling company (a legitimate corporate
business purpose under § 355). They each contributed their share of the realty company to the
bottling company. The bottling company then transferred the realty stock and some assets,
including cash, into a newly created subsidiary. The newly created subsidiary was then spun-off
to Badanes in exchange for his shares of the bottling company. The court held that this
transaction qualified under § 355.
However, Portland v. Mfg. Co. v. Comm’r., 56 T.C. 58 (1971) did not allow a seemingly
similar transaction. In Portland, partners A and B equally owned a joint venture and a
corporation. They transferred their interests in the joint venture to the corporation. The
corporation then transferred the joint venture into a new subsidiary and spun it off to B in
exchange for his shares in the corporation. The IRS and the Portland court agreed that this was
prohibited under Treas. Reg. § 1.355-4 because in substance the transaction was just an exchange
between shareholders in stock of one corporation for stock in another corporation.
We have a strong argument that our alternative transaction resembles the Badanes case
much more so than the Portland case. The main thrust of the transaction is to divide LandCo
between Fermier and Colona. As the Portland court noted, the Badanes case involved a division
of the bottling plant and seeing the transaction as an exchange between one shareholder’s stock
for another shareholder’s stock was merely incidental. Portland, 56 T.C. 58 at 78. Our situation
is stronger than Badanes. That is, Fernier and Colona are not exchanging one’s interest in one
corporation for the other’s interest; the crux of our transaction is to facilitate the division of
V. Reportable Transactions
Under the 2003 tax shelter disclosure regulations a taxpayer must disclose to the Service
certain “reportable transactions” that it participated in. Treas. Reg. §1.6011-4. These regulations
also require the “material advisors” of such transactions to prepare, maintain and furnish a list of
participants in the transactions. Treas. Reg. §301.6112-1.
“Reportable transactions” includes “a transaction that is offered to a taxpayer under
conditions of confidentiality”. Treas. Reg. §1.6011-4 (b)(3). “Conditions of confidentiality”
arise “if the taxpayer’s disclosure of the tax treatment or the tax structure of the transaction is
limited in any manner by an express or implied understanding or agreement with or for the
benefit of any person who makes or provides a statement, oral or written, to the taxpayer as the
potential tax consequences that may result from the transaction, whether or not such
understanding or agreement is legally binding.” Id.
In this current transaction, Fermier, Mimi and Colona signed a modified, broad
confidentiality agreement. There are signs indicating that this is a confidential transaction within
§ 1.6011-4. First, it was a confidentiality agreement signed by taxpayers upon the eve of a
planned tax-free transaction. Secondly, it was signed out of one taxpayer’s (Fermier) fear about
the deterrent effect of tax planning to potential buyers; thus it is likely to contain some
confidentiality clauses on the tax aspect of the transaction.
In any event, it would be prudent to add the following authorization clause in accordance
with the safe harbor provision of the regulations, Treas. Reg. §§1.6011-4 (b)(3)(iii): “the
taxpayer (and each employee, representative, or other agent of the taxpayer) may disclose to any
and all persons, without limitation of any kind, the tax treatment and tax structure of the
transaction and all materials of any kind (including opinions or other tax analyses) that are
provided to the taxpayer relating to such tax treatment and tax structure.” Also, we should
include the same language in the opinion we give to the client. This will create a presumption
that the transaction is not offered to the taxpayers under conditions of confidentiality. Id.
Another kind of reportable transaction that may have some bearing here is “transactions
with a significant book-tax difference”. Treas. Reg. §§1.6011-4 (b)(6). Such a transaction
includes one where the book income would differ from tax income by more than $10 million. Id.
Since that difference in our transaction is more than $15 million, it would fall into the literal
description of the regulations.
However, the definition only applies to (1) taxpayers that are reporting companies under
the Securities Exchange Act of 1934 and related business entities; or (2) business entities that
have $250 million or more in gross assets for book purposes at the end of any financial
accounting period that ends with or within the entity's taxable year in which the transaction
occurs. Id. LandCo does not fit into either description so the transaction is not a transaction with
a significant book-tax difference.
We also need to determine whether the Firm is a “material advisor” as defined in Treas.
Reg. § 301.6112-1(c)(2). A firm is a “material advisor” if (1) the total fee for the transaction
exceeds $50,000; (2) the Firm is going to make a tax statement regarding the transaction; and (3)
the taxpayer is engaged in § 1.6011-4 or similar tax shelter transactions. see Treas. Reg. §
301.6112-1(c)((3)(i)); Since the transaction (as discussed above) is not a “listed transaction”, the
Firm dose not meet the third requirement and thus is not a “material advisor.”
Since the proposed transaction has only weak arguments to establish “active trade or
business” and the uncertainty underlying the “business purpose” (especially in light of the
Service’s refusal to issue letter rulings on this issue), it will likely be subjected to taxation after
IRS scrutiny. The alternative transaction proposed in IV above provides a stronger and
authoritatively supported argument for achieving the same goals.
LAW OFFICES OF TEAM NUMBER __________
Tax Town, ABA State, 10000
Tax Town, ABA State, 10000
Re: 2003 Law Student Tax Challenge Problem
Thank you for retaining our firm as tax counsel regarding the divisional transaction (“spin-
off”) of LandCo. After careful analysis, unfortunately, we conclude that the proposed
transaction would probably not qualify for tax-free treatment under the Internal Revenue Code
(“Code”). However, we propose an alternative transaction that would achieve the same goals of
dividing the land and distributing it between you and your sister while likely meeting the
requirements for tax-free treatment under the Code.
I. Why the current proposed transaction would not be tax-free
To qualify for tax-free treatment, a divisional transaction has to meet certain requirements.
Two of the most important requirements are the “five-year active trade and business”
requirement and the “business purpose” requirement.
A. Five-Year Active Trade and Business Requirement
The Code requires that a company must be engaged in an active trade or business for 5 years
before it can carry out a spin-off transaction tax-free. LandCo has been leasing land for well
over 5 years, but the problem is that land-leasing might not be considered an “active” trade or
business by the Internal Revenue Service (“Service”).
Owners of a leasing company must perform significant services with respect to the operation
and management of the property. Although there is no fixed standard to determine what
constitutes significant services, the Service gives some guidance. Most authorities deem “net
leases” as strong evidence against “active” trade or business status because it shifts most of the
responsibilities regarding the leased property to the tenant.
There are some facts supporting the “active” trade status. Both you and your sister serve as
salaried officers and perform certain services to LandCo, which makes LandCo more active than
just a mere investment. However, 100 hours per year are probably too little and the courts
demand much more involvement that you and the other officers currently provide in the few
cases deciding that net leases were an active trade and business.
On a sort of side-note, we noticed that LandCo still has C earnings & profits. Combined with
the fact that LandCo’s activities have not been “active”, this could endanger the S corporation
status of LandCo. On the other hand, if you received any verification from the Service that
determines activities of LandCo were “active” for S corporation status purposes, then that would
probably be very helpful in establishing active trade or business for our current transaction.
B. Business Purpose
Another condition for qualifying for tax-free treatment requires that the corporation must
have a “business purpose” to carry out the transaction. As we understand it, the major
motivation for dividing the land between you and Colona is the different plans about the future
disposal of the land. While a perfectly understandable reason, this might not qualify as a
“business purpose” under the code. The reasons are twofold: First, the real divergence will not
become reality until 5 or 6 years down the road. The Service and courts require more imminent
effects to justify the immediate separation. Secondly, the nature of the business is land-leasing.
It is hard to argue that separating it into two leasing companies would promote their operations.
We also learned that your sister wanted to sell some equity interest in LandCo to her
employees in TFC, but because LandCo stock is very expensive, she could not do so. The
division would give her an opportunity to own a smaller company (half the size); therefore, she
would be able to compensate her employees using the stocks of the smaller company.
The Service has long acknowledged that compensating key employees is a valid business
purpose for spin-off transactions if certain conditions are met. One condition is that there is no
other tax-free way of achieving the same goal without causing undue burden and costs. The
Service could easily argue that LandCo should just create a subsidiary, contribute half of the land
to it, and then sell the stock of this new subsidiary to TFC employees. However, this could
probably be rebutted by the burden it poses on LandCo to recapitalize and reallocate stock
ownership constantly between you and your sister. Also, your sister would lose control of
LandCo, which is probably unacceptable to her.
Another, more serious, problem to the “key employee” business purpose is that the key
employees belong to TFC, not to LandCo. Your sister’s interest, as a shareholder, is considered
separate from the corporation’s interest unless there are extraordinary situations. Although the
current situation is quite unique in that LandCo is an S corporation, your sister controls 50% of
LandCo and 100% of TFC, and TFC, as the major customer, contributed 50% of LandCo’s
revenue, there are still uncertainties as to whether the shareholder interests here would be
considered coextensive with the corporate interest.
Since August 8, 2003, the Service will not give opinions on business purpose questions in
spin-offs transactions beforehand. In light of this change and uncertainties just discussed, we do
not recommend proceeding with the transaction as proposed. However, we do have an
alternative proposal to achieve the same goals.
II. Alternative Transaction
There is a likely way to achieve the same goals without the negative tax consequences.
This would involve you and Colona contributing your LLC interests in G&S and TFC to LandCo.
LandCo would then contribute TFC and 160 acres that TFC operates on to a new subsidiary
(NewCo). NewCo would then be distributed to Colona in exchange for her shares in LandCo.
This will leave you and your wife in control of LandCo, which would have G&S, and the 160
acres which G&S operates on, in its possession. Colona would be in control of NewCo, which
would have TFC, and the 160 acres of land TFC operates on, in its possession.
This alternative transaction would likely satisfy the “business purpose” test above
because TFC employees, after the contribution of the LLC interests to LandCo, would be
LandCo’s employees. It would also satisfy the active business test because both TFC and G&S
are active businesses. Furthermore, there is a case that specifically approved a very similar
transaction. Combined, this leads us to the conclusion that this alternative transaction has a
greater chance of withstanding I.R.S. scrutiny and would therefore be considered non-taxable.
III. Reporting Requirements
The Service requires taxpayers to report certain transactions, but ours is likely not one of
them. To be prudent, we suggest adding certain statements to the confidentiality agreements that
basically allow relevant people the freedom to disclose the tax aspect of the transaction.
The current transaction has some plausible arguments for non-taxability. However, given
the negative consequences of failing to meet the non-taxability standard, we believe it a more
prudent course of action to undertake the alternative transaction mentioned above.
TEAM NUMBER __________