Sunday, June 24, 2007

ATTRIBUTING A TRADE OR BUSINESS FROM A PARTNERSHIP OR LLC FOR SECTION 355 PURPOSES

Usually, if a corporation distributes the stock of a corporation it owns, it will be taxed on any appreciation in the value of that stock over its basis for tax purposes. The shareholders of the distributing corporation may also recognize income or gain on the receipt of the distributed stock. However, Code Section 355 will allow a corporation to distribute a controlled corporation to its shareholders without either the distributing corporation or its recipient shareholders from recognizing gain.

One of the requirements for nonrecognition treatment is that the distributing corporation and the controlled corporation must each be engaged, immediately after the distribution, in the active conduct of a trade or business that has been carried on for the previous 5 years. In circumstances when the active trade or business is owned in a partnership or limited liability company (LLC) taxable as a partnership, under certain circumstances, the active trade or business will be imputed to the distributing or controlled corporation for purposes of meeting the 5 year active trade or business test. Under prior rulings and proposed regulations, a "look-through" for this purpose is allowed if (a) the corporation has a significant interest in the partnership (which means it owns at least 1/3 of the partnership or LLC interests), AND (b) the corporation performs active and substantial management functions for the partnership or LLC with respect to the trade or business assets or activities.

Under a recently issued Revenue Ruling, the IRS has liberalized the look-through rules. Under the new rules, there are now two different ways to qualify for look-through treatment. First, a corporation can impute the trade or business activities of the partnership or LLC if it has a "significant interest" in the partnership or LLC – for this purpose, a "significant interest" is a 1/3 or greater ownership interest. The second way is if the corporation owns less than a significant interest, but performs active and substantial management functions for the partnership or LLC.

The new Revenue Ruling applies to an LLC that is taxable as a partnership. There is no reason that these rules should not also apply to an actual partnership.

These concepts appear to have been borrowed from the continuity of business enterprise rules in the corporate reorganization area, which apply similar requirements of "significant interest" and/or active and substantial management functions in regard to qualifying the continuity requirements by reason of a look-through for a partnership or LLC.

Rev Rul 2007-42, 2007-28 IRB

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