Proposed Regulations Address Corporate Separations, Incorporations, and Reorganizations and Update Section 355 Reporting Requirements

On May 2, 2024, Treasury and the IRS released Rev. Proc. 2024-24, which updates the procedure for requesting private letter rulings from the IRS regarding certain aspects of reorganizations that qualify under Section 368(a)(1)(D) by reason of Section 355 (i.e., divisive reorganizations) and stock distributions that qualify under Section 355 (collectively, Section 355 transactions). In addition, Treasury and the IRS released Notice 2024-38, which outlines their views and concerns and solicits feedback relating to certain matters addressed in Rev. Proc. 2024-24.

Following the issuance of Rev. Proc. 2024-24 and Notice 2024-38, on January 13, 2025, Treasury and the IRS released proposed regulations that contain guidance regarding the nonrecognition of gain or loss in corporate separations, incorporations, and reorganizations. In a separate set of proposed regulations, Treasury and the IRS also propose updated reporting requirements for Section 355 transactions.

The proposed regulations generally address (i) delayed distributions and retentions, (ii) plans of distribution and plans of reorganization, (iii) parties to a reorganization, (iv) direct issuances and intermediated exchanges, (v) post-distribution payments, (vi) replacement of distributing debt, and (vii) liability assumptions under Section 357. The proposed regulations do not include rules concerning the effect a transaction related to a divisive reorganization may have on controlled securities. In addition, the proposed regulations highlight the need for rules governing solvency and the continued viability of the distributing corporation and the controlled corporation, noting that such issues will be addressed in forthcoming guidance concerning the active trade or business requirement under Section 355(b).

Qualifying Retentions

Under Section 355(a)(1)(D)(ii), a distributing corporation may retain stock in a controlled corporation without causing a distribution of controlled corporation stock to be taxable if (i) the distributing corporation distributes stock representing control (within the meaning of Section 368(c)) of the controlled corporation, and (ii) the Secretary is satisfied that the retention was not in pursuance of a plan having as one of its principal purposes the avoidance of U.S. federal income tax. The proposed regulations set forth rules for determining whether a retention of stock in a controlled corporation does not have as one of its principal purposes the avoidance of U.S. federal income tax (a qualifying retention). 

Under the proposed rules, a retention can constitute a qualifying retention by coming within a safe harbor or by satisfying a facts and circumstances test. Regardless of whether the retention satisfies the safe harbor or the facts and circumstances test, the retained stock must be voted in proportion to the votes cast by the controlled corporation’s other shareholders for the retention to be a qualifying retention.

When controlled corporation stock is retained but the retention is not a qualifying retention, the proposed regulations provide that Section 355(a)(1) does not apply to the distribution.

Plans of Distribution and Reorganization

Section 355(a)(1)(D) requires that, at a minimum, control (within the meaning of Section 368(c)) of a controlled corporation be distributed as part of a distribution in order for the distribution to qualify under Section 355. In addition, a transaction can only qualify as a reorganization under Section 368 and the regulations thereunder if it occurs pursuant to a plan of reorganization.

To clarify whether a distribution is part of a distribution (within the meaning of Section 355(a)(1)(D)), the proposed regulations create a plan of distribution concept. For a distribution to be part of a plan of distribution, the proposed regulations require a distributing corporation to evidence a definite intent to carry out the distribution through a written commitment in one or more official records that substantiate the plan. Under the proposed regulations, a plan of distribution must meet certain substantive criteria and must be filed with the IRS. If no plan is filed with IRS, the Commissioner may nevertheless identify a plan of distribution for the transaction. The proposed regulations require the distributing corporation to distribute an amount of stock representing control (within the meaning of Section 368(c)) either (i) within a single tax year, or (ii) over two taxable years but only if all distributions prior to and including the control distribution are undertaken pursuant to a binding commitment described in the plan of distribution or reorganization. Failure to comply with this rule results in the inapplicability of Section 355(a)(1).

As it relates to a plan of reorganization, which is relevant to acquisitive and divisive reorganizations, Treasury and the IRS set forth a preferred approach to the plan of reorganization determination, while also providing that the Commissioner may correct or identify a plan of reorganization in the event the preferred method is not followed. Under the preferred approach, the proposed regulations provide that a plan of reorganization exists if the proposed plan meets the following requirements: 

• The proposed plan identifies all parties to the reorganization, all transactions properly included in the plan of reorganization, all liabilities to be assumed by the acquiring corporation and the creditors associated with those liabilities, all debt of the target corporation that will be satisfied with Section 361 consideration (i.e., consideration received by a target (or distributing) corporation from an acquiring (or controlled) corporation in exchange for assets pursuant to a plan of reorganization), and the creditors associated with that debt; 
• The proposed plan provides the intended U.S. federal income tax treatment of the transactions covered in the plan;
• The proposed plan describes the corporate business purpose for each transaction; and
• The proposed plan establishes that each transaction facilitates the continuance of the business of a party to the reorganization.

Under the proposed rules, a transaction is included in the plan if there is a definite intent to undertake the transaction before the first step, which must be documented in official records but can be subject to contingencies. In addition, the proposed rules contain standards for measuring whether a transaction is sufficiently related to other transactions to which a reorganization provision applies and, therefore, properly included in the plan of reorganization. A transaction is only part of a plan of reorganization if the transaction is consistent with and directly related to one or more corporate business purposes for the reorganization.

The proposed regulations provide that the plan of reorganization is adopted through formal documentation that marks the beginning of the plan, and the plan of reorganization must be completed expeditiously — a standard that is presumed met if the plan is completed in a 24-month period following the first step. However, the proposed rules allow for a plan to be amended after the first step of the original plan is taken if certain criteria are met.

Party to a Reorganization

The provisions permitting nonrecognition for exchanges occurring pursuant to a reorganization generally operate based on a participant in the transaction being a party to the reorganization under Section 368(b). The proposed regulations clarify (i) the rules for determining whether a person is a party to a reorganization, and (ii) the consequences of such determination.

Intermediated Exchanges and Direct Issuance Transactions

In certain circumstances, Sections 361(b)(3) and (c)(3) treat Section 361 consideration transferred to the target corporation’s creditors as if such consideration was transferred to the target corporation’s shareholders, which can be tax-free to the target corporation if the transfer occurs pursuant to the plan of reorganization.

For a transfer of Section 361 consideration by a distributing corporation to its creditor to be considered a distribution by the distributing corporation to its shareholders pursuant to the plan of reorganization, the proposed regulations require that (i) the creditor is a qualifying creditor, (ii) the distributing debt is eligible distributing corporation debt, (iii) the amount of distributing corporation debt that is eliminated does not exceed a maximum amount, and (iv) the transfer of Section 361 consideration in exchange for the distributing corporation debt must be part of a qualifying debt elimination transaction. Even when these requirements are satisfied, the amount of Section 361 consideration treated as transferred in a qualifying debt elimination transaction is reduced by distributing corporation debt that is transitorily eliminated.

A qualifying creditor is generally a creditor that holds eligible distributing corporation debt and that is not a related person, although the proposed regulations provide an exception to the general prohibition on related person creditors. Eligible distributing corporation debt includes (i) historical distributing corporation debt (including certain refinanced historical distributing corporation debt and certain debt incurred pursuant to a revolving credit agreement), (ii) qualifying trade payables, and (iii) direct issuance debt.

The proposed regulations limit the amount of distributing corporation debt that can be satisfied with Section 361 consideration. In particular, the base limitation is equal to the lesser of (i) the aggregate amount of distributing corporation debt, and (ii) the average of the amount of distributing corporation debt owed to persons other than persons related to the distributing corporation as of the close of each of the eight fiscal quarters that end immediately before the earliest applicable date. The actual limitation is the base limitation reduced by the aggregate amount of distributing corporation debt assumed by the controlled corporation pursuant to the plan of reorganization.

Qualifying debt elimination transactions include (i) a qualifying original creditor exchange, (ii) a qualifying intermediated exchange, and (iii) a qualifying direct issuance transaction. The requirements for a qualifying intermediated exchange include, among others, a minimum 30-day holding period of the debt. To constitute a qualifying direct issuance transaction, the direct issuance transaction must not resemble a sale of the Section 361 consideration in exchange for debt proceeds, a determination that is subject to a safe harbor that, if not met, is based on a facts and circumstances analysis.

Post-Distribution Payments

The proposed regulations provide that, in a divisive reorganization in which the distributing corporation receives a post-distribution payment, the distributing corporation does not recognize any gain if (i) the post-distribution payment constitutes Section 361 consideration, (ii) the distributing corporation places the post-distribution payment in a segregated account, and (iii) the distributing corporation distributes the post-distribution payment to its shareholders or creditors by the later of 90 days after receipt of the post-distribution payment or the end of the 12-month period beginning on the date of the Section 361(a) exchange.

The proposed regulations provide guidance on whether the post-distribution payment is Section 361 consideration (as opposed to a separate payment for goods or services) and contain rules addressing payments made under indemnification agreements.

Replacement of Distributing Debt

Under the proposed regulations, the amount of Section 361 consideration that the distributing corporation is treated as transferring to a creditor in a qualifying debt elimination transaction is reduced by the amount of eligible distributing corporation debt that is transitorily eliminated (i.e., eligible distributing corporation debt that is replaced).  However, the proposed rules contain exceptions for ordinary course borrowings and unexpected events.

Liability Assumptions under Section 357

In certain transactions otherwise subject to Section 351 or 361, Section 357 generally allows liabilities to be transferred to an acquiring corporation in a tax-free manner. However, Section 357(b) contains a safeguard that requires gain to be recognized based on the amount of liabilities assumed if an assumption of a liability is done with a principal purpose to avoid U.S. federal income tax or that is not a bona fide business purpose.

The proposed regulations address situations in which the transferee satisfies an assumed liability when the transferor has legal or practical dominion or control over any part of the payment. In general, such payments are considered boot in the Section 351 or 361 exchange (and therefore are not subject to Section 357). The proposed regulations contain an exception for indemnification payments.

The proposed regulations also address the principal purpose standard of Section 357(b). Pursuant to the proposed regulations, an assumption of a liability is done with a principal purpose to avoid U.S. federal income tax or that is not a bona fide business purpose, i.e., the assumption is of the type described in Section 357(b), if the liability assumed was not incurred in the transferor’s ordinary course of business. In the context of divisive reorganizations, the proposed rules provide that distributing corporation liabilities that are not eligible to be assumed are treated as assumed for a U.S. federal income tax avoidance purpose or a non-bona fide business purpose. Eligible distributing corporation liabilities are (i) described in the plan of reorganization, (ii) incurred in the ordinary course of business of the distributing corporation, and (ii) properly associated with the business assets transferred to that corporation and properly related to the controlled corporation’s business operations, the earnings of which will be used to properly satisfy those liabilities. The proposed regulations impose additional requirements for distributing corporation liabilities that are debt — specifically, the debt must be historical distributing corporation debt or meet an exception to the requirement that the debt be historical distributing corporation debt.

Proposed Reporting Requirements

The proposed regulations include a reporting requirement for covered filers that engage in Section 355 transactions. In particular, a covered filer must file with the IRS an annual report with regard to each Section 355 transaction on a Form 7216, Multi-Year Reporting Related to Section 355 Transactions, with the covered filer’s U.S. federal income tax return.

A covered filer generally includes (i) a distributing corporation; (ii) a controlled corporation; (iii) any significant shareholders thereof, which generally are determined based on stock ownership of 5% or more; and (iv) any other person required by the Commissioner in published guidance. A covered filer also includes any successor to any of the foregoing persons. However, a covered filer includes only taxpayers that file certain U.S. federal income tax returns (i.e., Form 1040, Form 1040-NR, Form 1120, Form 1065, Form 1120-F, and Form 1120-S).

The form must be filed annually throughout the required reporting period, which begins in the taxable year in which the first distribution occurs and ends in the fifth taxable year after the taxable year in which the control distribution occurs.