On March 13, 2018, the IRS Large Business and International Division (LB&I) identified five new campaigns that expand its focus areas under its issue-based examination and compliance process, including a campaign on costs that facilitate a Section 355 transaction. The campaigns are in addition to the 13 campaigns announced on January 31, 2017 (see Tax Alert 2017-0234) and the 11 campaigns announced on November 3, 2017 (see Tax Alert 2017-1876).

Campaigns are designed to select returns with identified potential compliance risks. As before, LB&I plans to address noncompliance through a variety of treatment streams, although four of the five campaigns will use issue-based examinations. Other treatment streams could include outreach to practitioners, changes to IRS forms and "soft" letters. It is anticipated that the Section 355 campaign will entail an issue-based examination approach, with focused information document requests.

LB&I stated that the five campaigns were identified through LB&I data analysis and suggestions from IRS compliance employees. LB&I's stated goal is to improve return selection, identify issues representing a risk of non-compliance and make the greatest use of limited resources.

In the announcement, LB&I briefly explained the issue, described the treatment streams, and named the lead LB&I executive and practice area.

Costs that facilitate a Section 355 transaction

Taxpayers must capitalize costs paid in the process of investigating or otherwise pursuing a Section 355 tax-free corporate distribution (e.g., spin-off or split-up), as such costs are facilitative, under Reg. Section 1.263(a)-5(a)(4). The IRS campaign description for Section 355 explains that some taxpayers, however, deduct the costs that facilitated the corporate distribution in the year they complete the distribution. This campaign will focus on ensuring taxpayer compliance with the requirement to capitalize the costs to facilitate the distribution.

Implications

In our experience, taxpayers often incur significant costs in the context of a spin-off transaction, including costs to separate one or more businesses. These costs are analyzed under the rules of Reg. Section 1.263(a)-5 to determine which amounts are capitalizable, deductible or amortizable. The primary rule for treating costs as nonfacilitative (i.e., as deductible or amortizable) is Reg. Section 1.263(a)-5(e)(1) (the "bright line date rule"), which applies only to three specific types of transactions (i.e., "covered transactions").¹ Also, Revenue Procedure 2011-29 provides a safe harbor election for allocating success-based fees paid in business acquisitions or reorganizations described in Reg. Section 1.263(a)-5(e)(3).²

Section 355 transactions are not among the types of transactions treated as "covered transactions." Nevertheless, not all costs incurred in a Section 355 transaction are facilitative and must be capitalized. For example, certain costs related to operational separation may be deductible or amortizable. As another example, some Section 355 transactions, referred to as Reverse Morris Trust (RMT)³ transactions, involve the distribution of a controlled corporation's stock under Section 355, followed by the acquisition of the controlled corporation by an unrelated third party in a reorganization described in Section 368. The tax-free reorganization may qualify as a "covered transaction" and certain costs incurred in an RMT transaction may be treated as nonfacilitative under the bright line date rule.

Given the potential for increased scrutiny by the IRS for Section 355 transactions, taxpayers should analyze their transaction costs to determine which costs are deductible and which must be capitalized. For example, taxpayers should seek to thoroughly support their positions taken with regard to non-facilitative separation costs for eligible transactions. There has been very little guidance issued by the IRS in this area. When analyzing their transaction costs, taxpayers should pay particular attention to:

— Location considerations (i.e., identification of costs as related to the spin-off entity or distributing entity)

— The assets to which the costs are properly allocated

— The timing of recovery of capitalized asset costs, as applicable, to the extent such costs are amortizable or depreciable

Taxpayers that may be affected by this campaign also should consider developing strategies to effectively respond to any formal or informal inquiries from the IRS.

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ENDNOTES

¹ Reg. Section 1.263(a)-5(e)(3) defines "covered transactions" as: (i) a taxable acquisition by the taxpayer of assets that constitute a trade or business; (ii) a taxable acquisition of an ownership interest in a business entity (whether the taxpayer is the acquirer in the acquisition or the target of the acquisition) if, immediately after the acquisition, the acquirer and the target are related within the meaning of Section 267(b) or 707(b); and (iii) a reorganization described in Section 368(a)(1)(A), (B), or (C) or a reorganization described in Section 368(a)(1)(D) in which stock or securities of the corporation to which the assets are transferred are distributed in a transaction that qualifies under Section 354 or 356 (whether the taxpayer is the acquirer or the target in the reorganization).

² 2011-1 C.B. 746. In lieu of maintaining the documentation required by Treas. Reg. Section 1.263 (a)-5 (f), this safe harbor permits electing taxpayers to treat 70% of the success-based fee as an amount that does not facilitate the transaction. The remaining portion of the fee must be capitalized as an amount that facilitates the transaction.

³ See Revenue Ruling 2003-79, 2003-2 C.B. 80, for a description of an RMT transaction.