In Revenue Ruling 2019-9, issued March 21, 2019, the Internal Revenue Service (Service) provides guidance on the active trade or business requirement under IRC Section 355(b) (the ATB Requirement) in certain distributions under IRC Section 355. Specifically, Revenue Ruling 2019-9 suspends Revenue Ruling 57-464, 1957-2 C.B. 244, and Revenue Ruling 57-492, 1957-2 C.B. 247 (the 1957 Rulings).

Background

Treas. Reg. 1.355-3(b)(2)(ii) states that a business's activities "ordinarily" must include the collection of income to constitute a trade or business under IRC Section 355(b). In its private letter ruling (PLR) program, the Service has generally required the collection of income in each year of the five-year period preceding a distribution under IRC Section 355 — significantly limiting the ability of certain research and development (R&D) intensive businesses and startups (no-income ATBs) to obtain a PLR before the collection of income.

On September 25, 2018, the Service announced that it was considering issuing guidance to address whether a business can satisfy the ATB Requirement if it undertakes entrepreneurial activities, as opposed to investment or other non-business activities, with the purpose of earning income in the future, but has not yet collected any income. Relatedly, Service officials have informally questioned whether the 1957 Rulings are impediments to the issuance of a PLR regarding a no-income ATB.

1957 Rulings

In Revenue Ruling 57-464, a corporation (the distributing corporation) contributed assets associated with its manufacturing business to a newly formed corporation (the controlled corporation) and distributed the stock of the controlled corporation to its shareholders. To satisfy the ATB Requirement, the distributing corporation relied on the rental of certain properties in which it had been engaged during the five-year period preceding the distribution. The Service determined that this business did not satisfy the ATB Requirement; although the distributing corporation had collected gross rental income of $20x per year, net income was negligible after deductions for depreciation and expenses. On these facts, the Service likened the distributing corporation's ownership of the rental properties to an investment and ruled that such rental activities did not satisfy the ATB Requirement.

In Revenue Ruling 57-492, the Service considered an oil exploration and production business that did not produce income or have all the elements necessary to do so during the five-year period. Reasoning that the activities at issue (negotiating for mineral rights, geophysical analysis and research) were preliminary steps and did not represent the commencement of an active business, the Service ruled that such activities did not satisfy the ATB Requirement.

No-income ATB rulings

More recently, a common fact pattern for no-income ATBs has involved R&D-intensive pharmaceutical businesses, in which the process of developing products for commercialization may last several years and incur significant expenses. Despite the substantial activities that occur in this period, the opportunities to collect income from the development of a new drug before FDA approval in certain cases may be limited.

In light of such cases, the Service has announced in Revenue Ruling 2019-9 that it is willing to entertain favorable rulings on no-income ATBs, pending completion of the study announced on September 25, 2018.

At an October 6, 2018, American Bar Association meeting, IRS Associate Chief Counsel (Corporate) Robert Wellen announced that the Service is considering factors that could substitute for the collection of income in determining whether a business satisfies the ATB Requirement. (See 2018 TNT 196-2.) The factors include:

1. Regular, continuing research and related activities by a significant number of full-time management and operational employees
2. Regular, continuing expenses for research and related activities
3. Significant progress toward developing an income-producing product
4. Holding out that the business is available to enter into an income-producing arrangement
5. An actual offer or expression of interest made or received by the business to enter into an income-producing arrangement
6. Similarly situated business have entered into income-producing arrangements with research that has progressed to a similar level as the taxpayer's research

Implications

Although it is not clear that each of these six factors is essential to distinguishing an entrepreneurial endeavor from a mere investment, Revenue Ruling 2019-9 itself is a welcome development to the extent that the Service viewed the 1957 Rulings as an impediment to issuing a favorable PLR.

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