In PLR 202009002, the IRS ruled that a business activity that does not generate income does not violate the "active trade or business" requirement under IRC Section 355 for a tax-free spinoff.

Facts

Distributing corporation (Distributing) conducts research and development (R&D) to identify and create new products. Generally, there is a four-step process from the initial research to the commercialization of a product in the industry.

The PLR defines Distributing's Business 1 as the activities involved in Step 1 through Step 2C1 of the process. Distributing has derived income in Business 1 from sources such as collaboration agreements. The activities of Business 1 are presumed to qualify as an active business.

In addition, for more than five years, Distributing has allocated managerial and operational employee time to Business 2, which is defined as Steps 2C2 through Step 3 of the process. Although Distributing believes that Business 2 has had the ability to generate income through similar sources as Business 1, by foregoing this income, Distributing believes that Business 2 has the ability to generate significantly more income following the completion of Step 3.

Distributing proposes to separate Business 1 from Business 2 by (1) forming a controlled corporation (Controlled); (2) contributing Business 2 to Controlled in exchange for all Controlled's stock; and (3) distributing Controlled's stock to Distributing's shareholders. Following the separation, Distributing will continue to conduct Business 1, and Controlled will conduct Business 2.

Law and analysis

Treas. Reg. Section 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 IRS 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 R&D-intensive businesses and startups (no-income ATBs) to obtain a PLR before the collection of income.

A common fact pattern for no-income ATBs involves 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 IRS announced its willingness to entertain rulings on no-income ATBs (see Tax Alert 2019-0686).

In this PLR, the IRS ruled favorably, saying: "The absence of income collection does not prevent Distributing's Business 2 from constituting a "trade or business" within the meaning of Treas. Reg. Section  1.355-3(b)(2)(ii) for purposes of determining whether the Distribution satisfies the active trade or business requirement of [IRC Section] 355."

Implications

This PLR likely goes farther than any other in blessing an ATB having no income history. It is hoped that the IRS will issue published guidance clarifying that a five-year business that has not yet generated income may nevertheless satisfy the active business requirement depending on the facts and circumstances. Moreover, it is hoped that such guidance would not be limited to business activities that could have been monetized before the spinoff.

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