IRS May Relax Collection of Income Prong of Section 355 Active Trade or Business Test for R&D Companies

September 27, 2018

On September 25, 2018, the Internal Revenue Service (the IRS) released a statement announcing a study of the "active trade or business" test for tax-free spin-offs under Section 355 (the ATB Test), as applied to entrepreneurial ventures whose activities consist of lengthy phases of research and development.1 Importantly, the IRS also indicated that, pending completion of the study, it would entertain requests for private letter rulings from such ventures regarding qualification for the ATB Test. This announcement has potentially significant implications for pre-revenue technology companies that have not previously been able to rely on Section 355.

Section 355 and the ATB Test. Section 355 generally allows a corporation to distribute stock or securities of a controlled subsidiary to its stockholders or security holders on a tax-free basis, provided that a number of requirements, including the ATB Test, are met. Where Section 355 does not apply, a spin-off of a subsidiary may, subject to the availability of net operating losses or other tax attributes, be fully taxable to both the corporation and the stockholders receiving a distribution of stock.

The ATB Test generally requires that, for the five years preceding the spin-off, the distributing corporation and the controlled corporation each are engaged in the active conduct of a trade or business, which "ordinarily must include the collection of income and payment of expenses."2 In order to satisfy the ATB Test, each business generally has been required to have revenues throughout the five-year period, except in extraordinary circumstances (for example, when failure to generate revenues in a taxable year was caused by events outside of the corporation's control).3 The inability to meet the ATB Test has prevented certain otherwise active technology companies from engaging in tax-free spin-offs because such companies have long lead times to revenue, and in some cases, such as biotech and medical device companies, must navigate complex regulatory processes before revenue is achieved.

The Release. The IRS acknowledged that many entrepreneurial ventures engage in extended periods of research and development, during which they collect little or no income but "nonetheless incur significant financial expenditures and perform day-to-day operational and managerial functions that historically have evidenced 'active' business." In light of the significant rise in these entrepreneurial ventures, the IRS and the Treasury Department are considering guidance regarding whether a business can satisfy the ATB Test if "entrepreneurial activities, as opposed to investment or other non-business activities, take place with the purpose of earning income in the future, but no income has yet been collected." Relaxation of the ATB Test in these situations could greatly benefit technology companies contemplating spin-offs, but that are unable to meet the ATB Test under current law.

Pending completion of the IRS study of the issue, the IRS indicated that it will entertain requests for private letter rulings regarding satisfaction of the ATB Test by corporations that have not collected income, which may indicate that the IRS is inclined to liberalize the ATB Test in a manner that would be beneficial to earlier stage technology companies.

For further information, please contact Greg Broome (, 415-947-2139); Eileen Marshall (, 202-973-8884); Myra Sutanto Shen (, 650-565-3815); Jonathan Zhu (, 650-849-3388); or any member of the tax practice at Wilson Sonsini Goodrich & Rosati.

Joe Mandry contributed to the preparation of this alert.

1 All Section references herein are to the Internal Revenue Code of 1986, as amended (the Code).
2 Treas. Reg. § 1.355-3(b)(2)(ii); Rev. Rul. 57-492, 1957-2 C.B. 247.
3 See, for example, Rev. Rul. 57-126, 1957-1 C.B. 123; Rev. Rul. 82-219, 1982-2 C.B. 82.