With lease accounting due to go through major changes over the next year, it is a good time to review other real estate rental issues, particularly those having to do with tax-free divestitures. In a private-letter ruling issued by the Internal Revenue Service last year, the agency delineates between situations that meet the “active business” requirements and those that don’t, for purposes of spin-offs.
Before looking into the private-letter ruling, let’s examine a similar situation to give the guidance some context. Consider a case in which one company, Pro Corp. (ProCorp), which is engaged in the active conduct of a trade or business, owns all of the stock of Sigma Corp. In turn, Sigma owns an office building and uses an independent contractor to manage the property. The independent contractor provides the following services:
• supplies and supervises janitors and maintenance personnel;
• collects rents;
• pays bills;
• advertises for tenants;
• negotiates leases; and
• handles tenant complaints.
The president of ProCorp — who is also an officer of Sigma — devotes some time to the operation of the building. He visits the building periodically to ensure the maintenance is done properly; he attends to all matters concerning zoning, building permits, and other local laws affecting the building; and he approves the leases negotiated and the repair contracts.
For valid business reasons, ProCorp distributes to its shareholders all of its stock in Sigma. The distribution does not qualify as a tax-free spin-off because the active business requirement is not met: Sigma is not engaged in the active conduct of a trade or business (see Revenue Ruling 86-125).
The Internal Revenue Code — specifically Section 355(b) — requires that both the distributing corporation (ProCorp) and the controlled corporation (Sigma) be engaged in the active conduct of a trade or business immediately after the distribution. To meet Section 355(b) requirements, each corporation must be engaged in entrepreneurial endeavors of “such a nature,” and to such an extent, as to qualitatively distinguish its operations from “mere investments.” In addition, the business activity has to be activity of the corporation itself, and not of independent contractors.
In the ProCorp case, however, the operational and management activity of the rental business is largely performed by independent contractors. Although some of Sigma’s activities could be considered managerial or operational, these activities are not different from those a prudent investor would be expected to undertake, and are not enough to qualitatively distinguish Sigma’s operations from mere investments. Accordingly, Sigma is not engaged in the active conduct of a trade or business.
However, if the corporation itself (through its employees) directly performs active and substantial management and operational functions, the corporation will be considered engaged in the active conduct of a trade or business. As a result, the IRS issued guidance last year in a private-letter ruling, LTR 200943019, to explain the distinction.