Section 355

What Is Section 355?

Section 355 refers to a provision within the Internal Revenue Code that allows a corporation to distribute stock and securities of a controlled corporation to its shareholders without the immediate recognition of gain or loss, either at the corporate level or by the recipients. This makes it a critical component of corporate finance and tax law for companies seeking to restructure. Essentially, it permits certain corporate divisions to occur on a tax-free basis, provided a stringent set of statutory and judicial requirements are met²⁵, ²⁶. The objective of Section 355 is to facilitate genuine business reorganizations, such as the separation of distinct business segments, rather than enabling transactions primarily designed for tax avoidance or the distribution of corporate earnings and profits as disguised dividends²⁴.

History and Origin

The concept of tax-free corporate divisions has evolved through various iterations of U.S. tax law. Prior to the Internal Revenue Code of 1954, the tax treatment of corporate separations varied significantly depending on the specific form of the transaction, often leading to divergent tax consequences for economically similar outcomes²³. The Internal Revenue Code of 1954, specifically Section 355, was enacted to create a unified framework for these corporate reorganizations, aiming to permit the tax-free division of existing business arrangements among existing shareholders²².

A significant moment in the history of Section 355 was the 1967 court case, Commissioner v. Mary Archer W. Morris Trust. This case affirmed the tax-free nature of a transaction where a company spun off an unwanted business segment before merging with another entity. Such transactions became known as “Morris Trust” transactions. However, concerns arose that this interpretation could be exploited to facilitate what were effectively corporate sales without corporate-level tax. To address these concerns, Congress enacted Section 355(e) in 1997 as part of the Taxpayer Relief Act, which generally requires the recognition of gain by the distributing corporation if a significant interest in either the distributing or controlled corporation is acquired as part of a plan that includes the distribution.

#²¹# Key Takeaways

• Section 355 permits qualifying corporate division transactions to be tax-free at both the corporate and shareholder levels.
• The primary types of distributions under Section 355 are spin-offs, split-offs, and split-ups.
• Strict requirements, including a legitimate business purpose and an active trade or business test, must be satisfied.
• The transaction must not be used primarily as a "device" for the distribution of earnings and profits.
• Section 355(e) and 355(f) are anti-abuse provisions designed to prevent certain tax-motivated acquisitions in conjunction with a Section 355 distribution.

Interpreting Section 355

Interpreting Section 355 involves a detailed analysis of both statutory requirements and judicial doctrines. The Internal Revenue Service (IRS) and courts scrutinize these transactions to ensure they align with the legislative intent of allowing tax-free separations of genuine businesses, not merely distributing passive assets or facilitating disguised sales. Key requirements for a Section 355 distribution include:

• Control: The distributing corporation must distribute enough stock to constitute "control" (generally 80% or more of voting power and 80% of all other stock classes) of the subsidiary immediately before the distribution.
• ²⁰ Active Trade or Business: Both the distributing corporation and the controlled corporation must be engaged in an active trade or business immediately after the distribution, and this business must have been actively conducted for at least five years prior to the distribution.
• ¹⁹ No "Device": The transaction must not be principally a "device" for the distribution of earnings and profits. This anti-abuse rule aims to prevent shareholders from converting ordinary dividends into lower-taxed capital gains.
• ¹⁸ Business Purpose: There must be a valid, non-tax business purpose for the separation. This is a critical subjective area that is evaluated on a case-by-case basis.
• Continuity of Interest and Business Enterprise: Shareholders must maintain a continuing equity interest in both the distributing and controlled corporations, and the businesses must continue to operate.

R¹⁷ecent IRS guidance, such as Notice 2024-38, indicates an ongoing focus on "monetization" or "value extraction" transactions and continued relationships between the separated entities, signaling evolving IRS positions on certain aspects of Section 355 qualifications.

#¹⁶# Hypothetical Example

Consider "Alpha Corp.," a diversified holding company with two distinct business units: a manufacturing division and a software development division. The management believes that separating the two businesses would allow each to pursue independent growth strategies and unlock greater shareholder value.

Alpha Corp. decides to spin off its software development division into a new, independent company, "Beta Software Inc." Alpha Corp. will transfer all asset transfer and liabilities related to the software business to Beta Software Inc. in exchange for 100% of Beta Software Inc.'s stock. Subsequently, Alpha Corp. distributes all shares of Beta Software Inc. to its existing shareholders on a pro rata basis. After the distribution, Alpha Corp. continues to operate the manufacturing division, and Beta Software Inc. operates the software development business.

For this to be a tax-free transaction under Section 355, Alpha Corp. must ensure that both the manufacturing and software businesses have been actively conducted for at least five years. Additionally, there must be a valid business purpose for the separation—for example, to allow each business to focus on its core competencies and attract specialized investors. If all Section 355 requirements are met, Alpha Corp. and its shareholders would not recognize gain or loss on the distribution of Beta Software Inc. stock.

Practical Applications

Section 355 is a fundamental provision in corporate restructuring. Its practical applications include:

• Spin-offs: A parent company distributes shares of a subsidiary to its existing shareholders without requiring them to surrender any of their original shares. This results in shareholders owning stock in both companies.
• ¹⁵Split-offs: Shareholders of the parent company exchange some of their parent company shares for shares in the subsidiary. This resembles a stock redemption.
• Split-ups: The parent company distributes the stock of two or more subsidiaries to its shareholders in complete liquidation of the parent. After a split-up, the original parent ceases to exist, and shareholders own stock only in the former subsidiaries.

The¹⁴se transactions are commonly used to achieve strategic goals such as unlocking shareholder value, enabling focused management for distinct business lines, facilitating mergers and acquisitions involving only specific business segments, or separating regulated businesses from unregulated ones. Recent IRS proposed regulations, such as those discussed in a 2025 PwC analysis, highlight evolving reporting requirements for Section 355 transactions to ensure compliance with tax-free treatment.

¹³Limitations and Criticisms

While Section 355 offers significant tax benefits for corporate reorganizations, it comes with strict limitations and has faced criticisms. One major limitation is the complex set of statutory and judicial requirements that must be satisfied. Failure to meet any of these can result in the entire distribution being a taxable event, leading to significant unrecognized gain at both the corporate and shareholder levels. For ¹²instance, the "active trade or business" test can be particularly challenging for companies with long research and development phases or those without immediate revenue generation.

Ano¹¹ther area of scrutiny involves anti-abuse rules like Section 355(d) and 355(e), which target distributions that are part of a plan to acquire a 50% or greater interest in the distributing or controlled corporation. These provisions were enacted to prevent the use of Section 355 to circumvent the repeal of the General Utilities doctrine, which generally requires corporate-level gain recognition on the distribution of appreciated property. Rece⁹, ¹⁰nt IRS pronouncements suggest an increased focus on transactions involving "monetization" or "value extraction" where a controlled corporation assumes substantial debt from the distributing corporation, indicating ongoing efforts to tighten the interpretation of Section 355 rules. The ⁸Securities and Exchange Commission (SEC) also considers a valid business purpose when assessing spin-offs.

⁷Section 355 vs. Spin-off

While the term "spin-off" is frequently used colloquially to describe any transaction under Section 355, Section 355 is the overarching legal provision that governs various types of tax-free corporate divisions. A spin-off is one specific method of corporate division permitted by Section 355. In a spin-off, the shares of a newly formed or existing subsidiary are distributed pro rata to the shareholders of the parent company, and shareholders do not surrender any of their original shares.

In ⁶contrast, Section 355 also covers "split-offs" and "split-ups." A split-off involves shareholders exchanging a portion of their shares in the parent company for shares in the subsidiary. A split-up involves the parent company distributing the stock of two or more subsidiaries and then liquidating itself. Therefore, while all spin-offs aim to qualify under Section 355 for tax-free treatment, not all Section 355 transactions are spin-offs; they can also be split-offs or split-ups.

FAQs

What are the main types of transactions covered by Section 355?

Section 355 primarily covers three types of corporate division transactions: spin-offs, split-offs, and split-ups. Each involves a different method of distributing a controlled corporation's stock to the distributing corporation's shareholders.

Why would a company pursue a Section 355 transaction?

Companies often pursue Section 355 transactions to separate distinct business lines, allowing each to have its own management, capital structure, and strategic focus. This⁵ can potentially unlock shareholder value, facilitate future mergers or acquisitions of specific business segments, or improve operational efficiency.

###⁴ What is the "active trade or business" requirement?
The active trade or business requirement under Section 355 mandates that both the distributing corporation and the controlled corporation must be engaged in an active business immediately after the distribution. Furthermore, this business must have been actively conducted for at least five years prior to the distribution, and it must not have been acquired in a taxable event during that period.

###³ What happens if a Section 355 transaction fails to qualify as tax-free?
If a transaction intended to qualify under Section 355 fails to meet the requirements, it typically becomes a taxable event. This can result in the distributing corporation recognizing gain on the distributed stock as if it were sold, and the shareholders recognizing ordinary income (as a dividend) or capital gains on the receipt of the stock, depending on the circumstances.

###¹, ² Does Section 355 apply to foreign companies?
Section 355 is part of the U.S. Internal Revenue Code and primarily governs U.S. federal income tax consequences. While its principles may influence international restructurings, the specific tax treatment for foreign companies or international distributions would depend on various factors, including applicable tax treaties and the tax laws of other involved jurisdictions.