ABA Tax Section Comments on Treatment of ‘No-Income’ Businesses

July 17, 2019

Hon. Charles P. Rettig
Commissioner
Internal Revenue Service
1111 Constitution Avenue, NW
Washington, DC 20224

Re: Comments Regarding Application of the Active Trade or Business Requirement under Section 355(b)

Dear Commissioner Rettig:

Enclosed please find comments in response to statements by the Internal Revenue Service regarding the application of the active trade or business requirement under Section 355 of the Internal Revenue Code to businesses without income collection. These comments are submitted on behalf of the Section of Taxation and have not been approved by the House of Delegates or the Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association.

The Section of Taxation would be pleased to discuss these comments with you or your staff.

Sincerely,

Eric Solomon
Chair, Section of Taxation
American Bar Association
Washington, DC

Enclosure

cc:
Hon. David Kautter, Assistant Secretary (Tax Policy), Department of the Treasury
Jeffrey Van Hove, Office of Tax Policy, Department of the Treasury
Krishna P. Vallabhaneni, Tax Legislative Counsel, Department of the Treasury
Colin Campbell, Attorney-Advisor, Department of the Treasury
Hon. Michael Desmond, Chief Counsel, Internal Revenue Service
William M. Paul, Deputy Chief Counsel (Technical), Internal Revenue Service
Robert H. Wellen, Associate Chief Counsel (Corporate), Internal Revenue Service
Lisa Fuller, Deputy Associate Chief Counsel (Corporate), Internal Revenue Service
Russell P. Subin, Senior Counsel, Office of Associate Chief Counsel (Corporate), Internal Revenue Service
Lola L. Johnson, Attorney Advisor, Office of Associate Chief Counsel (Corporate), Internal Revenue Service

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AMERICAN BAR ASSOCIATION
SECTION OF TAXATION

Comments on the Service's Statement Regarding Application of the Section 355 Active Trade or Business Requirement to Businesses Without Income Collection

These comments (“Comments”) are submitted on behalf of the American Bar Association Section of Taxation (the “Section”) and have not been approved by the House of Delegates or Board of Governors of the American Bar Association. Accordingly, they should not be construed as representing the position of the American Bar Association.

Principal responsibility for preparing these comments was exercised by Amie Colwell Breslow, Steve Fattman, Nicole Field, Philip Mammen, Eileen Marshall, Maury Passman, Amit Sachdeva, Rebecca Sager, Heather Sidwell, and Jay Singer. Significant contributions were made by Bill Alexander, Derek Cain, Bryan Collins, Jack Cummings, Elliott Freier, Scott Levine, Victor Penico, and Tom Wessel. The Comments have been reviewed by David Wheat, Council Director for the Corporate Tax and Affiliated & Related Corporations Committees and Lisa Zarlenga of the Section's Committee on Government Submissions.

Although members of the Section may have clients who might be affected by the federal tax principles addressed by these Comments, no member who has been engaged by a client (or who is a member of a firm or other organization that has been engaged by a client) to make a government submission with respect to, or otherwise to influence the development or outcome of one or more specific issues addressed by, these Comments has participated in the preparation of the portion (or portions) of these Comments addressing those issues. Additionally, while the Section's diverse membership includes government officials, no such official was involved in any part of the drafting or review of these Comments.

Contact:

Maury Passman
(202) 533-3775
MPassman@KPMG.com

Jay Singer
(202) 756-8461
JSinger@MWE.com

Date: July 17, 2019

I. EXECUTIVE SUMMARY

These Comments are in response to two requests for information concerning the active trade or business requirement for section 355¹ distributions.² On September 25, 2018, the Internal Revenue Service (the “Service”) issued a statement announcing that the Service and the Department of the Treasury (“Treasury”) are considering issuing guidance regarding the active trade or business (“ATB”) requirement under section 355(b) (the “ATB Requirement”).³ Specifically, the September 2018 Statement indicates that Treasury and the Service are considering guidance addressing the potential qualification under section 355(b) of businesses that have not yet collected income but that are nevertheless engaged in entrepreneurial activity (“No-Income ATBs”) — e.g., internal research and development (“R&D”), as distinguished from providing R&D services to unrelated customers.⁴ On May 6, 2019, the Service issued another statement in which it requested specific information to assist in identifying what types of No-Income ATBs should be treated as satisfying the ATB Requirement.⁵

We commend Treasury and the Service for considering guidance and private letter rulings (“PLRs”) on this question. These Comments discuss the application of section 355(b) to such businesses and recommend, in response to the Statements, that:

II. DISCUSSION

A. Section 355(b) Background

Section 355 provides for non-recognition treatment with respect to corporate distributions of the stock of a controlled corporation if certain requirements are met. One of the requirements to qualify under section 355 is that both the distributing corporation and the controlled corporation must be engaged, immediately after the distribution, in the active conduct of a trade or business.⁹ For this purpose, a corporation is treated as engaged in the active conduct of a trade or business if, and only if, the corporation is engaged in the active conduct of a trade or business, and the trade or business has been actively conducted throughout the five-year period ending on the date of distribution.¹⁰

This five-year requirement originated in the Internal Revenue Code of 1954, and it reflects Congressional reaction to prior law. In 1951 (after a 17-year hiatus), Congress reinstated tax-free treatment for qualifying spin-offs, provided the stock of the controlled corporation was distributed pursuant to a plan of reorganization.¹¹ Under the 1951 legislation, tax-free treatment was not available if it appeared that “any corporation which is a party to such reorganization was not intended to continue the active conduct of a trade or business after such reorganization.”¹² Treasury interpreted this limitation to allow the distribution of a controlled corporation that held only cash and investment assets, provided there was a clear and definite plan for the controlled corporation to purchase a continuing business shortly after the distribution.¹³

The House's 1954 proposal would have permitted the separation of active and inactive businesses. For this purpose, an inactive corporation would have been one with more than ten percent of its income comprised of personal holding company income. In exchange for allowing the separation of an inactive corporation, the House proposal would have imbued the inactive corporation with a ten-year taint, such that the disposition of its stock within ten years following its separation would have resulted in ordinary income for the shareholder to the full extent of the proceeds, and any amount received in a distribution from such corporation during the ten-year period would have been includible in the recipient shareholder's income without regard to the amount of earnings and profits of such corporation.¹⁴ To avoid characterization as inactive, a corporation would have had to have been engaged in active business for five years prior to the separation, and to have maintained separate books.¹⁵ The House proposal was met with significant criticism in the Senate Finance Committee hearings, and was not advanced.¹⁶ Instead, the Senate took a different approach, requiring both the distributing and controlled corporations to be engaged in an ATB immediately after the distribution, and requiring a business to have been conducted throughout the five-year pre-distribution period to qualify as an ATB.¹⁷ The Senate's approach was adopted in Conference, accompanied by an additional ATB restriction¹⁸ and a gloss in the conference report regarding business expansion.¹⁹

Shortly after the 1954 enactment of section 355, Treasury published proposed regulations implementing the ATB Requirement.²⁰ The regulations were issued as final in 1955 (“1955 Regulations”).²¹ In the 1955 Regulations, Treasury and the Service took the position that section 355 was not available for the vertical separation of a single business.²² They also took the position that a division of a vertically-integrated business along functional lines, such as the separation of coal mining operations from the manufacture and sale of steel and steel products, was impermissible, on the basis that the activities “in connection with the coal mine do not constitute a trade or business, since such activities are not themselves independently producing income although a part of the business operated for profit.”²³ In contrast, Treasury and the Service took the view that a business could be separated horizontally, such as along geographical lines, with activities in different states treated as separate businesses. For example, a corporation that manufactured and sold steel containers for oil and oil products was viewed as being engaged in a separate ATB in each state in which it operated.²⁴ Initially, this may have been viewed as favorable to taxpayers, because it allowed a division of a single business otherwise precluded under the 1955 Regulations; however, the Service's view was also unnecessarily restrictive in that it allowed the Service to argue that a geographically concentrated group of activities did not constitute a qualifying ATB unless those activities had been conducted in that geographic space throughout the five-year pre-distribution period.²⁵

The regulatory prohibition against dividing a single business was not well received by the courts, and the portion of the 1955 Regulations that articulated this position was held to be invalid in a reviewed Tax Court opinion four years after its promulgation.²⁶ The Service briefly maintained its position,²⁷ but after losing the second appellate decision²⁸ on the issue, it reversed course and announced that it would allow the division of a single business notwithstanding its 1955 Regulations.²⁹ Similarly, the geographic distinction quickly proved untenable, and was rejected in Lockwood.³⁰ In addition, the court in Rafferty — in a decision won by the Service — expressed significant doubt on the correctness of the 1955 Regulations in light of their overbreadth and the judicial rejection of their single-business requirement.³¹

The Service had more litigating success in the context of owner-occupied real estate, in which the judicial opinions describe real estate operations that were largely tangential, generated little income, and presented significant device concerns.³² Significantly, however, in the E Ward King appeal decided four months after Rafferty, the Service lost a real estate case in which the appellate court criticized the 1955 Regulations.³³ In sum, several of the positions the Service had taken in the 1955 Regulations were significantly undermined by the court decisions in Coady, Marett, Lockwood, Rafferty, and E. Ward King.

In response to these judicial developments, Treasury and the Service issued proposed regulations in 1977 to replace the 1955 Regulations,³⁴ and published the regulations as final in 1989 (“1989 Regulations”).³⁵

The rationale of the courts that addressed the 1955 Regulations is relevant to the No-Income ATB issue considered by these Comments. In the reviewed Tax Court opinion in Coady, the court stated:

A careful reading of the definition of the active conduct of a trade or business contained in subsection (b)(2) indicates that its function is also to prevent the tax-free separation of active and inactive assets into active and inactive corporate entities.³⁶

The First Circuit in Rafferty summarized the gravamen of an ATB:

It is our view that in order to be an active trade or business under § 355 a corporation must engage in entrepreneurial endeavors of such a nature and to such an extent as to qualitatively distinguish its operations from mere investments. Moreover, there should be objective indicia of such corporate operations.³⁷

The current ATB regulations were explicitly promulgated to adhere to Coady and Marett,³⁸ and should be interpreted in a manner consistent with these cases. Moreover, the Service has articulated the purposes underlying the ATB requirement as “the prevention of the temporary investment of liquid assets in a new business by an existing corporation in order to distribute the stock of the new business to the shareholders of the existing corporation in a 'spin-off' or other tax-free corporate division.”³⁹ Thus, the ATB requirement is properly viewed as a “backstop” to the nondevice requirement of section 355(a)(1)(B)⁴⁰ and the term “trade or business” should be defined by reference to the underlying policy.⁴¹

B. Current Law and Administrative Practice

As suggested by the Statements, guidance is needed to clarify whether a business can satisfy the ATB Requirement in various circumstances 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 (gross) income has yet been collected. The main issue considered here is whether the absence of the collection of gross income should prevent a business from satisfying the ATB Requirement.

As noted above, section 355(b) requires both the distributing corporation and the controlled corporation to be engaged in an ATB immediately after the distribution, and that such business(es) have been actively conducted for the five years immediately preceding the distribution. For this purpose, section 355 does not define the term “trade or business.” Regulations under section 355(b) provide that a corporation shall be treated as engaged in a trade or business immediately after the distribution “if⁴² a specific group of activities are being carried on by the corporation for the purpose of earning income or profit, and the activities included in such group include every operation that forms a part of, or a step in, the process of earning income or profit. Such group of activities ordinarily must include the collection of income and the payment of expenses.”⁴³

We are aware of few authorities addressing the scope of the “ordinarily” standard in Regulation section 1.355-3(b)(2)(ii). In one such authority, Rev. Rul. 82-219, Y corporation manufactured equipment specifically designed for an unrelated company, Z. In January 1980, Z unexpectedly went bankrupt and cancelled further orders from Y. Although Y's engineers subsequently redesigned its product, and its employees actively searched for customers, no customers were found until January 1981. During that year, Y sold no equipment. Y shut its plant down and substantially reduced its employees, although it continued to employ individuals to maintain its plant in anticipation of future sales. Thus, Y incurred expenses but generated no income for one year.

Concluding that a 1982 spin-off of Y by its parent corporation X satisfied the ATB requirement, the ruling stated:

Y has incurred expenses and engaged in substantial managerial and operational activities representative of the active conduct of a trade or business for each of the 5 years preceding the date of the distribution of the Y stock, but it has collected income for only 4 of the preceding 5 years, since no manufacturing receipts were received by it in 1980. The use of the word "ordinarily" in section 1.355-1(c) of the regulations indicates that there are exceptional situations where, based upon all the facts and circumstances, there is no concurrent receipt of income and payment of expenses which, nevertheless, will constitute an active trade or business within the meaning of section 355(b) of the Code. Y's failure to receive manufacturing receipts during 1980 was unforeseen and caused by events outside of its control. Y took all reasonable steps to secure manufacturing receipts by redesigning its limited use product and actively seeking new customers for such product, and shortly thereafter began to again receive manufacturing receipts from its business. These extraordinary facts, when coupled with Y's activities before January, 1980, and after January, 1981, indicate that Y was engaged in the active conduct of a trade or business within the meaning of section 355(b) for the 5-year period preceding the date of the distribution of its stock by X.⁴⁴

Rev. Rul. 82-219 might be read to suggest that the Service would allow a No-Income Business to satisfy the ATB Requirement only in narrow or “extraordinary” circumstances, particularly if the business is in the midst of a lengthy R&D phase.⁴⁵ In addition, until the recent issuance of the Statements and Rev. Rul. 2019-09,⁴⁶ described below, there was concern that the Service might not apply the term “ordinarily” in Regulation section 1.355-3(b)(2)(ii) in a fashion consistent with the policies underlying the ATB Requirement.⁴⁷ The Statements, which appear to reflect the Service's experience with ruling requests and taxpayer inquiries, announced that Treasury and the Service are considering issuing guidance regarding the application of the ATB Requirement to businesses that have yet to collect income.⁴⁸ According to the September 2018 Statement:

[T]he IRS has observed a significant rise in entrepreneurial ventures whose activities consist of research and development in lengthy phases. During these phases, the ventures often collect no income or negligible income but nonetheless incur significant financial expenditures and perform day-to-day operational and managerial functions that historically have evidenced an 'active' business. For instance, a venture in the pharmaceutical or technology field might engage in research to develop new products with the purpose of earning income in the future from sales or licenses. The venture might even forgo current income opportunities to obtain increased future income by developing products on its own. The nature and duration of the research phases is often dictated by regulatory agencies, which require complex review processes that can span multiple years and cost millions of dollars.”⁴⁹

The September 2018 Statement indicates that potential guidance might address whether a business can qualify as an ATB “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.”

In informal public comments, the Associate Chief Counsel (Corporate) has noted the following factors as being relevant to the determination of whether such a business satisfies the ATB Requirement:

As noted above, the Service also recently issued Rev. Rul. 2019-09.⁵¹ Rev. Rul. 2019-09, which does not contain a fact pattern, suspends Rev. Rul. 57-464⁵² and Rev. Rul. 57-492⁵³ pending the completion of the study described in the Statements. Rev. Rul. 2019-09 states that those rulings “could be interpreted as requiring income generation for a business to qualify as an ATB.”

In Rev. Rul. 57-464, a corporation separated its manufacturing business from its rental real estate business. The real estate consisted of three residences (one of which was occupied by the sister-in-law of the corporation's president, apparently rent-free, and one of which was rented by employees of the corporation) and a small office building. The ruling concludes that the real estate business's “net income was negligible after deductions for depreciation and other expenses. These properties were acquired either as an investment or as a convenience to the employees of the manufacturing business.”⁵⁴ The ruling adds that “as in Example (4) of section 1.355-1(d) of the [former] regulations, such rental activity was only incidental to the manufacturing business.”⁵⁵

We believe that Rev. Rul. 57-464 is out of step with the Service's ruling position (even before Rev. Rul. 2019-09) and current law. First, the Service's most recent guidance on whether the relevant measure under the ATB Requirement is gross or net income indicates that the appropriate measure is gross income.⁵⁶ In addition, Rev. Rul. 57-464 does not focus to any extent on whether services are provided by the corporation in connection with the renting of the properties.⁵⁷ Furthermore, the analysis of the ruling, in concluding that the rental activity was incidental to the corporation's manufacturing business, appears to be an application of the long repudiated position that the ATB requirement may not be satisfied by the division of a single business.⁵⁸ In the wake of the Statements, we believe it was prudent to suspend Rev. Rul. 57-464. To the extent that the revenue ruling's analysis depended on the magnitude of the corporation's net income, it is understandable that Treasury and the Service viewed suspension of the ruling as necessary or helpful to issuing PLRs blessing the absence of gross income. In any case, for the reasons described above, it is difficult to see how Rev. Rul. 57-464 would survive the study described in the Statements, no matter how the government handles the No-Income ATB question. We recommend that Rev. Rul. 57-464 be obsoleted.

The other ruling suspended by Rev. Rul. 2019-09, Rev. Rul. 57-492, involved a corporation that for over 20 years was engaged in refining, transporting, and marketing petroleum products. In 1947, the corporation began activities related to oil exploration. It negotiated for mineral rights and began geological and geophysical work in 1948 and 1949. The corporation obtained permits in February 1951 and began drilling exploratory wells in 1953 and 1954, when it discovered oil in commercial quantities. During this period (i.e., 1947-1954), the corporation had incurred substantial expenditures for exploration and drilling activities. Oil was discovered in commercial quantities in 1954. The corporation later transferred the oil exploration and production assets to a new corporation and distributed the stock of the new corporation to its shareholders.⁵⁹ The ruling concluded that the controlled corporation failed the ATB Requirement.

The ruling stated that:

“[s]uch activities were preliminary steps, either required by law or dictated by prudent business considerations to investigate, inspect and appraise the prospective venture in order to determine if it should be continued or abandoned. This is further borne out by the fact that, prior to February, 1951, the old corporation was forestalled from engaging in active exploration by operation of law, since the mineral rights were not acquired by the old corporation until that time.”⁶⁰

The ruling explained that section 355:

“contemplates that an active business ordinarily includes the collection of income as well as the payment of expenses. Before oil was discovered in commercial quantities in 1954, the venture here involved did not include any income producing activity or any source of income. If the venture had been discontinued any time prior to such discovery of oil, the old corporation would never have been engaged in producing oil. Furthermore, prior to the discovery in 1954 of oil in commercial quantities, the exploration and producing activities conducted by the old corporation were not themselves independently producing income, nor did they contain for the past five years, all of the elements necessary to produce income.”⁶¹

Thus, the ruling appears to rest on two grounds. First the venture did not, until 1954, consist of activities that would produce income independently of the distributing corporation's other business, which was active. The ruling is obsolete to this extent because it is based on the portion of the 1955 Regulations that has since been repealed. Second, the venture did not result in the collection of income for all five years preceding the distribution. That rationale is consistent with our understanding of how the government generally applied the “collection of income” standard prior to the Statements. Although the recommendation of these Comments is based largely on our understanding of R&D intensive businesses and businesses that go through lengthy periods developing products, processes, or systems, as well as high-tech start-up businesses, the principle underlying our recommendation is consistent with treating the entrepreneurial activities described in Rev. Rul. 57-492 (including prior to the discovery of oil in commercial quantities) as an ATB. Assuming that the Government agrees, Rev. Rul. 57-492 should either be obsoleted as no longer consistent with the Service's views post-Rev. Rul. 2019-09 or revoked upon the issuance of further guidance.

The final authority that we are aware of that may bear on the questions considered here is Regulation section 1.355-3(b)(2)(iv)(B), which provides that “[t]he active conduct of a trade or business does not include . . . (B) The ownership or operation (including leasing) of real or personal property used in a trade or business, unless the owner performs significant services with respect to the operation or management of the property.”⁶² One might ask whether this limitation applies to businesses that do not collect income but that engage solely in activities directed at developing intellectual property for commercial use. Should such activities be treated as “services with respect to the operation or management of the property”? If such activities are entrepreneurial (i.e., engaged in with a view to providing products or services to customers at a profit), then the limitation should not prevent a business engaged in R&D with such a profit motive from constituting an ATB.

C. New Guidance

As suggested by the Statements, since the issuance of the 1955 Regulations, it has become more common for companies to consider spin-offs of businesses that have been engaged in significant, active, and resource-intensive R&D over a period prior to the generation of revenues or profits. For example, a technology-related business may be conducted in corporate form to develop intellectual property, and it may take a period of years to reach the point where the technology can be commercially exploited. During this period, the corporate venture may employ a significant number of technology professionals, including scientists and engineers, to develop the technology. In addition, the corporate business venture may employ persons to perform various business-related functions (executive, managerial, bookkeeping, finance and treasury, human resources, in-house legal, real estate, procurement, maintenance, etc.). This may involve the expenditure of considerable resources to support these activities, often funded through multiple rounds of angel and venture capital financing.

Whatever may be said about these business ventures, they often will exhibit all of the aspects of an ATB other than the collection of gross income or profit. At the same time, these business ventures do not bear indicia of a corporate bail-out, nor do they implicate the inactive business concerns that motivated the Senate's rejection of the 1954 House proposal or pre-1954 law. In this regard, note that the Regulations under section 355(a)(1)(B), the device prohibition, look to the following factors as evidence of device: (i) the spin-off is pro rata, (ii) the spin-off is followed by a sale or exchange of the stock of distributing or controlled, (iii) distributing or controlled owns assets not used in an ATB, and (iv) distributing or controlled is engaged in a secondary business that can be sold without adversely affecting the business of the other corporation.⁶³ Frequently, the only factor present in the case of the potential separation of a No-Income ATB is the pro rata nature of the distribution. In addition, under the current Regulations, a compelling business purpose to separate and distribute (as described further below) is frequently strong evidence of nondevice.⁶⁴ Finally, the device statute merely prohibits a distribution from having as its principal purpose the bail-out of earnings and profits of either distributing or controlled. In light of the underlying policy of the ATB Requirement (i.e., that it is intended to be an additional safeguard against a device), the Government should have relatively few concerns issuing guidance under the ATB Requirement addressing the separation a No-Income ATB.

Regarding the business purpose to separate a No-Income ATB, many of these business ventures find it critical to secure financing to sustain their business operations, and on occasion it may be important to separate aspects of the technology under development so that potential funding sources can specifically devote their funding to a particular group of activities without risk that the funding may be diverted to other activities. This critical business need invokes the rationale of the 1951 Congress that reinstated the tax-free spin-off transaction, in that it is economically unsound to impede the separation of business into a greater number of enterprises when undertaken for legitimate business purposes.

D. Recommendation

To this end, we recommend that in administering the ATB requirement, Treasury and the Service interpret and apply the phrase “ordinarily must include the collection of income” flexibly, consistent with the direction of the Statements, to allow a group of activities that exhibits all of the attributes of an ATB other than the collection of gross income to qualify as an ATB for purposes of section 355(b). In such cases, where a corporation is engaged in substantial activities directed at developing a commercially viable product or service for sale in an ongoing business, the policy concerns underlying the ATB Requirement are satisfied. Accordingly, we recommend that Treasury and the Service issue guidance that would provide that such a corporation can satisfy the ATB Requirement. For example, Treasury and the Service could issue sub-regulatory guidance in the form of a revenue ruling addressing a typical fact pattern. Specifically, Treasury and the Service should consider guidance containing the simple fact patterns and conclusions illustrated below.

The examples below are intended to illustrate circumstances under which taxpayers engaged in certain research-intensive entrepreneurial activities can satisfy the ATB Requirement without having collected gross income or profit for the five years preceding a distribution and/or without collecting income or profit during the time period contemplated by the phrase “immediately after the distribution.”⁶⁵ Such taxpayers should not be required to collect gross income or generate profit to satisfy the requirement of Regulation section 1.355-3(b)(2)(ii) if they have engaged in regular and continuing research and/or developmental activities (including product research) by managerial and operational employees with an intent to earn gross income or a profit and incurred significant expenses in so doing. In addition, the requirement of Regulation section 1.355-3(b)(2)(iv)(B), that a business that consists of owning and operating personal property perform “significant services with respect to the operation and management of the property[,]” should be satisfied if the business has engaged in significant internal activity (i.e., not as a service to customers) doing R&D with respect to intellectual property.

Example 1. Biopharmaceutical Business

Corporation X conducts businesses in the biomedical and biopharmaceutical fields. X has conducted an active biomedical business for 30 years and entered the biopharmaceutical business more than five years ago when it formed corporation Y, a wholly owned subsidiary. For at least five years, X has invested significant resources in Y and has employed scientists, researchers, and support professionals at operational and managerial levels with the intention of developing and exploiting a commercially viable drug compound. Throughout that period, Y has been engaged in pre-clinical, clinical trials, and discovery research with respect to certain chemical compounds and has paid operational and managerial expenses such as salaries and R&D costs. Y plans to continue the clinical trials and other research activity related to developing the drug compound.

For non-Federal tax business purposes, X will separate the biopharmaceutical business from its biomedical business by distributing all of the Y stock to its shareholders. Y will fund its operations through capital on hand and new financing. As of the date of the distribution, Y's biopharmaceutical business has not collected gross income or profit. Moreover, Y has not received final regulatory approval to market its drug for commercial use. Such approval is not certain or imminent.

Notwithstanding that Y has not collected gross income, Y is engaged in the active conduct of a trade or business. For five years, Y has engaged in regular and continuing research and/or developmental activity through managerial and operational employees with the intent to generate income or profit. Such activity has resulted in significant, regular operational expenses over the five-year period. Accordingly, Y satisfies the requirements of section 355(b).

Example 2. Software and Search Engine

Corporation A has been engaged in the development of word processing software for at least five years and in the development of a search engine for legal research for one year. Individuals M and N are the founders of A and its majority shareholders. M and N have worked full time at least five years developing the software and for one year developing the search engine. In addition, throughout such respective periods, A has employed five individuals in each activity who are developing the products for commercial use. These individuals, whose only activity is the full-time development of the respective products, have been supervised by M and N. As needed, A hires attorneys, accountants, and other professionals to provide necessary non-technology services, and A also incurs routine general and administrative business expenses. Neither A's software nor its search engine business has collected gross income or profit. All of A's activities are undertaken with the intent to commercialize the two products, although the timeframe for bringing the products to market is unclear due to the need to perfect the technology and the changing marketplace. Assume that the search engine business is an expansion of the word processing business under the principles of Rev. Rul. 2003-38.⁶⁶

Unrelated investor, Z, wishes to invest in the search engine technology but not the software. In order to facilitate Z's investment, A decides to separate the two development activities by transferring the search engine assets and activities (e.g., the intellectual property rights, the five employees, and the business plan) to a newly formed corporation, B, in exchange for all of B's stock, and to distribute B's stock to its shareholders.

Notwithstanding that neither business has generated gross income or profit, A has been engaged in the active conduct of a trade or business. For five years, A has engaged in regular and continuing research and/or developmental activity through managerial and operational employees with the intent to generate income or profit. Such activity has resulted in significant, regular operational expenses over the five-year period. Accordingly, A and B satisfy the requirements of section 355(b).

In addition to these examples, we believe that outside of the R&D context the Service's ruling practice similarly should not require a corporation to have collected gross income or profit in each of (or, in some cases, any of) the five years preceding the distribution where the Service is confident that the policy underlying the ATB Requirement is not offended.⁶⁷ In addition, given the importance of policy in the longstanding administration of section 355(b), our view of the Factor List is that factors 3, 4, 5, and 6 are not necessary to establish that activities constitute a trade or business because their presence is not necessary to the effectuation of that policy. Indeed, Factors 3, 4, 5, and 6 could frustrate policy by injecting unnecessary uncertainty around the moment in time when such factors can be viewed as having been satisfied, if such is necessary to determine when a trade or business has commenced for purposes of the five-year rule. In this regard, we note that the requisite entrepreneurial intent manifests itself in different ways throughout the life of a business. The activities and operational focus of the business changes depending on the stage in which the business exists. Accordingly, we recommend that Treasury and the Service take a flexible approach with respect to the types of activities⁶⁸ that the guidance takes into account, guided by the policies underlying section 355 and the ATB requirement.