On May 12, 2003, the Internal Revenue Service provided helpful guidance for farm and ranch corporations when it issued a public ruling supporting tax-free corporate separations. The ruling provides that family disagreements over a farm's future direction and future business goals can serve as a valid business purpose for separating a farm corporation on a tax-free basis.
Farm corporations are fairly common today. During the 1960s and 1970s, farmers and ranchers often organized corporations to hold agricultural assets. Many viewed these corporations as flexible and useful structures that allowed for the easy division of ownership. By using a farm corporation, senior family members could give away equity interests to their children and still keep the farm and ranch assets under one entity.
But time and family tensions have stressed the farm corporation. Since 1986, federal tax laws disfavored the corporate entity. Family disagreements also pressure the farm corporation. In many cases these disagreements stem from the familiar tensions between on-farm and off-farm heirs. With these stresses, the family may look to a corporate division or separation as an appropriate relief valve.
One common method to divide a corporation is a "split-off" transaction. In a split-off, the stock of a newly created subsidiary is distributed only to some shareholders. In other words, the corporation is separated into two, with the ownership of one corporation going to some shareholders and the ownership of the other corporation remaining with other family members. This division can be a useful technique to separate out the heirs' ownership.
But corporate division is not a casual undertaking. This structural corporate change raises important and fundamental tax issues. Neglecting these tax consequences can be expensive since a taxable corporate division can create a large tax bill for both the corporation and the shareholders.
Realizing the potential tax exposure, most tax professionals insist that corporate separations comply with Section 355 of the Internal Revenue Code. With several requirements-including four statutory tests and two judicial tests-this favorable rule permits a tax-free corporate division. Of all these requirements, the judicial tests of business purpose and continuity of interest can be challenging to prove.
The new IRS ruling is good news for farm corporations seeking to meet the judicial business-purpose test. Under the ruling, family disagreements as to future business can serve as a recognized business purpose for separating a farm corporation. The IRS ruling describes a fairly common fact pattern involving a farm corporation owned by father, mother, son, and daughter. Son is described as interested in the corporation's livestock business and daughter is interested in its grain business. Son would like to expand the livestock business, even with debt. Daughter is more conservative, believing that the grain business can and should be expanded without debt. To enable son and daughter to focus upon the farming business in which they are most interested and to further the estate planning goals of father and mother, the new IRS ruling describes how to achieve a tax-free split-off transaction.
In the split-off, the historic farm corporation transfers the livestock business to a newly formed corporation ("Newco"). The farm corporation then distributes 50% of the Newco stock to son in exchange for all of his farm corporation stock. The corporate separation is then completed when the farm corporation distributes the remaining Newco stock equally to father and mother. Father and mother also intend to amend their wills to provide that son will inherit stock only in Newco and daughter only in the farm corporation.
The split-off completes the separation. Going forward, daughter will manage and operate the farm corporation and have no stock interest in Newco. Son will manage and operate Newco and have no stock interest in the farm corporation. The transaction effectively resolves the ongoing family business pressures.
As mentioned above, this new ruling contains helpful guidance and a useful roadmap for resolving family disputes involving farm corporations. The ruling acknowledges the family pressures so common in operating an agricultural business and validates this justification for separating corporate ownership. The ruling goes even further by describing the corporate income tax and estate planning techniques available to solve family issues.
Our tax lawyers can help clients look for creative ways to solve problems. If you would have an interest in corporate division transactions, please call Jim Walker at (303) 628-9510 or by e-mail at jwalker@rothgerber.com.