Section 355 split-offs: what the IRS withdrew on October 21

On October 21, 2026, the IRS and Treasury published a partial withdrawal of a set of section 355 regulations they first proposed in July 2016. The withdrawn pieces were a "per se" device rule and two anti-abuse rules, all of which had been proposed but never finalized. For most closely held Oklahoma companies, the news changes less than the headlines suggest, but it is a good moment to walk through how we think about a Section 355 split-off, the tax-free way one company becomes two.

We see two versions of this problem. The first is a business divorce: two owners of a company that runs two lines of business want to go their separate ways, each keeping one line. The second is a carve-out: a company wants to separate a division before a sale, or before bringing in an outside investor, without the corporation and its shareholders each paying tax on the way out.

What the IRS withdrew, and what it did not

The notice withdraws proposed §§ 1.355-2(d)(2)(iv)(E), 1.355-2(d)(5), and 1.355-9(d) from the 2016 proposal (REG-134016-15, 81 FR 46004). The agencies said comments on these rules had been generally critical.

Under the 2016 proposal, a distribution would have been treated as a device, regardless of any other favorable facts, when one corporation's "Nonbusiness Asset Percentage" reached 66 2/3 percent or more and the two corporations' percentages fell into certain mismatched bands. Nonbusiness assets, under that proposal, meant gross assets other than those used in a business, with reasonable working capital counted as business assets. The two anti-abuse rules would have disregarded transactions, such as taking on or repaying debt or issuing or redeeming stock, undertaken with a principal purpose of moving that percentage, or of moving a parallel "Five-Year-Active-Business Asset Percentage" that the proposal said had to be at least five percent for each corporation.

Two caveats matter more than the withdrawal itself. The notice states that the withdrawal "does not affect the potential application of other rules or judicial doctrines," naming substance-over-form and step-transaction specifically, and it says the agencies "continue to study the issues addressed in the 2016 proposed regulations." We read that as: the mechanical test is off the table for now, but the underlying concern about stuffing one side of a split with cash and investments has not gone anywhere.

The notice withdraws only proposed rules. Nothing in the current regulations changed on October 21, and the facts-and-circumstances device test in the existing regulations still governs them.

Why a Section 355 split-off is worth the trouble

Start with the ordinary way. A corporation that distributes a division to a shareholder generally recognizes gain on the appreciated assets, and the shareholder is generally taxed on what comes out. For a C corporation, that is two layers of tax on the same value.

Section 355 is the exception. If a distributing corporation controls a subsidiary and distributes that subsidiary's stock to its shareholders, and the statutory conditions are met, the shareholders recognize no gain or loss on the receipt. The statute applies "whether or not the distribution is pro rata with respect to all of the shareholders," and it applies whether or not the shareholder surrenders stock in the distributing corporation.

That last sentence is where business divorces live. A non-pro-rata distribution, where one owner surrenders all of her stock in the parent and takes all the stock of the subsidiary in exchange, is a split-off. One owner ends up with the parent and one business; the other owner ends up with the former subsidiary and the other business. If the deal qualifies, neither owner and neither corporation pays tax at that moment.

Oklahoma's corporate income tax computation generally starts from the federal figure, so the federal answer tends to drive the state answer as well; the state side deserves its own look in any specific deal.

Our framework: four questions, asked in order

We run every proposed separation through the same four questions, in this order, because the earlier ones most often end the conversation.

Question one: the five-year active business test

Section 355(b) requires that both the distributing and controlled corporations be engaged, immediately after the distribution, in the active conduct of a trade or business. That business must have been actively conducted "throughout the 5-year period ending on the date of the distribution," and it must not have been acquired within that five-year period in a transaction in which gain or loss was recognized.

In our experience, this is the test that fails most often in closely held companies, and it fails for a mundane reason. One of the two businesses was bought, for cash, three years ago. A taxable purchase inside the five-year window generally disqualifies that business from carrying its own side of the split. The regulations distinguish an expansion of an existing business, which generally keeps the original start date, from the acquisition of a new or different business, which does not.

Under the regulations, the corporation itself generally must perform active and substantial management and operational functions. Holding stock, land, or other property for investment does not count. Owning and operating real property used in a business does not count either, unless the owner performs significant services in managing and operating it. A split that leaves one owner with the operating company and the other with the building the company rents often trips here.

Question two: the corporate business purpose

The regulations require "a real and substantial non Federal tax purpose germane to the business of the distributing corporation." The purpose has to belong to the corporation, not to the shareholders. A shareholder's wish to diversify, or to stop working with a co-owner, is ordinarily a shareholder purpose, although the regulations allow that a shareholder purpose which nearly coincides with a corporate purpose can still qualify.

In a business divorce, the corporate purpose is usually the easiest part of the file to build, as long as the owners are honest about it. Owners who cannot agree on strategy or capital allocation generally hurt the business, and separating the lines so each can be run by the person committed to it is a purpose the business itself has. The documentation should say so in the company's own voice: board minutes and a record of the operational reasons a divided company works better.

For a pre-sale carve-out, the business purpose and the device question pull against each other, which brings us to the question that decides most of these deals.

Question three: the device test and the planned sale

Section 355(a)(1)(B) requires that the transaction "was not used principally as a device for the distribution of the earnings and profits" of either corporation. The worry is a bailout: pulling corporate earnings out at capital-gain rates by distributing a subsidiary and then selling it, instead of paying a dividend.

The statute says later sales by distributees are not, by themselves, a device, but that protection does not extend to sales under an arrangement "negotiated or agreed upon prior to such distribution." The regulations then set out a weighing test. Among the facts that count as evidence of device:

• A pro rata or substantially pro rata distribution. A split-off in a business divorce is, by design, not pro rata, which helps.
• A sale after the distribution. The regulations say the greater the percentage of stock sold and the shorter the time between distribution and sale, the stronger the evidence. A sale arranged before the distribution is "substantial evidence of device."
• Cash and liquid assets "not related to the reasonable needs of a business." This is the concern the withdrawn 2016 rule tried to turn into a bright line, and it remains a live factor under the regulations that are still in force.
• A secondary business whose principal function is serving the other corporation and which could be sold without harming it.

On the other side, a corporate business purpose is evidence of nondevice, and the regulations say the stronger the device evidence, the stronger the purpose has to be. The regulations also list circumstances that are ordinarily not a device, including a separation in which neither corporation has earnings and profits.

Here is how the device problem shows up in a closely held company. Two owners agree to split the company, and the plan, said out loud or not, is that one of them sells his half to a competitor next year. The closer that sale is in time, the larger the share sold, and the more the sale was discussed before the split, the worse the device picture gets. A carve-out "to make the division easier to sell" is an honest commercial goal and, said that plainly, it is close to a confession.

Our practice is to ask the question early and bluntly: is anyone in this room planning to sell within the next few years? The answer shapes whether section 355 is the right tool or whether a taxable structure, priced as such, is the cleaner path. The choice between an asset sale and a stock sale for the piece being sold is a separate analysis, and it often runs alongside this one.

Question four: 50-percent acquisitions under 355(d) and 355(e)

Even a distribution that passes the device test can trigger corporate-level gain under two further provisions. Section 355(d) applies when, immediately after the distribution, a person holds a 50-percent-or-greater interest in either corporation through stock acquired by purchase during the five-year period ending on the distribution date. Section 355(e) applies when the distribution is part of a plan under which one or more persons acquire a 50-percent-or-greater interest in either corporation.

Section 355(e) carries a presumption worth memorizing. An acquisition of a 50-percent-or-greater interest during the four-year period beginning two years before the distribution is presumed to be part of such a plan unless it is established otherwise. In a business divorce, that means the two years after the split are a period in which a sale of either resulting company needs careful attention, and in which the file built for question three does double duty.

A third provision, section 355(g), bars the treatment where a resulting corporation's investment assets are two-thirds or more of the fair market value of all its assets and a person who did not hold a 50-percent-or-greater interest in it before the transaction holds one immediately after. A company that has built a large investment portfolio alongside its operations feels this test and the device factors pulling in the same direction.

The entity questions that come before any of this

Section 355 is a corporate provision. A company taxed as a partnership, which includes most Oklahoma LLCs that have not elected otherwise, does not need it; partnership tax rules handle divisions on their own terms, with their own traps. For an S corporation, section 355 can apply to the separation, and the S corporation questions about the resulting entities are a separate set of issues we work through alongside the corporate ones.

Control is a threshold item. The distributing corporation must distribute all of its stock and securities in the controlled corporation, or at least an amount constituting control within the meaning of section 368(c), and if it retains any, it must show the retention was not part of a plan with a principal purpose of avoiding federal income tax. Where the two businesses sit inside a single corporation today, the first step is usually to drop one into a new subsidiary, and that step has its own requirements that have to line up with the distribution that follows.

What we tell owners before they start

Think of section 355 as a license to separate rather than a license to cash out. The statute was written for owners who intend to keep running two businesses, and every test above is a different way of checking that intention.

A few points come up in nearly every file:

1. Pull five years of history for each business before anyone draws an org chart. The date and manner of each acquisition decides more than any other single fact.
2. Write the business purpose in the corporation's words, contemporaneously. A memo drafted after the split, in the shareholders' words, is worth little.
3. Inventory the cash and investments on each side. The withdrawn 2016 rule is gone, but the regulations still treat liquid assets beyond the reasonable needs of a business as evidence of device, and a lopsided allocation invites the question.
4. Map the next four years. The 355(e) presumption window runs from two years before the distribution to two years after, and a buyer who appears inside it can expect questions about the plan.
5. Get the buy-sell and the operating documents out before the tax analysis starts. A business divorce that is already governed by a buy-sell agreement may point to a redemption or cross-purchase instead, and that is a different tax conversation.

The honest counterweight is that section 355 is demanding by design. A split that fails is not a missed opportunity; it is a taxable distribution at both the corporate and shareholder level, discovered on audit years later, with interest.

Seen that way, the October 21 withdrawal removes a proposed bright line that most closely held companies would never have approached. It does not loosen the test that actually applies to them. The companies that would have had trouble under the old rules are likely to have the same trouble under the rules that remain, and the ones that run a real separation of two real businesses still have a path.

If your company is heading toward a split, or you are thinking about separating a division ahead of a sale, this is the point at which a conversation with our Oklahoma City office tends to pay for itself. Reach us through the contact page before the structure is drawn and well before anyone talks to a buyer; the order these steps happen in is most of the outcome.

This article is general information about Oklahoma, Texas, and federal law, not legal advice, and it does not create an attorney-client relationship. Facts matter; talk to a lawyer about yours.