The business purpose test requires that a transaction, to be respected, must have a business purpose separate and apart from any associated tax advantages. The business purpose test may be viewed as having two elements that, if satisfied, should prevent government scrutiny and adjustment of a transaction under the doctrine: (1) the acquisition was motivated by a nontax business purpose; and (2) the method of the acquisition was motivated by a nontax business purpose.
The business purpose requirement came out of case law surrounding government challenges to corporate reorganizations. Today, its use is more expansive—and not limited to corporate reorganizations.
In its present use, the most common application of the business purpose test is where a group of corporations can be denied affiliated group status. Consequently, they will be prohibited from including a corporation on its consolidated return. The IRS will ask whether there was a business purpose associated with the acquisition of the target corporation. If there is none, the affiliate group status will be denied.
Corporate divisions are also closely scrutinized as tax-free reorganizations under the business purpose test because they can easily be used in an attempt to convert dividend distributions into capital gain distributions.
The business purpose test, as a judicial doctrine, was the predecessor of specific Code provisions that exist today to deny the use of the net losses of a target corporation if the major reason of its acquisition was to secure the benefits of the net losses (in other words where there is only a tax-reason for the acquisition). This series of Code provisions prevents the acquiring corporation from utilizing pre-acquisition net operating losses to reduce the taxable income on the associated consolidated group return.
The policy behind the reorganization provisions is to enable the continuation of an ongoing business under modified corporate form without a current tax impact. But in the absence of a valid business purpose underlying a modification to corporate form, the government may perceive tax abuses—and it will inquire whether the modification was used improperly to achieve a non-taxable sale or dividend distributions.
To complicate matters, even strict literal compliance with the letter of the law surrounding the reorganization statutes may be insufficient to achieve a tax-free reorganization. The courts have consistently required that the underlying business purpose of the reorganization provisions be complied with. The IRS has used the business purpose test as a sword to disallow transactions deemed abusive on multiple occasions.
In reality, whenever an exchange—which is intended to be tax free—results in the exchange of materially different properties, realization of gain or loss occurs, and this ordinarily has to be recognized for tax purposes unless a tax free exchange “non-recognition” provision applies. To qualify as tax free, the reorganization has to be driven by business circumstances—rather than solely a desire to lower a company’s tax burden.