Rev. Rul. 57-464

Advice has been requested whether section 355 of the Internal Revenue Code of 1954 applies to the transaction described below.

A certain corporation had been engaged in the business of manufacturing heating equipment. Its manufacturing operation was conducted in a modern factory building. The corporation also owned an old factory building in a different location, which was used for storage purposes, and three rental properties.

The rental properties of the corporation consisted of the following:

(1) A two-story duplex apartment building constructed in 1950 at a cost of 200 x dollars. It had been rented since that time to employees of the corporation and others for a gross rent of 14 x dollars a year.

(2) A five-room frame house constructed in 1951 at a cost of 50 x dollars. It had been occupied by a tenant for the last five years at a gross rental of 5 x dollars a year.

(3) A small office building at the old factory which had been occupied by a tenant for the last five years at a rental of 2 x dollars a year.

(4) A house which was acquired in 1955, at a cost of 70 x dollars, and was occupied by a sister-in-law of the president of the corporation.

For bona fide business reasons, the corporation desired to separate the rental properties from the manufacturing operation so that one corporation would be engaged solely in manufacturing and selling and the other in handling and supervising rental properties.

Accordingly, the assets of the corporation applicable to the manufacturing business were transferred to a new corporation, and the stock of the new corporation was distributed to the shareholders of the transferor corporation. The assets transferred included cash, accounts receivable, inventories, the factory building and equipment used in the manufacturing business, and related items, all having a total net book value of 1300 x dollars. The assets retained by the old corporation included the rental properties and the old factory, having a total net book value of 430 x dollars.

At issue is whether the activities in connection with the real estate constituted the active conduct of a trade or business within the meaning of section 355(b) of the Internal Revenue Code of 1954, where one-half of the book value of the real estate consisted of an old factory used for storage by the corporation and the remainder of the real estate consisted of several small dwellings that produced only a nominal rental.

As provided in section 355(b) of the Code and explained in section 1.355-1 of the Income Tax Regulations, section 355 is applicable only to the separation of two or more existing businesses operated, directly or indirectly, by a single corporation. The two businesses must have been in active operation for at least five years. Section 355 does not apply to the division of a single business.

Section 1.355-1(c) of the regulations states in part that a trade or business consists of a specific existing group of activities being carried on for the purpose of earning income or profit from only such group of activities, and the activities included in such group must include every operation which forms a part of, or a step in, the process of earning income or profit from such group. Such group of activities ordinarily must include the collection of income and the payment of expenses. It does not include the holding for investment purposes of stock, securities, land or other property, or the ownership and operation of land and buildings all or substantially all of which are used and occupied by the owner in the operation of a trade or business.

Examples set forth in section 1.355-1(d) of the regulations illustrate the application of these principles ot specific cases. Example (3) concerns a bank owning an eleven-story downtown office building, the ground floor of which is used in the banking business and the remaining ten floors of which are rented to various tenants. Inasmuch as the rental activities are substantial in amount and require direction by a separate real estate department, the rental activity in this case does constitute a separate trade or business. This is in contrast to Example (4) where a bank owns a two-story building in a suburban area, the ground floor and half the second floor of which are used in the banking business. The remainder of the second floor is rented as storage space to a neighboring retail merchant. The rental of the second floor does not constitute engaging in an active business, such activity being only incidental to the banking business.

In the instant case, one-half of the book value of the assets remaining with the transferor corporation consisted of rental properties. The other half consisted of the old factory used for storage in the manufacturing business, which use was not in itself the active operation of a business as defined in the regulations. Therefore, if the transferor corporation can be said to be engaged in the active conduct of a business after the separation, it must be by virtue of the rental of properties during the last five years.

The rental properties in question yielded gross rental of 20 x dollars a year. However, net income was negligible after deductions for depreciation and other expenses. These properties were acquired either as an investment or as a convenience to employees of the manufacturing business. On the state of the facts, the operation of these rental properties for the last five years did not constitute the active conduct of a trade or business within the meaning of section 355 of the Code. Rather, as in Example (4) of section 1.355-1(d) of the regulations, such rental activity was only incidental to the manufacturing business.

Therefore, since the corporation was engaged in the active conduct of only one trade or business, the provisions of section 355 of the Code are not applicable to the distribution of stock of the new corporation. As provided in section 351 of the Code, no gain or loss is recognized to the old corporation upon the transfer of property to the new corporation solely in exchange for all the stock in such corporation. The distribution of the shares of stock of the new corporation to the shareholders of the old corporation is treated as a distribution to which section 301 of the Code applies. Such distribution constitutes a dividend to the shareholders of the original corporation to the extent provided in section 301 and 316 of the Code.