Rev. Rul. 69-460

Advice has been requested regarding the application of the "business purpose requirement" prescribed by section 1.355-2(c) of the Income Tax Regulations to a distribution of stock of a controlled corporation that otherwise qualifies under section 355 of the Internal Revenue Code of 1954.

Section 1.355-2(c) of the regulations states that the distribution by a corporation of stock or securities of a controlled corporation to its shareholders with respect to its own stock or to its security holders in exchange for its own securities will not qualify under section 355 of the Code where carried out for purposes not germane to the business of the corporations. This provision makes it clear that section 355 of the Code applies only to certain specified distributions or exchanges of the stock or securities of controlled corporations incident to the readjustment of corporate structures required by business exigencies and which effect only a readjustment of continuing interests in property under modified corporate forms.

In order that the distribution of stock qualify under section 355 of the Code it is essential that there be a valid business purpose whether the distribution of the stock of the controlled corporation is a distribution of the stock of an existing subsidiary or a distribution pursuant to a reorganization under section 368(a)(1)(D) of the Code. The fact that there is a valid business reason for the creation of a new corporation does not necessarily satisfy the business purpose requirement for the distribution of the stock pursuant to section 355 of the Code. In the case of Commissioner v. Marne S. Wilson, 353 F. 2d 184 (1965), reversing 42 T.C. (1964), the court stated that even if there is no tax avoidance motive, a distribution of stock of a controlled corporation, such distribution having no business purpose, does not result in the tax advantages which section 355 of the Code confers upon those who satisfy the legal requirements for its benefits.

The application of the business purpose requirement is illustrated in the situations described below.

Situation 1.

X corporation has been engaged in business as a liquor wholesaler for the last five years. The stock of X is owned equally by A (president) and B (general manager), who are unrelated to each other.

Serious disputes between A and B as to expansion, marketing channels, and discount policy have created a situation where the parties are so antagonistic that the normal operations of the business are seriously affected. It is therefore proposed that 50 percent of the operating assets and liabilities relating thereto be transferred to Y corporation in exchange for all the stock of Y, followed by the distribution of the Y stock to B, solely in exchange for the surrender by B of all of his X stock.

The non pro rata distribution was undertaken for reasons germane to corporate business problems and was necessary for the future conduct of the business. Therefore, the business purpose requirement as set forth in section 1.355-2(c) of the regulations is satisfied.

Situation 2.

X corporation, the stock of which is closely held by one family, is engaged in the manufacture of precision scientific equipment. X owns all the stock of Y corporation which is in the tool and die business.

Due to competition, X has had difficulty in retaining key managerial personnel. Certain top management employees of X have indicated that they would consider remaining with the company if they could be given a proprietary interest in X through the opportunity to purchase a stock interest. At the present time any significant stock interest in X would be expensive due primarily to the inclusion of the Y stock in the assets of X. Moreover, X is not desirous of giving its employees any interest in the Y business.

X, therefore, proposes to distribute all of Y's stock pro rata to its shareholders. X will then sell stock to three key employees in an amount that will give each of them a five percent interest in X. The distribution will be undertaken for reasons germane to the business of the corporation. Therefore, the business purpose requirement as set forth in section 1.355-2(c) of the regulations is satisfied.

Situation 3.

A owns all of the stock of X corporation which is engaged in the shoe business. X owns 85 percent of the stock of Y corporation which is engaged in the manufacturing and sale of skiing equipment. The skiing equipment business has prospered in the past few years and B, the operating manager of Y, is desirous of sharing in the future profits of Y by the purchase of a nominal stock interest in Y. It is immaterial to B whether the majority shareholder of Y is X or A. In order to sell B a five percent stock interest in Y, X will distribute all the stock in Y to A.

B could have purchased his five percent stock interest of Y from X or directly from Y without the necessity of having X distribute the Y stock to A and having A make the sale. The sale of stock to a key employee is a valid business and corporate purpose. However, the stock distribution was not necessary to carry out such a purpose. Therefore, the transaction will result in a distribution taxable to A as provided by section 301 of the Code.