Rev. Rul. 75-337

Advice has been requested whether the "business purpose" requirement of section 1.355-2(c) of the Income Tax Regulations is satisfied in the following transaction, which is otherwise qualified under section 355 of the Internal Revenue Code of 1954 and the regulations thereunder.

X corporation operated an automobile dealership. Its franchise for the sale and service of automobiles was in the name of individual A who managed X and owned 53 percent of its stock. A was 70 years old and this stock constituted the bulk of his estate. The balance of the stock was held by A's five daughters in equal proportions. Three of the daughters were also actively employed in the X business. The other two daughters were not actively employed by X.

Y corporation, a wholly owned subsidiary of X, was engaged in the business of renting automobiles.

The franchise policy of the automobile manufacturer did not favor granting or continuing a franchise where there were inactive shareholders unless the manager holding the franchise owned a majority of the stock. As an alternative, the manufacturer's policy permitted the granting or continuing of a franchise where there was no majority shareholder, provided the shareholders were few in number and all were active in the business. The manufacturer does not grant franchises to corporations, only to individuals or partnerships. The franchise was renewable periodically and was not transferable by inheritance or otherwise.

As the first step in a plan to insure that X's shareholders would be able to renew the franchise upon the death or retirement of A, who was then 70 years old, X distributed three-fourths of the Y stock to the two inactive-daughter shareholders in exchange, value for value, for all of their X stock. The remaining one-fourth of the Y stock was distributed to A in exchange for shares of his X stock of equal value. A intended that upon his death the inactive-daughter shareholders would receive their inheritance in Y stock and assets other than stock of X.

The distribution of the Y stock to A furthered the objective of enabling X's shareholders to retain the automobile franchise by increasing the percentage of ownership in X on the part of the active shareholders (other than A) and by providing A with Y stock which he could bequeath or gift to the inactive-daughter shareholders, leaving his remaining X stock available for bequests or gifts to the active shareholders.

Section 355 of the Code provides, in general, for the tax-free distribution by a corporation to its shareholders of the stock of a controlled subsidiary in exchange for shares of stock in the distributing corporation provided certain requirements are met. For this purpose "control" means, in general, ownership of at least 80 percent of the voting stock and at least 80 percent of the non-voting stock of a corporation.

Section 1.355-2(c) of the regulations provides that a distribution by a corporation of stock of a controlled corporation will not qualify under section 355 of the Code where carried out for purposes not germane to the business of the corporations, and that the distribution must be incident to a readjustment of corporate structures required by business exigencies.

Upon the death or retirement of A, the present stock ownership of X with proportionate bequests or gifts to A's daughters (because A's X stock represented the bulk of his estate) would preclude the existence of a majority active shareholder of X or all active shareholders in X for the purpose of renewing the X shareholders' franchise under the manufacturer's dealership policy. In order to insure qualification under the alternate conditions of the franchise policy, it was necessary to set the stage for X shareholders to retain the franchise at A's death or retirement, without chancing a potential interruption in the continuity of, or even the loss of, the franchise which might occur if nothing was done until after A's death or retirement. This was accomplished by first causing the Y stock to be distributed and then having A provide in his will or by gift for only the active shareholders to receive his shares of X stock.

Thus, the distribution of Y stock is germane to the continuation of the X business in the reasonably foreseeable future. Execution of the plan will forstall an impending disruption to the X business by reason of the current active family group being unable to renew X's franchise upon A's death or retirement.

In Rafferty v. Commissioner, 452 F.2d 767 (1st Cir. 1971), it was held, under a plan to avoid any remote possibility of interference in a business by future sons-in-law, that the spin-off had no immediate business reason, involved a personal motive and had as its primary purpose a desire to make bequests in accordance with an estate plan. The difficulties anticipated were so remote that they might never come to pass. The daughters might never marry--thus eliminating completely any cause to worry about business interference by future sons-in-law. There was, at best, "only an envisaged possibility of future debilitating nepotism," and the effect on the business was conjectural.

In the instant case, the problem was immediate due to the advanced age of A and was directly related to the retention of a franchise vital to the business of the distributing corporation. Accordingly, the distribution by X of the Y stock to the inactive-daughter shareholders and to A in exchange for X stock is supported by a valid business purpose within the contemplation of section 1.355-2(c) of the regulations.