Rev. Rul. 83-114

ISSUE

Whether section 355 of the Internal Revenue Code applies to the distribution of stock of a controlled corporation under the circumstances described below.

FACTS

P corporation has owned all of the stock of S corporation for more than 5 years. Each corporation has been engaged in the active conduct of a trade or business for more than 5 years.

As the result of a federal anti-trust, decree, P was required to divest itself of any interest in S. Accordingly, P distributed all the S stock pro rata to its shareholders. Subsequent to the distribution, it is anticipated that unrelated corporation Z will merge with and into S in a reorganization under section 368(a)(1)(A) of the Code. Immediately before the distribution of S stock P canceled a bona fide indebtedness of 700x dollars that S owed P. The cancellation resulted in more than a 100 percent increase in S's net worth. After the distribution of the S stock, P and S continued the active conduct of their respective businesses.

While it was not necessary for P to cancel the indebtedness of S in order for S to continue its business operations at the same level, repayment of the debt by S in the foreseeable future, however, was virtually impossible since S had committed itself to major capital expansion. In addition, S's investment banker indicated that it would be easier to attract additional investment in S if S's balance sheet showed a relatively small amount of long-term debt. Consequently, the management of P and S concluded that it would be sound business practice to have P cancel S's indebtedness and thereby permit S to attract additional capital and to use all of its earnings to expand its business. There was no plan by the shareholders of P at the time of distribution to liquidate either P or S, to sell any of the assets of P or S other than in the ordinary course of business-or to sell, redeem or otherwise dispose of their stock in either P or S

LAW AND ANALYSIS

Section 355(a)(1) of the Code provides, in part, that if a corporation distributes to a shareholder, with respect to its stock, stock of a corporation which it controls immediately before the distribution, no gain or loss will be recognized to (and no amount will be includible in the income of) such shareholder on the receipt of such stock under certain conditions.

Section 355(a)(1)(C) of the Code provides that the requirements of section 355(b) must be satisfied for the distribution to qualify for nonrecognition of shareholder gain or loss. Section 355(b) is satisfied if the distributing corporation and the controlled corporation are each engaged in the active conduct of a trade or business immediately after the distribution. The trade or business must have been actively conducted throughout the 5-year period ending on the date of distribution and must not have been acquired within that period in a transaction in which gain or loss was recognized in whole or in part.

Pursuant to section 1.355-2(c) of the Income Tax Regulations, the distribution by a corporation of stock of a controlled corporation to its shareholders with respect to the distributing corporation's stock will not qualify under section 355 of the Code unless the purposes for the distribution are germane to the business of both corporations. Section 355 contemplates a continuity of the entire business enterprise under modified corporate forms and a continuity of interest in all or part of the business enterprise on the part of the owners of the enterprise prior to the distribution or exchange.

Section 355(a)(1)(B) of the Code provides that the distribution transaction will not qualify for nonrecognition of shareholder gain or loss if the transaction was used principally as a device for the distribution of the earnings and profits of the distributing corporation, or the controlled corporation, or both. Section 1.355-2(b)(3) of the regulations provides that in determining whether a transaction was used principally as a device for the distribution of earnings and profits all the facts and circumstances of the transaction must be considered. Particular attention must be paid to the nature, kind, and amount of the assets of the distributing and controlled corporations (and corporations controlled by them).

In Rev. Rul. 58-68, 1958-1 C.B. 183, parent corporation (X) made a large contribution to subsidiary corporation (Y) through a cancellation of loans. X then distributed all of the Y stock to X's sole shareholder. Z corporation, the stock of which was owned exclusively by X's sole shareholder and spouse, was then merged into Y, with the shareholders of Z receiving additional Y stock in exchange for their stock in Z. Rev. Rul. 58-68 holds, in part, that the transaction was used principally as a device for the distribution of the earnings and profits of the parent, because the distribution of the stock of the controlled corporation was immediately preceded by a very large contribution (through debt cancellation) to the capital of the subsidiary, and because the distribution was immediately succeeded by a merger negotiated prior to the distribution. In addition, Rev. Rul. 58-68 held that the active business requirements of section 355(b) of the Code were not met since the transaction was preceded by a contribution to capital, resulting in more than a 100 percent increase in net worth. However, Rev. Rul. 64-102, 1964-1 (Part 1) C.B. 136, modified Rev. Rul. 58-68 to remove the implication that the active business requirements of section 355(b) can never be met were more than 50 percent of the assets of a controlled corporation were acquired by a capital contribution immediately prior to the distribution.

The conclusion of Rev. Rul. 58-68, suggesting that a contribution to capital followed by a pro rata distribution of a controlled corporation's stock in itself constitutes a transaction used principally as a device for the distribution of earnings and profits, will no longer be followed. Although a cancellation of indebtedness may be evidence of a device to distribute earnings and profits of one or both corporations, it is necessary to look at all of the facts and circumstances surrounding the spin-off before it can be concluded that the stock distribution was used principally as a device. See section 1.355-2(b)(3) of the regulations. Further, a distribution of a controlled corporation's stock followed by a prearranged merger into the controlled corporation is not in itself a sufficient basis for determining that the transaction was necessarily a device. See generally Rev. Rul. 76-527, 1976-2 C.B. 103, in which a transaction involving a pro rata distribution of a controlled corporation's stock was held to satisfy the business purpose requirement of section 1.355-2(c) of the Income Tax Regulations where the business purpose of the distribution was to allow the controlled corporation to use its own stock in its expansion effort.

HOLDING

In the present situation, the business reason for the distribution was to allow P to comply with a federal antitrust decree. The business reason for the contribution to capital, through debt cancellation, was to allow S to expand its operations and attract additional investment capital. On consideration of the facts and circumstances, including the business reasons for both the distribution and the contribution to capital, it is concluded that the transaction was not principally a device for the distribution of earnings and profits. Accordingly, the nonrecognition provisions of section 355 of the Code apply to the receipt of S stock by the shareholders of P.

Moreover, any subsequent acquisition of assets by S would not per se be considered a device. The existence of a device would depend upon an analysis of all the facts and circumstances surrounding the transaction. See Rev. Rul. 76-527.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 58-68 is revoked.

PROSPECTIVE APPLICATION

Under the authority in section 7805(b) of the Code, this revenue ruling will not be applied adversely to Taxpayers who want to treat their transactions in accordance with the position set forth in Rev. Rul. 58-68 and who consummated the transaction before August 8, 1983, the date of publication of this revenue ruling in the Internal Revenue Bulletin.