SUBSIDIARY OPERATED BY INDEPENDENT CONTRACTOR IS NOT ACTIVE BUSINESS IN DISTRIBUTION BY CONTROLLED CORPORATION

Rev. Rul. 86-125

Whether a corporation is considered to be engaged in the active conduct of a trade or business within the meaning of section 355(b) of the Internal Revenue Code and section 1.355-1(c) of the Income Tax Regulations, under the following circumstances.

FACTS

P is a closely held corporation, which for more than 5 years has operated an insurance brokerage business. In addition, P has held all the stock of a subsidiary corporation, S, for more than 5 years. S owns a downtown office building, but Z, an unrelated real estate management company acting as an independent contractor, has been under contract to manage the property for many years. Z supplies and supervises janitors and maintenance personnel for S's office building. Z also arranges for all repairs to be made to the building by independent contracting companies. Z collects rents, pays all bills, including gas, water, sewage, electricity, and insurance, and, after deducting a monthly fee, remits the balance each month to S. Z advertises for tenants and negotiates the terms of the leases. Tenant complaints are directed to Z.

A, the president and principal stockholder of P and an officer of S, devotes some time to the operation of the office building. A visits the building to insure that the cleaning and maintenance done by Z's employees are done properly. In addition, A approves the leases negotiated by Z's employees and the contracts entered into for repair of the building. A attends to all matters concerning zoning, building permits, and other local laws and ordinances affecting the building. No other officers or employees of P or S attend to the operation of the office building. P's outside accountant audits monthly the itemized list of income and expenses collected and paid by Z and reports the results to S.

X, an unrelated corporation, operates a larger insurance brokerage business. X desired to acquire the insurance brokerage business of P solely in exchange for X voting common stock. X, however, would not acquire P if P continued to hold the S stock. The management of P believed the association of its business with X would ensure the future growth and profitability of P. Accordingly, P distributed the stock of S pro rata to the P shareholders. Since the distribution, S has continued to use the services of Z as it had prior to the transaction.

Except for the question here at issue, regarding the active conduct of a trade or business, the transfer meets all the requirements of section 355 of the Code and the regulations thereunder.

LAW AND ANALYSIS

Section 355(a) of the Code provides that under certain circumstances a corporation may distribute stock or securities in a corporation it controls to its shareholders or security holders in a transaction that is nontaxable to such shareholders or security holders. Furthermore, such a distribution of a subsidiary's stock can qualify for section 355 treatment when such distribution is followed by a second nonrecognition transaction in which the distributing corporation shareholders exchange their stock for stock in another corporation. Rev. Rul. 68-603, 1968-2 C.B. 148.

Section 355(b) of the Code requires that both the distributing and controlled corporations be engaged, immediately after the distribution, in the active conduct of a trade or business that has been actively conducted throughout the 5-year period ending on the date of distribution.

To meet the requirements of section 355(b) of the Code, each corporation must, as stated in Rafferty v. Commissioner, 452 F.2d 767, 772 (1st Cir. 1971), cert. denied, 408 U.S. 922 (1972), "engage in entrepreneurial endeavors of such a nature and to such an extent as to qualitatively distinguish its operations from mere investments. Moreover, there should be objective indicia of such corporate operations." Such objective indicia are found in active and substantial managerial and operational activities of the corporation. In addition, this business activity has to be activity of the corporation itself (through its officers and employees) and not the activity of independent contractors. Rev. Ruls. 80-181, 1980-2 C.B. 121, 79-394, 1979-2 C.B. 141, and 73-234, 1973-1 C.B. 180.

In Rev. Rul. 73-237, 1973-1 C.B. 184, it was held that a corporation engaged in the construction industry general contracting business is engaged in the active conduct of a trade or business within the meaning of section 355(b) of the Code, despite its utilization of independent subcontractors. However, in that revenue ruling, X corporation utilized its own salaried employees to submit bids, negotiate and enter into contracts with principals and with subcontractors, purchase or lease equipment and supplies, and supervise subcontractors to ensure compliance with contract specifications. As general contractor, X had the primary responsibility for the completion of each job. In analyzing X's activity in that revenue ruling, consideration has to be given to the fact that X was engaged not in construction, as such, but in general contracting. The business of general contracting is to an extent unique in that it presupposes that most, or all, of the actual construction work will be contracted out to subcontractors. However, the operation of a rental office building does not presuppose that either the managerial or operational activity will be contracted out.

In Rev. Rul. 73-237, the activity of X, carried on through its own employees, constituted active and substantial managerial and operational activity in the general contracting business. This activity of X contrasts with the activity carried on by S (through its officer) in the present situation. Here, the operational and management activity of the office building rental business is largely performed either by Z through Z's employees, or by independent contractors hired by Z. Clearly, S is not engaged in active and substantial operational and managerial activity with regard to the office building rental business. Although some of S's activities could be considered to be either managerial or operational, these activities are not different from those a prudent investor would be expected to undertake, and are not enough to "qualitatively distinguish its operations from mere investments." Thus, Rev. Rul. 73-237 is distinguishable from the present situation.

HOLDING

Because of the absence of substantial operational and managerial activities, the active business requirement of section 355(b) of the Code is not met, and the distribution of the stock is not governed by section 355. The P shareholders' receipt of the S stock constitutes a distribution of property made by P to its shareholders subject to the provisions of sections 301 and 311.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 73-237 is distinguished.