Rev. Rul. 86-4

1986-1 C.B. 174, 1986-2 I.R.B. 5.

CONTROLLED CORPORATIONS; STOCK DISTRIBUTION; DEVICE TO DISTRIBUTE

EARNINGS AND PROFITS

Published: January 13, 1986

Section 355.-Distribution of Stock and Securities of a Controlled Corporation,

26 CFR 1.355-1: Distribution of stock and securities of controlled corporation

  Controlled corporations; stock distribution; device to distribute earnings and profits. The transfer of a small percentage of investment assets relative to the other assets transferred by a corporation to a controlled corporation prior to the distribution of the stock of the controlled corporation is a factor to be considered in determining whether the transaction is a device for the distribution of earnings and profits. Rev. Rul. 56-557 clarified.

ISSUE

  Whether the transfer of a small percentage of investment assets relative to the other assets transferred by a corporation to a controlled corporation prior to the distribution of the stock of the controlled corporation may be considered evidence that the transaction is a device for the distribution of earnings and profits within the meaning of section 355(a)(1)(B) of the Internal Revenue Code.

FACTS

  P corporation has been engaged in the active conduct of two businesses, business Q and business R, throughout the past 5 years. For bona fide business reasons, P is required to separate ownership of the two businesses. Accordingly, P proposes to transfer all the assets associated with business R and investment assets not related to business R to corporation S, a newly- formed corporation, in exchange for all the outstanding stock of S and the assumption by S of related liabilities. P will then distribute all the S stock to P's shareholders, pro rata. The fair market value of the investment assets is 20x dollars, and the fair market value of all the assets associated with business R is in excess of 155x dollars.

LAW AND ANALYSIS

  Section 368(a)(1)(D) of the Code provides that a reorganization includes a transfer by a corporation of all or part of its assets to another corporation if, immediately after the transfer, the transferring corporation, or one or more of its shareholders, or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock of the corporation to which the assets are transferred is distributed in a transaction which qualifies under section 354, 355, or 356.

  Section 355(a)(1) of the Code provides generally for the distribution, without recognition of gain or loss to the shareholders, of stock of a corporation controlled by the distributing corporation, provided certain requirements are met. Pursuant to section 355(a)(1)(B), the distribution will not qualify under section 355 if the transaction was used principally as a device for the distribution of earnings and profits of the distributing corporation, or the controlled corporation, or both. Section 1.355- 2(b)(3) of the Income Tax 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.

  Rev. Rul. 83-114, 1983-2 C.B. 66, holds that a contribution to capital following by a pro rata distribution of a controlled corporation's stock, while not per se a transaction used principally as a device for the distribution of earnings and profits, may constitute evidence thereof. A determination as to whether the transaction is a device for distribution of earnings and profits requires an evaluation of all the facts and circumstances surrounding the transaction, including the business reasons for the contribution to capital and subsequent stock distribution. See also Rev. Rul. 78-383, 1978-2 C.B. 142.

  On the other hand, in Rev. Rul. 56-557, 1956-2 C.B. 199, involving facts similar to those described above, it was held that, in connection with the transfer by the distributing corporation to the newly-formed controlled corporation of 155x dollars of assets relating to an active business, the transfer of 20x dollars of assets having no relation to the transferred business did not render the provisions of section 355 inapplicable. Neither the facts nor the discussion set forth in that ruling clearly indicate the reasons for the transfer of the investment assets. Rev. Rul. 56-557 might be read to indicate that a relatively small percentage of investment assets among the transferred assets is not relevant to the inquiry as to whether the transaction is a device for the distribution of earnings and profits under section

355(a)(1)(B) of the Code. Because the ruling is misleading, Rev. Rul. 56-557 needs clarification.

HOLDING

  In the present situation, the transfer by P to S of investment assets not related to the transferred business is a factor to be considered in determining whether the transaction is a device for the distribution of earnings and profits regardless of the percentage of such assets relative to the total amount of assets transferred. The percentage of investment assets transferred relative to the other assets held by P and S will be taken into account, along with the other facts and circumstances surrounding the transaction, including the reasons for the asset transfers and stock distribution, in determining whether the transaction is a device for the distribution of earnings and profits, and, thus, fails to qualify under section 355 of the Code.

EFFECT ON OTHER REVENUE RULINGS

  Rev. Rul. 56-557 is clarified.

Rev. Rul. 86-4, 1986-1 C.B. 174, 1986-2 I.R.B. 5.