Rev. Rul. 88-33
1988-1 C.B. 115, 1988-20 I.R.B. 20.
Internal Revenue Service
Revenue Ruling
CONTROLLED CORPORATION; STOCK DISTRIBUTION; BUSINESS PURPOSE
Published: May 16, 1988
26 CFR 1.355-2: Limitations
Controlled corporation; stock distribution; business purpose. The business purpose requirement of section 1.355-2(c) of the regulations is satisfied when a corporation distributes the stock of its subsidiary in order to eliminate the time, expense and administrative fees involved in meeting state regulatory requirements imposed on the parent corporation because of the subsidiary's business.
A publicly traded corporation designs, manufactures, and markets computers and software for electronic games. No single shareholder owns even three percent of the outstanding stock of the corporation. The corporation had a wholly owned subsidiary, which was engaged in the design and manufacture of hardware and software for the electronic gaming industry in a state. The subsidiary was subject to annual licensing by the state gaming commission. The parent was subject to the same procedure because of its relation to the subsidiary. The two corporations do not share officers or directors. Because of the tremendous time and expense involved in completing the questionnaires and financial reports necessary for the annual licensing, the parent distributed all of the subsidiary stock pro rata to the parent's shareholders.
ISSUE. At issue is whether the business purpose requirement of regulation section 1.355-2(c) is satisfied when the subsidiary's stock was distributed to reduce the time and expense of compliance with state regulatory licensing requirements.
HOLDING. The Service has held that the business purpose requirement of regulation section 1.355-2(c) is satisfied by the parent's motive for the stock distribution: reduction of state regulatory compliance costs.
ANALYSIS. The Service relied on several revenue rulings which found a valid business purpose for a distribution where the transaction resulted in a substantial reduction in the costs of doing business or a substantial reduction in the impediments to do business. In Rev. Rul. 76-187, 1976-1 C.B. 97, the Service noted that a distribution to reduce state and local capital taxes paid by the corporations was found to have a legitimate business purpose. Similarly, the Service found in Rev. Rul. 77-22, 1977-1 C.B. 91, that a distribution to increase the amount of available commercial credit had a valid business purpose.
ISSUE
Is the business purpose requirement of section 1.355-2(c) of the Income Tax Regulations satisfied when stock of a controlled corporation is distributed in order to reduce substantially the amount of administrative time and expense necessary for compliance with state regulatory licensing and reporting requirements?
FACTS
P, a large, widely held, publicly traded corporation, has engaged primarily in the design, manufacture, and marketing of computers and associated software. No single P shareholder owns as much as 3 percent of the outstanding P stock.
At the time the transaction described below was consummated, § corporation had been a wholly owned subsidiary of P for more than 5 years. § had been engaged for over 5 years in the design and manufacture of hardware and software for the electronic gaming industry in state Q. No officer or director of P was also an officer or director of S.
Under the law of Q, every gaming corporation and any corporation related to a gaming corporation must be licensed annually by the Q Gaming Commission. Because § was a wholly owned subsidiary of P, it too was subject to the Q licensing procedure. Under the laws of Q, P would have been subject to the annual licensing procedure even if P and § were brother-sister corporations. As part of the Q annual licensing procedure, both § and P had to prepare and file detailed annual financial reports. In addition to the annual financial reports, Q required that every officer and director of § and P submit each year to a full personal investigation, including a detailed, lengthy personal questionnaire. The annual licensing fee imposed by Q is 25,000x dollars for S, and an additional 25,000x dollars for P. The annual preparation of the questionnaires by the officers and directors of P involved a significant number of working hours for P's top management. As a result, the amount of time of that P's top management could devote to the management of P's business was unnecessarily reduced, which reduction had a significant negative impact on the normal operations of P. These questionnaires also required a substantial increase in record keeping and the involvement of P's outside accountants and lawyers at an added annual cost to P of 20,000x dollars.
In order to eliminate the continuing administrative time and expense directly involving S, P and it officers and directors in meeting the annual Q licensing requirements for S, P distributed all the § stock pro rata to the P shareholders. Except for the question of the business purpose, the distribution of § stock by P met all the requirements of section 355 of the Internal Revenue Code and the applicable regulations.
LAW AND ANALYSIS
Section 355 of the Code provides that under certain circumstances a corporation may distribute stock in a corporation it controls to its shareholders in a transaction in which no gain or loss is recognized to (and no amount is includible in the income of) the shareholders. Section 1.355-2(c) of the regulations provides that a distribution by a corporation of stock of a controlled corporation to is shareholders with respect to its own stock will not qualify under section 355 if carried out for purposes not germane to the business of the corporations. This provisions is intended to limit the application of section 355 to those readjustments of corporate structure that are required by business exigencies.
Several revenue rulings have found a valid business purpose for a distribution under section 355 of the Code where the transaction resulted in a substantial reduction in the costs of doing business or a substantial reduction in impediments to the business of either the distributing or controlled corporation. Rev. Rul. 76-187, 1976-1 C.B. 97, concerned a distribution of the stock of a subsidiary corporation to the sole corporate shareholder in order to reduce substantially the amount of state and local capital taxes paid by the corporations. The ruling holds that the distribution was undertaken for a valid business purpose. In Rev. Rul. 77-22, 1977-1 C.B. 91, a distribution of the stock of a subsidiary in order to increase the amount of commercial credit that would be available constituted a valid business purpose under section 355.
In the present situation, the distribution was undertaken for reasons similar to those in the cited revenue rulings - to eliminate significant limitations on profitability. The distribution relieved P of a substantial annual administrative burden imposed upon it and its management by Q as a result of P's stock ownership of S; and it removed P's computer business from the gaming licensing review of Q. An important factor present here is the annually recurring negative effect on business that was relieved by the distribution. Accordingly, the distribution by P of the § stock was for a purpose germane to the business of P within the meaning of section 1.355-2(c) of the regulations.
HOLDING
The business purpose requirement of section 1.355-2(c) of the regulations is satisfied by P's distribution of § stock to remove P's nongaming business from the licensing review process and to free P from the substantial continuing administrative expense and time required of P by Q for the annual licensing of S.
DRAFTING INFORMATION
The principal author of this revenue ruling is Mr. Micheal J. Danbury of the Corporation Tax Division. For further information regarding this revenue ruling, contact Mr. Thomas J. Kane on (202) 566-9293 (not a toll-free call).
Rev. Rul. 88-33, 1988-1 C.B. 115, 1988-20 I.R.B. 20.