Rev. Rul. 88-34

1988-1 C.B. 115, 1988-20 I.R.B. 21.

                       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 under section 355 of the Code is met if a corporation distributes all of the stock of its subsidiary corporation in order to enable the subsidiary to hire a key employee who also wishes to acquire shares of stock of the subsidiary.

  A publicly held corporation has no shareholder who owns as much as a five percent interest. The corporation wholly owns a subsidiary. The president of the subsidiary has recently retired. The subsidiary wants to hire another individual with experience as a president of a corporation in the same line of business. The individual will accept the position only if permitted to acquire a direct interest in the subsidiary, without acquiring any interest in the parent. To induce this individual to accept the job, the parent will distribute the subsidiary's stock pro rata to its shareholders. Within a year of accepting the position, the individual will acquire stock in the former subsidiary.

  ISSUE. At issue is whether the distribution of the subsidiary's stock to entice the individual to accept the position as president of the subsidiary is a valid business purpose under regulation section 1.355-2(c).

  HOLDING. The Service has found that the business purpose requirement of section 1.355-2(c) is satisfied by the parent's distribution of the subsidiary stock to hire the individual as the subsidiary's president.

  ANALYSIS. The Service cited Rev. Rul. 69-460, 1969-2 C.B. 51, which held that the distribution of subsidiary stock to enable key employees to buy stock in the subsidiary was undertaken for a valid business purpose. The Service also relied on Rev. Rul. 85-127, 1985-2 C.B. 119, which held that a valid business purpose exists where a corporation transferred one of its businesses to a new corporation and distributed the stock of the new corporation to retain a key employee and to permit the employee to purchase a majority of stock in the new corporation.

                                     ISSUE

  Is the business purpose requirement of section 355 of the Internal Revenue Code and section 1.355-2(c) of the Income Tax Regulations met where a distribution of the stock of a controlled corporation is made to enable that corporation to hire a new president?

                                     FACTS

  X, a large widely held and publicly traded corporation, owned all the stock of Y corporation for more than five years. X and Y were each engaged in the active conduct of a separate and distinct trade or business for over five years. No shareholder of X owns as much as 5 percent of the outstanding stock of X.

  The president of Y has recently retired and Y has conducted an extensive search for a new president. Y has interviewed A, an individual with substantial prior experience and an outstanding reputation as the president of a public corporation engaged in the same line of business as Y. Because of A's prior experience and success in managing a similar corporation, A is the person Y wishes to hire as its new president. A is interested in becoming the president of Y but will not accept the position unless permitted to acquire a significant equity interest in Y. A has further advised Y that A is not interested in acquiring X stock or in acquiring an equity interest in Y as a subsidiary of X.

  In order to permit Y to obtain the services of A, X has distributed all of the stock of Y pro rata to the shareholders. Thereafter, A will be employed by Y at an annual salary of $250x and, within one year, will purchase newly issued shares of stock from Y having a fair market value of $775x.

  Except for the issue of the business purpose for the distribution, the proposed distribution by X of the Y stock meets all the requirements of section 355 of the Code and the pertinent regulations.

                                LAW AND ANALYSIS

  Section 355 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 not taxable to those shareholders or security holders. Section 1.355-2(c) of the regulations states that a distribution by a corporation of stock or securities of a controlled corporation will not qualify under section 355 when carried out for purposes not germane to the business of the corporations. This provision is intended to limit the application of section 355 to those readjustments of a corporate structure that are required by business exigencies.

  Situation 2 of Rev. Rul. 69-460, 1969-2 C.B. 51, concerns a distribution of the stock of a subsidiary corporation so that key employees of the parent corporation could afford to buy stock in that corporation. That ruling holds that the distribution was undertaken for a valid business purpose. Rev. Rul. 85-127, 1985-2 C.B. 119, holds that the business purpose requirement was also met where a corporation transfers one of its businesses to a new corporation and distributes the stock of the new corporation to its shareholders in order to retain the services of a key employee and permit that employee to obtain a majority of the stock of the new corporation.

  In the present situation, the distribution enables the subsidiary corporation to hire the key employee it believes is necessary to the continued success of the business. This is consistent with both Rev. Rul. 69-460 (Situation 2) and Rev. Rul. 85-127.

                                    HOLDING

  The pro rata distribution of the stock of Y by X to the X shareholders to enable Y to hire A as its new president is for a valid business purpose within the meaning of section 1.355-2(c) of the regulations. The distribution qualifies under section 355 of the Code because all other requirements of section 355 and the regulations thereunder have been met.

                              DRAFTING INFORMATION

  The principal author of this revenue ruling is Mr. Grid Glyer 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. 88-34, 1988-1 C.B. 115, 1988-20 I.R.B. 21.