Rev. Rul. 89-27
1989-1 C.B. 106, 1989-9 I.R.B. 7.
Internal Revenue Service
Revenue Ruling
ACTIVE CONDUCT OF A TRADE OR BUSINESS; OIL AND GAS
Published: February 27, 1989
26 CFR 1.355-3: Active conduct of a trade or business.
Active conduct of a trade or business; oil and gas. A nonoperator owner of working interests in oil and gas properties satisfies the active conduct of a trade or business requirement of section 355(b) of the Code under certain circumstances.
A corporation owned working interests in oil and gas properties. The corporation participated in management decisions relating to exploration and production, but did not operate the properties. The corporation gathers and analyzes technical data to use in deciding whether to develop a property. The corporation also participates in drilling decisions, such as determining the location, total depth, and whether to complete or plug a hole.
ISSUE. At issue is whether a corporation that is a nonoperator owner of working interests in oil and gas properties can satisfy the active conduct of a trade or business requirement of section 355(b) so that a distribution of its stock to the shareholders of its parent is tax free under section 355(a)(1).
HOLDING. The Service has concluded that, under the facts and circumstances described, a nonoperator owner of working interests in oil and gas properties is engaged in the active conduct of a trade or business under section 355(b). Accordingly, the distribution of the corporation's stock to the shareholders of its parent is tax free under section 355(a)(1).
ANALYSIS. The Service asserted that the active conduct of a trade or business generally requires that substantial operational and management activities must be carried on directly by the corporation, not by independent contractors. Citing Rev. Rul. 73-237, 1973-1 C.B. 184, the Service stated that the fact that some of the corporation's business activities are performed by outsiders does not preclude the corporation from being actively involved in a trade or business. The Service concluded that the final determination of whether a corporation is actively engaged in a trade or business depends on all the facts and circumstances of each case.
ISSUE
Can a corporation that is a nonoperator owner of working interests in oil and gas properties satisfy the active conduct of a trade or business requirement of section 355(b) of the Internal Revenue Code?
FACTS
For more than 5 years, X, a domestic corporation, has been engaged directly and through its subsidiaries in the exploration, development, production and marketing of petroleum products.
Y is a domestic corporation engaged, as discussed below, in the oil and gas business in state Z. All of the stock of Y has been owned by X for more than 5 years. The activities of Y are performed by its employees. Y employs, on a full time basis, geologists, petroleum engineers, accountants and other employees necessary to conduct its business.
Y is in constant search for properties that may yield commercial quantities of oil and gas and has, in previous years, acquired nonoperator working interests in such properties.
As owner of a working interest, Y participates in deciding whether to develop the property. This requires extensive gathering and analyzing of technical data by Y. Once a decision is made to develop any property, Y enters into a standard form operating agreement with other owners of working interests in the property.
Under the agreement, one working interest owner (other than Y) is designated as operator and generally supervises the daily activities involved in development and production. Y pays its pro rata share of costs of development and expenses of operations involving the property. In addition, Y meaningfully participates in management decisions, inspects the drilling site to determine if the drilling operations conform to the agreement, and analyzes data obtained from drillsite activities. Y also participates in deciding the location and depth of the wells to be drilled and whether to drill a new well, deepen an old well, and to abandon a well. Although the operating agreement reserves the right to Y to take the production in kind, Y typically authorizes an agent to market the production. Y has derived substantial revenue from its oil and gas operations during the last 5 years.
For valid business reasons, X proposes to distribute pro-rata to its shareholders all of the shares of Y. Thereafter, Y will continue its present operations, including the acquisition of additional working interest in new properties.
Except for the question here at issue concerning the active conduct of a trade or business requirement of section 355(b) of the Code, the distribution by X of the Y shares meets all of the other regulations thereunder.
LAW AND ANALYSIS
Section 355 of the Code provides rules for the distribution of stock of a corporation controlled by the distributing corporation without recognition of gain or loss to the shareholders. For such treatment, section 355(b)(1)(A) requires that both the distributing corporation and the controlled corporation must be engaged in the active conduct of a trade or business. Section 355(b)(2)(B) provides that a corporation will be treated as engaged in the active conduct of a trade or business only if such trade or business has been actively conducted throughout the 5-year period ending on the date of distribution.
Section 1.355-3(b)(2)(ii) of the Income Tax Regulations, in defining 'trade or business' for section 355 purposes, provides that a trade or business consists of a specific existing group of activities being carried on for the purpose of earning income or profit from such group of activities, and the activities included in such group must include every operation which forms a part of, or a step in, the process of earning income or profit. Such group of activities ordinarily must include the collection of income and the payment of expenses.
In defining 'active conduct' of a trade or business the regulations indicate that in order for a trade or business to be actively conducted, substantial management and operational activities generally must be directly carried on by the corporation itself and such activities generally do not include the activities of others outside the corporation, including independent contractors. However, the fact that a portion of a corporation's business activities is performed by others will not preclude the corporation from being engaged in the active conduct of a trade or business if the corporation itself directly performs active and substantial management and operational functions. Section 1.355-3(b)(2)(iii) of the regulations.
In Revenue Ruling 73-237, 1973-1 C.B. 184, a corporation's direct performance of substantial management and operational activities, apart from those activities performed by independent contractors, was held to satisfy the active conduct of trade or business requirement of section 355(b) of the Code.
A determination whether a trade or business is actively conducted for purposes of section 355(b) is based on all the facts and circumstances. In the instant case, Y's business activities include its direct performance of active and substantial management and operational functions, apart from those activities performed by others. Section 1.355-3(b)(2)(iii) of the regulations; Rev. Rul. 73-237; also see Rev. Rul. 73-234, 1973-1 C.B. 180; compare Rev. Rul 73-236, 1973-1 C.B. 183.
HOLDING
Under the facts of this case, Y, an non-operator owner of working interests in oil and gas properties, is engaged in the active conduct of a trade or business within the meaning of section 355(b) of the Code. Accordingly, the distribution by X to its shareholders of the Y stock qualified as a tax-free distribution under section 355(a)(1) of the Code.
DRAFTING INFORMATION
The principal author of this revenue ruling is Peter G. Lynard of the Office of Assistant Chief Counsel (Corporate). For further information regarding this revenue ruling, contact Mr. Richard F. McManus on (202) 566-3422 (not a toll- free call).
Rev. Rul. 89-27, 1989-1 C.B. 106, 1989-9 I.R.B. 7.