Rev. Rul. 70-18

Advice has been requested whether the distribution by a corporation to its sole shareholder of the common stock of another corporation, under the circumstances described below, qualifies as a nontaxable distribution under section 355 of the Internal Revenue Code of 1954.

Corporation X, engaged in the sale and service of new and used cars, owned 40 percent of the outstanding stock of corporation Z, an underwriter of high risk automobile insurance. Corporation Y, which sold automobile insurance, owned 60 percent of the outstanding stock Z. All the outstanding stock of X and Y was owned by individual A. Each corporation had been engaged in the active conduct of its respective business for more than five years, and the stock of Z owned by X and Y had been owned by them for more than five years.

Due to state regulations applicable to insurance underwriters, it became necessary to eliminate X's ownership of Z's stock. At approximately the same time, the building that housed the business of Y was condemned by the state and Y's insurance business was moved into X's facilities.

After the consolidation of Y's activities into X's facilities, a plan was adopted whereby Y was merged into X in accordance with state law. No gain or loss was recognized to A, X or Y on the merger. Immediately thereafter X distributed all the outstanding stock of Z to A to comply with state regulations concerning insurance underwriters. Thereafter, X and Z continued to actively conduct their respective businesses.

Section 355(a) of the Code provides, in part, that no gain or loss shall be recognized if (1) a corporation distributes to a shareholder, with respect to its stock, solely stock of a corporation which it controls immediately before the distribution, (2) the transaction was not used principally as a device for the distribution of earnings and profits, and (3) the requirements of subsection (b) of section 355 of the Code (relating to active businesses) are satisfied. Subsection (b) provides in part that control of the corporation the stock of which is distributed cannot have been acquired within the five-year period preceding the distribution unless it was acquired within such period by reason of a transaction in which gain or loss was not recognized in whole or in part.

For purposes of section 355 of the Code, the term "control," as defined in section 368(c) of the Code means the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.

Section 1.355-2(c) of the Income Tax Regulations provides, in part, that the application of section 355 of the Code is limited to certain specified distributions with respect to the stock or securities of controlled corporations incident to such readjustment of corporate structures as is required by business exigencies and which, in general, effect only a readjustment of continuing interests in property under modified corporate forms. Section 355 of the Code contemplates a continuity of the entire business enterprise under modified corporate forms and a continuity of interest in all or part of such business enterprise on the part of those persons who, directly or indirectly, were the owners of the enterprise prior to the distribution.

Section 1.355-4(b)(1) of the regulations provides that if control of the active trade or business was acquired within the five-year period, it must have been acquired in a transaction in which gain or loss was not recognized.

Revenue Ruling 62-138, C.B. 1962-2, 95, holds that successive distributions were each within the purview of section 355 of the Code. In that case, a banking corporation, actively engaged in the banking business for a period of more than five years, also owned all of the stock of a realty corporation acquired more than five years before. The realty corporation owned and operated four parcels of developed realty that it used in the active conduct of several rental businesses for a period of more than five years. The realty corporation transferred two separate rental parcels to a newly created subsidiary in exchange for all of its capital stock. The stock of the new corporation was then distributed by the realty corporation to the banking corporation, which, in turn, distributed the stock of the new corporation to its shareholders.

The conclusion in that Revenue Ruling was based on the facts that there was no change in the aggregate interests held by the banking corporation's shareholders, no new parties in interest were added as a result of the transaction, and none were eliminated. The shareholders after the transaction held the same enterprises in modified corporate form as before the transaction and the corporate enterprises were continued as such.

In the instant case, sufficient business reasons existed to establish the validity of the merger as having a substantial business purpose other than to gain the control required to effect the spin-off. Prior to the transactions A owned all of the outstanding shares of X and Y directly and all of the Z shares indirectly. After the transaction A owned all the shares of the merged corporations directly and all the shares of Z directly.

In this case, control of Z was acquired within the five-year period preceding the distribution in a transaction in which no gain or loss was recognized as provided by section 1.355-4(b)(1) of the regulations. There was a continuity of the entire business enterprise under modified corporate form and a continuity of interest therein by those persons who, directly or indirectly, were the owners of the enterprise prior to the exchange and distribution.

Accordingly, no gain or loss is recognized to (and no amount is includible in the income of) A, the shareholder of X, on the receipt by him of all of the stock of Z as provided in section 355 of the Code. No gain or loss is recognized to X or to Z as a result of the distribution.