CONTROLLED FIRM STOCK DISTRIBUTION IS NONTAXABLE, BUSINESS PURPOSE IS MET IF UNPROFITABLE SKI RESORT IS SEPARATED FROM PROFITABLE GOLF/ TENNIS RESORT TO SATISFY UNDERWRITER

Rev. Rul. 85-122

ISSUE

Is the business purpose requirement of section 1.355-2(c) of the Income Tax Regulations met when stock of a controlled corporation is distributed under the circumstances described?

FACTS

P is a closely held corporation that owns and operates a golf and tennis resort in State A. P has for more than 5 years owned all the stock of S, a corporation that owns and operates a ski resort in State B. The golf and tennis resort operated by P, although profitable, is in need of substantial amounts of additional working capital to finance operation adequately. Due to various factors, including poor weather conditions, the ski resort operated by S has been experiencing significant losses for several years, and S is nearly bankrupt.

It is desired to sell P debentures in order to obtain additional working capital for P. P has approached an underwriter to explore debt financing through a private placement of its debentures. Except for this effort to sell P debentures, the underwriter has no relationship with P or P's shareholders. The underwriter has considerable experience in dealt with debt financing in situations of this type. The underwriter has advised P that potential investors could decline to invest in P because P's balance sheet would divulge its holding of S, and raise fears that the funds invested in P would be diverted to improve S's financial position. The underwriter has stated that, even if sufficient interest could be stimulated among potential investors, the terms and conditions of the debentures would be significantly more burdensome to P, if P remains associated with S. Finally, the underwriter has stated that a holding company structure in which P and S would both be first tier subsidiaries of a new parent company would not solve P's problem, as potential investors would take into account S's performance in evaluating the group's financial statements.

The underwriter has engaged in informal preliminary discussions of P's situations with persons who frequently purchase the underwriter's offerings. Even though the underwriter has attempted to explain that P (as S's shareholder) is not liable to S's creditors, the underwriter encountered reluctance to invest in P as long as P and S are associated. Based on prior experience with similar situations, and on the result of these informal preliminary discussions, the underwriter has recommended that all of the S stock be distributed to the P shareholders. This would permit P to prepare financial statements without reflecting the results and conditions of S's operation. The underwriter will then put together a syndicate of investors to purchase the P debentures. The amount of capital to be raised is considered adequate to meet the needs of P's operation.

In accordance with the underwriter's recommendation that P divest itself of S, P will distribute the S stock pro rata to the P shareholders. Except for the question here at issue regarding business purposes, distribution of the S stock to the P shareholders will meet all the requirements of section 355 of the Internal Revenue Code and the regulations thereunder.

LAW AND ANALYSIS

Section 355 of the Code provides that under certain circumstances of a corporation may distribute stock or securities in a corporation it controls to its shareholders or its security holders in a transaction that is nontaxable to such 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 to its shareholders with respect to its own stock will not qualify under section 355 of the Code when carried out for purposes not germane to the business of the corporations. This requirement is intended to limit the application of section 355 to those readjustments of corporate structure that are required by business exigencies.

The distribution by P of the S stock is for purposes germane to the business of P within the meaning of section 1.355-2(c) of the regulations, since it is the result of a recommendation by an independent and experienced underwriter who, from both prior experience and present contacts, has concluded that any relationship between P and S will have a significant adverse affect on investor perception of P debentures, and since it is reasonable to expect that the distribution of the S stock will be of significant help to P in securing needed additional capital

HOLDING

The business purpose requirement of section 1.355-2(c) of the regulations is met when the S stock is distributed under the circumstances described.