BUSINESS PURPOSE EXISTS IF CORP. TRANSFERS ONE OF TWO ACTIVE BUSINESSES TO NEW CORP. FOR ALL STOCK AND SPLITS OFF SUBSIDIARY TO RETAIN KEY EMPLOYEE-SHAREHOLDER

Rev. Rul. 85-127

ISSUE

Is the business purpose requirement of section 1.355-2(c) of the Income Tax Regulations met by a distribution of stock of a controlled corporation, under the circumstances described below?

FACTS

X corporation has two divisions, Division I and Division II, each of which has been engaged in the active conduct of a trade or business for each of the past 5 years. X has outstanding 500 share of common stock, which are held 400 shares by individual A and 100 shares by individual B.

The value of the X stock has increased substantially in recent years largely as a result of the efforts of B, a key employee and manager of X's Division II. B is seriously considering terminating employment with X, if not offered the opportunity to acquire a controlling equity interest in the business of Division II. However, B lacks the funds to purchase any additional equity.

In order to retain B's services for Division II, X proposes to undertake the following two steps. X will transfer to Y, a newly formed corporation, the assets, subject to liabilities, associated with the business of Division II solely in exchange for 500 shares of Y's common stock. Then, X will distribute 300 shares of the Y common stock to B in exchange for all of B's 100 shares of X common stock, and X will distribute the remaining 200 shares of Y common stock to A, without A surrendering any X stock. The value of the Y stock received by B will be equal to the value of the X stock surrendered by B.

Except for the business purpose issue, the distribution of the Y stock to A and B, as described above, will meet all the requirements of sections 368(a)(1)(D) and 355 of the Internal Revenue Code and the regulations thereunder.

LAW AND ANALYSIS

Section 368(a)(1)(D) of the Code provides that a reorganization includes a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356.

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 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 provision is intended to limit the application of section 355 to those readjustments of corporate structure that are required by business exigencies.

The transfer of the Division II business to Y and the distribution by X of the Y stock will be carried out for purposes germane to the business of X within the meaning of section 1.355-2(c) of the regulations, since this transfer and distribution will enable the business to retain a key employee.

HOLDING

The distributions of the Y stock is supported by a valid business purpose within the meaning of section 1.355-2(c) of the regulations. Since all other requirements of section 355 of the Code and regulations thereunder have been met, the distribution qualifies under section 355. The transfer by X of part of its assets to Y in exchange for Y stock is a reorganization as defined in section 368(a)(1)(D) of the Code.