PROPERTY LEASED TO TENANT FARMERS IS NOT 'ACTIVE BUSINESS' IN TRANSFER AND EXCHANGE OF PROPERTY

Rev. Rul. 86-126

ISSUE

Whether a corporation is considered to be engaged in the active conduct of a trade or business within the meaning of section 355(b) of the Internal Revenue Code and section 1.355-1(c) of the Income Tax Regulations under the following circumstances.

FACTS

A and B are the only officers and shareholders of P corporation. Each has held 50 percent of P's outstanding common stock for more than 5 years. A and B are both farmers who are engaged in the business of farming their own individual tracts of farmland not owned by P. P has for more than 5 years held title to large tracts of farmland elsewhere in the same state. Each tract of land held by P is leased for one year at a time to a tenant farmer who has agreed with P to share one-half of all income and expenses of the farm. Each party to the lease is responsible for securing the financing necessary to pay that party's share of expenses. In the case of each tract leased, the planting, raising, and harvesting of corn and soybeans (the only crops grown on these farms) are done by the tenant farmer. The tenant farmer also supplies the farm equipment used in these activities. The tenant farmer repairs and maintains the equipment, and also maintains the irrigation system, fences, and other fixtures located on the property. After consulting with A and B, the tenant farmer purchases all herbicides, insecticides, and fertilizers used on the property. Also after consulting with A and B, the tenant farmer contracts to sell the crops at a future date, or sells then when harvested. Each tenant farmer is responsible for accounting to A and B for P's share of the proceeds.

A and B each devote to substantial part of their time to the operation of their own respective farms which are unconnected with the farmland owned by P. After completing work on their own properties, A and B, in their capacity as officers of P, occasionally inspect the crops and improvements located on each leased tract. If any corrective steps must be taken, A or B points out the problem to the tenant farmer, who makes the necessary corrections in the way the tenant farmer sees fit. A and B also decide each year what portion of each tract will be leased, in the light of soil conservation needs, market conditions, and federal price support and acreage reserve programs. They review each tenant farmer's accounting of operations and sales.

For valid business reasons, P will transfer to a newly-formed subsidiary corporation, S, one-half of all the property held by P, and then will distribute all the S stock to B in exchange for all B's stock in P. After the distribution, P and S will continue to conduct operations in the same manner with tenant farmers as P had prior to the distribution.

Except for the question here at issue regarding the active conduct of a trade or business, the transfer will meet all the requirements of sections 368(a)(1)(D) and 355 of the Code and the regulations thereunder.

LAW AND ANALYSIS

Section 355(a) 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 nontaxable to such shareholders or security holders.

Section 355(b) of the Code requires that both the distributing and controlled corporations be engaged, immediately after the distribution, in the active conduct of a trade or business that has been actively conducted throughout the 5-year period ending on the date of distribution.

To meet the requirements of section 355(b) of the Code, each corporation must, as stated in Rafferty v. Commissioner, 452 F.2d 767, 772 (1st Cir. 1971), cert. denied, 408 U.S. 922 (1972), "engage in entrepreneurial endeavors of such a nature and to such an extent as to qualitatively distinguish its operations from mere investments. Moreover, there should be objective indicia of such corporate operations." Such objective indicia are found in active and substantial managerial and operational activities of the corporation. In addition, this business activity has to be the activity of the corporation itself (through its officers and employees) and not the activity of independent contractors. Rev. Ruls. 80-181, 1980-2 C.B. 121, 79-394, 1979-2 C.B. 141, and 73-234, 1973-1 C.B. 180.

In Rev. Rul. 73-234, it was held that a corporation engaged in farming with tenant farmers was engaged in the active conduct of a trade or business within the meaning of section 355(b) of the Code. However, in that revenue ruling, Y corporation, through its employees, A and B, was engaged in hiring seasonal workers, purchasing and supplying equipment, maintaining equipment, arranging financing, planning all rotation and planting and harvesting of crops, purchasing livestock, planning livestock breeding, selling all crops and livestock, and accounting to the tenant farmers for their shares of the proceeds. This activity of Y carried on through its own employees and constituting active and substantial managerial and operational activity, contrasts with the activity carried on by the employees of P in the present situation. Here, P either did not engage in the above activities at all, or engaged in them only on a limited basis. At best, P could be considered to engage in some managerial and operational activity but not enough to "qualitatively distinguish its operations from mere investments." Thus, Rev. Rul. 73-234 is distinguishable from the present situation.

HOLDING

Because of the absence of active and substantial operational and managerial activities, the active business requirement of section 355(b) of the Code is not met and P's distribution of the S stock is not governed by section 355. B will recognize gain on the receipt of the S stock in exchange for P stock, and P will be subject to the provisions of section 311. See Rev. Rul. 74-516, 1974-2 C.B. 121.

In addition, because there is no distribution of stock or securities to B under section 354, 355, or 356 of the Code, the transfer of property from P to S does not meet the requirements of section 351(a)(D). However, this transfer does meet the requirements of section 351(a). The fact that P distributed the S stock to B does not violate the control requirement of Section 351(c).

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 73-234 is distinguished.