rr-03-74.pdf

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Part I

Section 355.BDistribution of Stock and Securities of a Controlled Corporation

26 CFR 1.355-2: Business Purpose

Rev. Rul. 2003-74

ISSUE

Whether, in the situation described below, the distribution of the stock of a
controlled corporation by a distributing corporation to enable the management of each
corporation to concentrate on its own business satisfies the business purpose
requirement of ' 1.355-2(b) of the Income Tax Regulations.
FACTS
Distributing is a publicly traded corporation that conducts a software technology
business. Controlled, a wholly owned subsidiary of Distributing, conducts a paper
products business. One shareholder, who does not actively participate in the
management or operations of Distributing or Controlled, owns eight percent of the
outstanding Distributing stock.

The software business develops and markets software for various applications.

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It is a high-growth business that depends for its success on innovation and acquisitions
of related businesses. It is the business around which Distributing originally developed
and remains the core operation. The paper products business manufactures and
distributes paper products. It was acquired five years ago to support the software
business and is significantly smaller than the software business. The paper products
business grows at a slow to moderate rate largely through increased efficiencies in
productivity.
Distributing’s senior management devotes more of its time to the software
business because it believes that business presents better opportunities for growth.
Indeed, it would like to concentrate solely on the software business but is prevented
from doing so by the need to service the paper products business. The management of
the paper products business, on the other hand, believes that the disproportionate
attention paid the software business deprives the paper products business of the
management resources needed for its full development.
To enable Distributing’s senior management to concentrate on the software
business and the management of the paper products business to concentrate on its
own operation, Distributing distributes the Controlled stock to Distributing’s
shareholders, pro rata. Because Distributing’s senior management would have
continued responsibility for the paper products business as long as Distributing owns a
controlling interest in the stock of the corporation operating the paper products
business, there is no other nontaxable transaction that would permit Distributing’s senior
management to concentrate on the software business and permit the paper products

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business to have a senior management that adequately serves that business.
Distributing’s directors and senior management expect that each business will benefit in
a real and substantial way from the separation.
Following the distribution, no officer will serve both Distributing and Controlled.
However, two of Distributing’s eight directors will also serve on Controlled’s six-person
board. Director A will help with administrative aspects of the transition. His term will
expire after two years, and he cannot seek reelection. Director B is recognized as an
expert in corporate finance. His presence on the Controlled board is intended to
reassure the financial markets by providing a sense of continuity. His term will expire
after six years, at which time he may seek reelection. Both directors are officers of
Distributing, but neither will be an officer or employee of Controlled.
Apart from the issue of whether the business purpose requirement of ' 1.355-
2(b) is satisfied, the distribution meets all of the requirements of ' 355.
LAW
Section 355 provides that if certain requirements are met, a corporation may
distribute stock and securities in a controlled corporation to its shareholders and
security holders without causing the distributing corporation or the distributees to
recognize gain or loss.

To qualify as a distribution described in § 355, a distribution must, in addition to
satisfying the statutory requirements of § 355, satisfy certain requirements in the
regulations, including the business purpose requirement. Section 1.355-2(b)(1)

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provides that a distribution must be motivated, in whole or substantial part, by one or
more corporate business purposes. A corporate business purpose is a real and
substantial non-Federal tax purpose germane to the business of the distributing
corporation, the controlled corporation, or the affiliated group to which the distributing
corporation belongs. Section 1.355-2(b)(2). The principal reason for the business
purpose requirement is to provide nonrecognition treatment only to distributions that are
incident to readjustments of corporate structures required by business exigencies and
that effect only readjustments of continuing interests in property under modified
corporate forms. Section 1.355-2(b)(1). If a corporate business purpose can be
achieved through a nontaxable transaction that does not involve the distribution of stock
of a controlled corporation and that is neither impractical nor unduly expensive, then the
separation is not carried out for that corporate business purpose. Section 1.355-2(b)(3).
ANALYSIS
The distribution of Controlled stock by Distributing to Distributing’s shareholders
will enable Distributing’s senior management to concentrate its efforts on the software
business, which it believes presents better opportunities for growth, and allow the
management of the paper products business to secure for that business the
management resources needed for its full development. There is no other nontaxable
transaction that would permit Distributing’s senior management to concentrate on the
software business and permit the paper products business to have a senior
management that adequately serves that business, and it is expected that the
separation of the two businesses will enhance the success of each business in a real

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and substantial way.
Although the continuing relationship between Distributing and Controlled
evidenced by the two common directors appears inconsistent with the assertion that the
software business and the paper products business require independent management
teams, this relationship does not conflict with the business purpose for the separation.
Director A will serve for only a short period and will further that purpose by aiding in the
creation of two independently administered operations. Director B will assist the
separation by calming market concerns that might otherwise adversely affect one or
both businesses. Further, the two directors together constitute only a minority of each
board.
Hence, the distribution of Controlled stock by Distributing to Distributing’s
shareholders is motivated in whole or substantial part by a real and substantial non-
Federal tax purpose germane to the businesses of Distributing and Controlled and
satisfies the corporate business purpose requirement of § 1.355-2(b).

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HOLDING
In the situation described above, the distribution of the stock of a controlled
corporation by a distributing corporation to enable the management of each corporation
to concentrate on its own business satisfies the business purpose requirement of '
1.355-2(b).
DRAFTING INFORMATION
The principal author of this revenue ruling is Richard M. Heinecke of the Office of
Associate Chief Counsel (Corporate). For further information regarding this revenue
ruling contact Mr. Heinecke on (202) 622-7930 (not a toll-free call).