Rev. Rul. 78-442: Qualifying ATB though gain recognized under § 357(c)

Citations: Rev. Rul. 78-442; 1978-2 C.B. 143

Rev. Rul. 78-442

Advice has been requested whether the "active trade or business" requirements of section 355(b)(2)(C) of the Internal Revenue Code of 1954 have been satisfied and if so, whether section 355(a)(3) is applicable to the distribution of stock, under the circumstances described below.

X corporation has conducted two active businesses, within the meaning of section 355(b) of the Code, for more than 5 years. X transferred the property of one of the businesses to Y, a newly formed corporation, in exchange for all the stock of Y and the assumption by Y of certain liabilities of X attributable to the business transferred. Thereafter, X distributed all the stock of Y to the shareholders of X in a transaction intended to meet the requirements of sections 368(a)(1)(D) and 355. The transaction was undertaken for valid business purposes and was not used principally as a device to distribute earnings and profits of either X or Y. Immediately after the transaction, the shareholders of X were in control of both X and Y within the meaning of section 368(c). On the date of the transfer, the amount of the liabilities assumed by Y exceeded the total adjusted basis of the property transferred by X but the amount of the liabilities was less than the total fair market value of the transferred property.

Section 368(a)(1)(D) of the Code provides, in part, 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 tranferring corporation, or one or more of its shareholders, or any combination thereof, is in control of the corporation to which the assets are transferred; but only if, in pursuance of the plan, stock of the corporation to which the assets are transferred is distributed in a transaction which qualifies under section 355.

Section 355(a)(1) of the Code provides for the distribution, without recognition of gain or loss to the shareholders, of stock of a corporation if certain requirements are met. One of the requirements set forth in section 355(b)(1)(A) states that both the distributing corporation (X) and the controlled corporation (Y) must be engaged in the active conduct of a trade or business immediately after the distribution. Section 355(b)(2)(C) provides that a corporation will be treated as engaged in the active conduct of a trade or business if, and only if, such trade or business was not acquired in a transaction in which gain or loss was recognized, in whole or in part, within the 5-year period ending on the date of distribution.

Section 357(c) of the Code provides, in part, that gain will be recognized in an exchange to which section 351 applies or to which section 361 applies by reason of a plan of reorganization within the meaning of section 368(a)(1)(D), to the extent that the sum of the amount of the liabilities assumed plus the amount of the liabilities to which the property is subject exceeds the total of the adjusted basis of the property transferred pursuant to such exchange.

In the instant case, section 351 of the Code applies to the transfer, and if the transaction is a reorganization within the meaning of section 368(a)(1)(D), section 361 applies. Therefore, gain will be recognized to X under section 357(c) on the transfer of property to Y and the assumption by Y of the liabilities of X.

The specific question is whether the gain required to be recognized under section 357(c) of the Code prevents Y from satisfying the trade or business test of sections 355(b)(1)(A) and (b)(2)(C).

The rules of section 355(b)(2)(C) of the Code are intended to prevent the acquisition of a trade or business by the distributing or the controlled corporation from an outside party in a taxable transaction within 5 years of a distribution by the distributing corporation of the stock of a controlled corporation in a transaction to which section 355 would otherwise apply. It was not intended to apply to an acquisition of a trade or business by the controlled corporation from the distributing corporation. Therefore, the acquisition by Y of an active business from X in exchange for Y stock does not violate the provisions of section 355(b)(2)(C), even though gain is recognized to X on the transaction by reason of section 357(c).

Likewise, for the same reasons, section 355(a)(3) of the Code is not applicable to the distribution of the Y stock by X. Section 355(a)(4) provides that for purposes of section 355 (other than section 355(a)(1)(D)) and so much of section 356 as relates to this section, stock of a controlled corporation acquired by the distributing corporation by reason of any transaction which occurs within 5 years of the distribution of such stock and in which gain or loss was recognized in whole or in part, shall not be treated as stock of such controlled corporation, but as other property.

Accordingly, since the active business acquired by Y had been actively conducted by X for more than 5 years prior to the distribution of the Y stock to the shareholders of X, the requirements of section 355(b)(2)(C) of the Code are satisfied. Since all the other requirements of section 355 are met, the transaction qualifies as a reorganization within the meaning of section 368(a)(1)(D), and no gain or loss will be recognized to (and no amount will be includible in the income of) the X shareholders under section 355(a)(1) on the distribution of the Y stock to them.