Rev. Rul. 59-400

Advice has been requested whether a distribution of stock by a corporation engaged in the hotel and real estate business qualifies under the nontaxable provisions of section 355 of the Internal Revenue Code of 1954.

M corporation was engaged in two businesses, operating a hotel and renting improved real estate (both commercial and residential). The hotel business was started upon organization in 1920 and has been actively conducted up to the present time. In 1934, M corporation also entered into the rental real estate business when it purchased property, constructed a garage and automobile agency facilities thereon and rented it to a dealer. In the intervening years, it acquired other rental properties which it has continued to operate. In 1954, the hotel had a fair market value of 550 x dollars and a net book value of 350 x dollars. The rental properties had a fair market value of 305 x dollars and a net book value of 167 x dollars.

During the five-year period commencing with 1954, the operation of the hotel business resulted in earnings, after taxes, of 240 x dollars, and the operation of the real estate business resulted in earnings of approximately 75 x dollars. In 1958, a new rental office building was built for 400 x dollars, some 175 x dollars thereof being provided by loans from banks. At the beginning of 1959, the hotel business was placed in a new corporation N , and the stock thereof distributed to the shareholders of M on a pro rata basis. N corporation received the hotel, plus certain receivables and other hotel business assets. M corporation retained the real estate liabilities and assets, which at that time had a net book value of 372 x dollars and a fair market value of 705 x dollars.

Section 355 of the Code states, in part, that in order for a distribution of stock to qualify under the nontaxable provisions of such section, each of the corporations involved must be engaged in a trade or business which has been actively conducted throughout the five-year period ending on the date of distribution, and that the transaction must not be used principally as a device to distribute the earnings and profits of either corporation.

The purpose behind the five-year limitation of section 355 is to prevent the corporate earnings of one business from being drawn off for such a period and put into a new business and thereby, through the creation of a marketable enterprise, convert what would normally have been dividends into capital assets that are readily saleable by the shareholders.

It is the position of the Internal Revenue Service that where a corporation which is devoted to one type of business also engages in the rental business, and substantial acquisitions of new rental property are made within the five-year period preceding the separation of these businesses, a `spin-off' transaction will not qualify under section 355 unless it can be shown that the property acquisitions were substantially financed out of the earnings of the rental business and not out of the earnings of the other business.

From the facts presented herein, it is readily apparent that there has been a very substantial increase in the rental properties subsequent to 1954, primarily as a result of the addition of the large office building in 1958, further, it is also apparent that, viewing the transaction most favorably to the taxpayer, earnings properly attributable to the hotel business, in the amount of approximately 150 x dollars, have been employed in increasing the real estate business. In view of this substantial financing out of the earnings of the hotel business, it is held that the distribution of the stock of N corporation to the shareholders of M corporation will not qualify as a nontaxable distribution under section 355 of the Code.