Rev. Rul. 73-236
Advice has been requested whether the requirements of sections 368(a)(1)(D) and 355(b) of the Internal Revenue Code of 1954 have been met in the transaction described below.
For over five years X, an unincorporated domestic trust qualifying as an association taxable as a corporation under section 7701(a)(3) of the Code, has been engaged in two businesses: (1) the sale of real estate which it develops and improves, and (2) the leasing of some of the buildings which it constructs.
In order to avail itself of a means of attracting needed investment capital, X intends to qualify as a real estate investment trust ("REIT"), as defined in section 856 of the Code. In order to meet the requirement of section 856(a)(4) of the Code, X had to rid itself of property, including substantially all of its undeveloped land, that it held primarily for sale to customers in the ordinary course of its business. To accomplish this, X transferred this property to Y, a newly formed corporation, in exchange for all the Y stock and distributed the Y stock to its beneficiaries pro rata. Immediately after the distribution of the Y stock and as part of one overall plan, X converted itself to a REIT. X, in compliance with the provisions of section 856 of the Code, then engaged primarily in the leasing of real estate properties, each of which was managed and operated through an independent contractor.
Section 368(a)(1)(D) of the Code provides that the term "reorganization" includes a transfer by a corporation (X) of all or a part of its assets to another corporation (Y) if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), 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 or securities of the corporation to which the assets are transferred are distributed in a transaction which qualifies under section 354, 355, or 356 of the Code.
Section 354 of the Code does not apply to the transaction because Y did not acquire substantially all the assets of X (section 354(b)(1)(A) of the Code). Section 356 of the Code is inapplicable since it relates to the receipt of property other than stock or securities of the corporation to which the stock is transferred.
Section 355 of the Code provides rules for the distribution, without recognition of gain or loss to the shareholders, of stock of a corporation controlled by the distributing corporation. For such treatment section 355(b)(1)(A) of the Code requires that both the distributing corporation and the controlled corporation must be engaged immediately after the distribution in the "active conduct of a trade or business." Section 355(b)(2)(B) of the Code 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 has been actively conducted throughout the five-year period ending on the date of distribution.
The only issue to which this Revenue Ruling is directed is whether X, after the distribution and while qualifying as a REIT under section 856 of the Code, is also engaged in the active conduct of a trade or business within the meaning of section 355(b) of the Code.
The only trades or businesses which could qualify under section 355(b) of the Code would be those actively conducted immediately after the distribution which had also been actively conducted during the five-year period before the distribution. X conducted only one business after the distribution which it had conducted before the distribution--namely, the business of leasing real estate. Therefore, only that business may be considered in determining whether the active trade or business test has ben met with respect to X under section 355(b) of the Code.
Section 1.355-1(c) of the Income Tax Regulations, in defining "active business," provides, in part, that a trade or business consists of a specific existing group of activities being carried on for the purpose of earning income or profit from only such group of activities, and the activities included in such group must include every operation which forms a part of, or a step in, the process of earning income or profit. Such group of activities ordinarily must include the collection of income and the payment of expenses. It does not include the holding for investment purposes of stock, securities, land or other property.
Section 355 of the Code, by requiring that a trade or business be actively conducted, connotes substantial management and operational activities directly carried on by the corporation itself. The activities of others outside the corporation, including independent contractors, may not be considered in determining whether the corporation itself is engaged in the active conduct of a trade or business for purposes of section 355 of the Code. However, the fact that a portion of a corporation's business activities is performed by independent contractors will not preclude the corporation from being engaged in the active conduct of a trade or business if the corporation itself directly performs active and substantial management and operational functions.
Section 856(c)(2), (3) and (4) of the Code prescribes certain limitations on the source of income of a qualified REIT. In order to ensure that it would meet the requirements of section 856(c) of the Code, X conducted its real estate leasing operations in such a manner as to qualify all of its rental income as "rents from real property" within the meaning of section 856(d) of the Code. Also, with respect to its remaining undeveloped land, X, in compliance with the requirements of section 856 of the Code, plans development of such land into rental property, income from which will also qualify as "rents from real property" under section 856(d) of the Code (see Rev. Rul. 67-353, 1967-2 C.B. 252).
Section 856 of the Code does not use the term "active conduct of a trade or business." However, section 856(d)(3) of the Code excludes from the term "rents from real property" amounts received with respect to real property "if the real estate investment trust furnishes or renders services to the tenants of such property, or manages or operates such property, other than through an independent contractor * * *."
The legislative history of section 856 of the Code indicates that the Code provisions regarding real estate investment trusts were intended to accord a type of tax treatment to real estate investment trusts comparable with that provided for certain regulated investment companies, the distributed earnings of which are taxed only to the shareholders. See H.R. Rep. No. 2020, Eighty-sixth Congress, 2d sess. 3, 1960-2 C.B. 819, 820, which states that these provisions were intended to restrict "this 'pass through' of the income for tax purposes to what is clearly passive income from real estate investments, as contrasted to income from the active operation of businesses involving real estate."
In view of the foregoing it is concluded that X's rental activities conducted as a REIT preclude X from directly performing substantial management and operational activities, and, thus, X is not engaged in an active trade or business immediately after the distribution of the Y stock to its beneficiaries within the meaning of section 355(b) of the Code.
Compare Rev. Rul. 73-237, below, which holds that a general construction contractor's direct performance of substantial management and operational activities, apart from those activities performed by subcontractors acting as independent contractors satisfies the active conduct of a trade or business requirements in section 355 of the Code; and Rev. Rul. 73-234, page 180, this Bulletin, which holds that a corporation's direct performance of substantial management and operational farm activities, apart from those activities performed by tenant farmers acting as independent contractors, satisfies the active conduct of a trade or business requirements in section 355 of the Code.
Accordingly, the receipt by the beneficiaries of X of the Y stock is not a distribution to which section 355 of the Code applies and thus the requirements of section 368(a)(1)(D) of the Code are not met. The distribution of the Y stock to the beneficiaries of X is a distribution to which section 301 of the Code applies. No gain or loss is recognized to X on the transfer of property to Y in exchange for the Y stock under section 351(a) and (c) of the Code.