rr-02-49.pdf

Preserve advance releases and the authoritative Internal Revenue Bulletin rendition; directory timestamps are file-publication metadata, not legal effective dates. HTML bulletins begin June 2003; earlier available issues require full PDF parsing.

This collection currently includes the publisher’s available advance-release directory. Historical bulletin renditions are discovered separately; an advance-release record alone does not certify the collection archive complete.

Part I

Section 355.00-00.BDistribution of Stock and Securities of a Controlled Corporation

26 CFR 1.355-3: Active conduct of a trade or business.

Rev. Rul. 2002-49

ISSUE

Under the facts described below, is the 5-year active conduct of a trade or
business requirement of ' 355(b) of the Internal Revenue Code satisfied when, during
the 5-year period prior to a transaction that otherwise meets the requirements of ' 355,
a corporation holding a membership interest in a member-managed limited liability
company purchases the remaining interests in that limited liability company, contributes
a portion of the business to a newly formed controlled subsidiary, and then distributes
the stock of the controlled subsidiary to its shareholders?

FACTS

Situation 1
. As of the first day of Year 1, LLC is a domestic member-managed
limited liability company that has been classified as a partnership for Federal tax
purposes since its date of organization. As of that day, LLC owns several commercial
office buildings that it leases to unrelated third parties. On the first day of Year 1, D, a
corporation, owns a 20 percent profit/loss and capital interest in LLC (the Interest). At
that time, D has no business assets other than the Interest. In addition, at that time, X,
a corporation, owns a 20 percent profit/loss and capital interest in LLC and one or more
persons hold the remaining 60 percent profit/loss and capital interests of LLC.

LLC periodically repaints and refurbishes its existing properties. In addition, LLC
continuously seeks to acquire additional properties to expand its rental business. When

-2-

a property is located, LLC negotiates its purchase and financing and determines
whether renovations or alterations are necessary to make the building suitable for
rental.

Pursuant to the terms of its leases, LLC provides day-to-day upkeep and
maintenance services for its office buildings. These services include trash collection,
ground maintenance, electrical and plumbing repair, and insect control. Additionally,
LLC advertises for new tenants, verifies information contained in lease applications,
negotiates leases, handles tenant complaints, prepares eviction notices and warnings
for delinquent tenants, collects rent, and pays all expenses, including gas, water,
sewage, electricity and insurance for the office buildings. LLC also maintains financial
and accounting records to reflect income and expenses relating to each of its rental
properties as well as LLC=s general expenses.

Throughout the period during which D owns the Interest, D and X jointly manage
LLC and have equal control over the management of LLC. D=s and X's officers perform
active and substantial management functions with respect to LLC=s activities, including
the decision-making regarding significant business decisions of LLC (
e.g.
, decisions
with respect to significant renovations of properties, the purchase and sale of
properties, and significant financings and refinancings). Neither D nor X, however, can
make a significant business decision without the consent of the other. In addition, D=s
and X's officers regularly participate in the overall supervision, direction, and control of
LLC=s employees in their performance of LLC=s operational functions. None of the
members of LLC other than D and X participate in the management or operational
functions of LLC.

On the first day of Year 3, D purchases all of the remaining interests in LLC (the
Remaining Interests) from the other members of LLC. At all times prior to the first day
of Year 3, the other members of LLC are unrelated to D, X, or their respective
shareholders. In connection with D=s purchase of the Remaining Interests, LLC
becomes an entity disregarded as an entity separate from D. After the purchase of the
Remaining Interests, D=s officers continue to conduct the activities and functions with
respect to LLC that they and X=s officers conducted prior to D=s purchase of the
Remaining Interests and LLC=s employees continue to conduct the activities and
functions with respect to LLC that they conducted prior to D=s purchase of the
Remaining Interests.

On the first day of Year 6, for a valid business purpose, when D owns no
business assets other than those that it owns through LLC, D causes LLC to distribute
to D rental properties that constitute 40 percent of the value of LLC=s rental properties.
D then transfers those properties to C, a newly formed, wholly owned subsidiary of D,
and distributes the stock of C pro rata to D=s shareholders in a transaction intended to
meet the requirements of ' 355. After the distribution, D and LLC, together, and C will
conduct the same activities and functions with respect to the portions of the business
that they each own after the distribution that D and LLC conducted as of the beginning

-3-

of Year 1. Assume that, except for the issue of whether the distribution satisfies the
requirements of ' 355(b), D=s distribution of C stock otherwise satisfies all of the
requirements of ' 355.

Situation 2
. The facts are the same as in Situation 1 except that, instead of
owning the Interest on the first day of Year 1, on the first day of Year 2, D acquires the
Interest by contributing appreciated securities to LLC in a transaction described in '
721.

LAW

Section 355(a) provides that, under certain circumstances, a corporation may
distribute stock and securities in a corporation it controls to its shareholders and
security holders in a transaction that is nontaxable to such shareholders and security
holders. Sections 355(a)(1)(C) and 355(b)(1) require that both the distributing and
controlled corporations be engaged, immediately after the distribution, in the active
conduct of a trade or business. Section 355(b)(2)(B) requires that such trade or
business have been actively conducted throughout the 5-year period ending on the date
of the distribution. In addition, under ' 355(b)(2)(C), that trade or business must not
have been acquired in a transaction in which gain or loss was recognized, in whole or in
part, within the 5-year period.

Section 1.355-3(b)(2)(iii) of the Income Tax Regulations provides, in part, that
the determination of whether a trade or business is actively conducted will be made
from all of the facts and circumstances. Generally, the corporation is required itself to
perform active and substantial management and operational functions. Generally,
activities performed by the corporation itself do not include activities performed by
independent contractors. A corporation, however, may satisfy the active conduct of a
trade or business requirement through the activities that it performs itself even though
some of its activities are performed by others. Under ' 1.355-3(b)(2)(iv), however, the
active conduct of a trade or business does not include the ownership and operation
(including leasing) of real or personal property used in a trade or business unless the
owner performs significant services with respect to the operation and management of
the property.

Section 1.355-3(b)(3)(ii) provides that the fact that a trade or business underwent
change during the 5-year period preceding the distribution (for example, by the addition
of new or the dropping of old products, changes in production capacity, and the like)
shall be disregarded, provided that the changes are not of such a character as to
constitute the acquisition of a new or different business.

Section 721(a) provides that no gain or loss shall be recognized to a partnership
or to any of its partners in the case of a contribution of property to the partnership in
exchange for an interest in the partnership.

-4-

Rev. Rul. 92-17, 1992-1 C.B. 142, considers whether D, a corporate general
partner in a limited partnership, is engaged in the active conduct of a trade or business
within the meaning of ' 355(b). For more than 5 years, D owned a 20 percent interest
in LP, a limited partnership that owned several commercial office buildings leased to
unrelated third parties. D's officers performed active and substantial management
functions with respect to LP, including the significant business decision-making of the
partnership, and regularly participated in the overall supervision, direction, and control
of LP=s employees in operating LP=s rental business. Rev. Rul. 92-17 concludes that D
is engaged in the active conduct of trade or business within the meaning of ' 355(b).

Rev. Rul. 99-6, 1999-1 C.B. 432, considers the Federal income tax
consequences of one person=s purchase of ownership interests in a limited liability
company that is classified as a partnership for Federal tax purposes. In Situation 1 of
Rev. Rul. 99-6, A and B are equal partners in AB, a domestic limited liability company.
A sells A's entire interest in AB to B. After the sale, the business is continued by the
limited liability company, which then is owned solely by B. After the sale, no entity
classification election is made under ' 301.7701-3(c) of the Procedure and
Administration Regulations to treat the limited liability company as an association for
Federal tax purposes. Rev. Rul. 99-6 holds, in part, that, when B purchases A's entire
interest in AB, the AB partnership terminates. For purposes of determining the
treatment of B, AB is deemed to make a liquidating distribution of all its assets to A and
B, and, following this distribution, B is treated as acquiring from A the assets deemed to
have been distributed to A in liquidation of A's partnership interest.

ANALYSIS

Situation 1
. In order to satisfy the active conduct of a trade or business
requirement of ' 355(b), each of D and C must be engaged in the active conduct of a
trade or business immediately after the distribution in Year 6. In this case, immediately
after the distribution, each of D and C are engaged in commercial office leasing
activities that constitute the conduct of an active trade or business.
See
' 1.355-
3(b)(2)(iv).

Under ' 355(b)(2)(B) and (C), this trade or business must have been actively
conducted throughout the 5-year period ending on the date of the distribution, and must
not have been acquired within that 5-year period in a transaction in which gain or loss
was recognized in whole or in part. During Years 1 and 2, while D owns the Interest, D
conducts active and substantial management functions with respect to LLC, and
regularly participates in the overall supervision, direction, and control of LLC=s
employees. Accordingly, consistent with Rev. Rul. 92-17, for purposes of ' 355(b),
during that period, D is engaged in the active conduct of the commercial office leasing
business.

The commercial office leasing business actively conducted by D during Years 3,
4, and 5 is the same commercial office leasing business actively conducted by D in

-5-

Years 1 and 2. Therefore, D=s purchase of the Remaining Interests on the first day of
Year 3, which causes the LLC to become disregarded as an entity separate from D,
does not result in the acquisition of a new or different business.
See
' 1.355-3(b)(3)(ii).
Because this transaction does not result in the acquisition of a new or different
business, the requirements of ' 355(b)(2)(B) and (C) are satisfied even though gain or
loss is recognized in the transaction.

Because immediately after the distribution of C stock to D's shareholders each of
D and C will be engaged in the active conduct of a trade or business that is treated as
having been actively conducted throughout the 5-year period ending on the date of the
distribution and that was not acquired during that period in a transaction prohibited by
' 355(b)(2)(C), the distribution satisfies the 5-year active conduct of a trade or business
requirement of ' 355(b).

Situation 2
. As in Situation 1, for purposes of ' 355(b), prior to D's purchase of
the Remaining Interests, while D owns the Interest, conducts active and substantial
management functions with respect to LLC, and regularly participates in the overall
supervision, direction, and control of LLC=s employees, D is engaged in the active
conduct of the commercial office leasing business. In addition, as in Situation 1, D is
not treated as acquiring a new or different trade or business as a result of purchasing
the Remaining Interests on the first day of Year 3.

Unlike in Situation 1, however, D will be treated as having acquired such trade or
business in a transaction in which gain or loss was recognized within the 5-year pre-
distribution period in violation of ' 355(b)(2)(C). Although D=s acquisition of the Interest
on the first day of Year 2 was a transaction in which no gain or loss was recognized
(under ' 721(a)), had D instead directly acquired the trade or business that the Interest
represents in exchange for the property D contributed to LLC, such exchange would
have been a transaction in which gain or loss was recognized. For purposes of '
355(b), therefore, D will be treated as acquiring the trade or business attributable to the
Interest on the first day of Year 2 in a transaction in which gain or loss was recognized.

Because both immediately before and immediately after the distribution D and C
are engaged in a trade or business that is treated as having been acquired in a
transaction in which gain or loss was recognized within the 5-year pre-distribution
period, the distribution violates the prohibition of ' 355(b)(2)(C). Accordingly, the
distribution does not satisfy the 5-year active conduct of a trade or business
requirement of ' 355(b).

EFFECT ON OTHER REVENUE RULING(S)

Rev. Rul. 92-17 is amplified.

DRAFTING INFORMATION

-6-

The principal author of this revenue ruling is Russell P. Subin of the Office of
Associate Chief Counsel (Corporate). For further information regarding this revenue
ruling, contact Mr. Subin at (202) 622-7790 (not a toll-free call).