SECTION 2. SPECIFIC — Internal Revenue Bulletin 1996-19

.01 Key Employee.

(1) General . To establish that a Corporate Business Purpose for the distribution is to provide an equity interest in a business of Distributing or Controlled to a current or prospective employee, or employees, ordinarily, the taxpayer must demonstrate to the satisfaction of the Service that:

(a) The transfer of Distributing or Controlled stock to this employee, or these employees, will accomplish a real and substantial purpose germane to the business of Distributing, Controlled or the affiliated group (as defined in § 1.355– 3(b)(4)(iv)) to which Distributing belongs. Among other things, the taxpayer must explain why the individual, or each individual, is considered a key employee, and why it is necessary to give the individual, or each individual, an equity interest of the type and amount proposed in the transaction.

(b) Generally within one year of the distribution, the employee, or the employees as a group, will receive a significant amount, in terms of percentage and value, of voting stock of either Distributing or Controlled. (An acquisition of a significant percentage of stock may not be required, however, if it would be prohibitively expensive for the employee,

or employees, to acquire a significant percentage of stock.) The taxpayer must state when the employee, or employees, will acquire the stock and fully describe the terms and method of acquisition (for example, purchase, compensation, or exercise of an option).

(c) The objective to be accomplished by transferring stock to the employee, or employees, cannot be accomplished by an alternative nontaxable transaction that does not involve the distribution of Controlled stock and which is neither impractical nor unduly expensive. (For example, the Service generally will consider that it is unduly expensive to create a controlled corporation that would terminate an existing S corporation election. In such cases, however, the taxpayer must demonstrate why another nontaxable transaction, such as the transfer of assets to a partnership or limited liability company, is neither impractical nor unduly expensive.) Where the taxpayer contends that a transaction involving a distribution will provide the employee, or employees, voting power representing a meaningful voice in the governance of their employer’s business that is not available through an alternative transaction, the Service will consider such cases on a case-by-case basis, taking into account factors such as the distribution of voting power among the shareholders, family relationships, and competing economic interests.

(2) Options and restricted stock . The Service will scrutinize closely situations in which stock issued to the employee, or employees is subject to an option or restriction.

(3) Stock ownership plans . The principles of section 2.01(1) and (2) of this Appendix A also apply if a business purpose is to transfer Distributing or Controlled stock to an employee stock ownership plan described in § 4975(e)(7) (an ‘‘ESOP’’), treating the ESOP as a group of key employees. Other plans relating to employee stock ownership will be considered on a case-by-case basis.

.02 Stock offering. To establish that a Corporate Business Purpose for the distribution is to facilitate a stock offering, ordinarily, the taxpayer must demonstrate to the satisfaction of the Service that:

(1) The issuing corporation needs to raise a substantial amount of capital in the near future to fund operations, capital expenditures, acquisitions, the retirement of indebtedness, or other business needs.

(2) The stock offering will raise significantly more funds per share (net of transaction costs of the distribution), or is otherwise more advantageous, if Distributing and Controlled are separated in connection with the offering. The taxpayer ordinarily must submit substantiation in the form of an analysis based on the professional judgment of persons qualified to speak to such matters. The analysis should be supported by data involving comparable corporations, businesses, and stock offerings and should compare the expected results of an offering, taking into account the proposed distribution, with the expected results of an offering by Distributing or Controlled without the distribution. Generally, the Service will acknowledge (without extensive substantiation) that an offering of publicly traded stock by a widely held corporation with no significant shareholders will raise more funds per share than an offering by the same corporation in the position of a controlled subsidiary.

(3) The funds raised in the stock offering will, under all circumstances, be used for the business needs of Distributing, Controlled, or the affiliated group (as defined in § 1.355–3(b)(4)(iv)) to which Distributing belongs. The taxpayer should explain when and how the funds will be used in satisfying such business needs.

(4) The stock offering will be completed within one year of the distribution. (5) If the stock of a corporation with one or more significant shareholders will be purchased by a limited number of investors who require the distribution as a condition of their participation, the Service may require appropriate substantiation from these investors. .03 Borrowing. To establish that a Corporate Business Purpose for the distribution is to facilitate borrowing, ordinarily, the taxpayer must demonstrate to the satisfaction of the Service that:

(1) Distributing or Controlled needs to raise a substantial amount of capital in the near future to fund operations, capital expenditures, acquisitions, or other business needs.

(2) The separation will enable Distributing or Controlled to borrow significantly more money or borrow on significantly better nonfinancial terms. The taxpayer ordinarily must submit substantiation, such as an analysis based on the professional judgment of persons qualified to speak to such matters.

(3) The funds raised in the borrowing will, under all circumstances, be used for the business needs of Distributing, Controlled, or the affiliated group (as defined in § 1.355–3(b)(4)(iv)) to which Distributing belongs. The taxpayer should explain when and how the funds will be used in satisfying such business needs.

(4) The borrowing will be completed within one year after the distribution. If the distribution will enable Distributing or Controlled to borrow money at a lower cost, see section 2.04 of this Appendix A, relating to cost savings.

.04 Cost savings. To establish that a Corporate Business Purpose for the distribution is cost savings, ordinarily, the taxpayer must demonstrate to the satisfaction of the Service that the distribution will produce significant cost savings. Ordinarily, the taxpayer’s submission should include analysis based on the professional judgment of persons qualified to speak to this matter (such as the taxpayer’s insurer for insurance savings, an investment banker for lower borrowing costs, or, in appropriate cases, the taxpayer’s employees). The analysis must explain the savings and why the savings cannot be achieved through a nontaxable transaction that does not involve the distribution of stock of Controlled and which is neither impractical nor unduly expensive.

Significant cost savings generally are projection period cost savings equal to at least one percent of the base period net income of Distributing’s affiliated group. Projection period cost savings are the total anticipated future cost savings to

Distributing, Controlled, and their affiliated group for the 3-year period following the distribution, reduced by the transaction costs of the distribution and any anticipated additional direct or indirect costs to Distributing, Controlled and their affiliated group, all of which are computed on an after-tax basis. For this purpose, all savings (whether or not from the same source) and all additional costs to Distributing, Controlled, and their affiliated group are aggregated. Base period net income is the total net consolidated financial income of Distributing’s affiliated group for the 3-year period preceding the distribution, all of which is computed on an after-tax basis, using generally accepted accounting principles. The taxpayer may choose to use the 5-year periods preceding and following the distribution for the base period and projection period instead of 3-year periods. Members of an affiliated group are determined in accordance with § 1.355-3(b)(4)(iv). In the case of foreign tax savings, explain the extent to which the foreign tax that is expected to be saved would have resulted in foreign tax credits or foreign tax credit carryovers for federal tax purposes.

The Service may apply different guidelines in various situations, including the following:

(1) Projection period cost savings will not equal one percent of base period net income. (2) Net income for one or more of the 3 (or 5) years preceding the distribution is nominal or is affected by extraordinary or nonrecurring items of gain, loss, income or deduction, or there is a loss for any year.

(3) Controlled stock will be distributed to a member of Distributing’s affiliated group. (4) There are cost savings from the reduction of both federal and nonfederal taxes. In certain situations, a purpose of reducing nonfederal taxes is not a Corporate Business Purpose. See § 1.355–2(b)(2). .05 Fit and Focus.

(1) General . This section 2.05 of Appendix A provides guidelines for a ruling request in which a Corporate Business Purpose for the distribution is that the separation will enhance the success of the businesses by enabling the corporations to resolve management, systemic, or other problems that arise (or are exacerbated) by the taxpayer’s operation of different businesses within a single corporation or affiliated group. Except as provided in section 2.05(2) of this Appendix A, the Service ordinarily will rule with respect to pro rata as well as non pro rata distributions.

(2) Significant shareholder or nonpublicly traded . If Distributing is not publicly traded (or is publicly traded, but has a significant shareholder), the Service ordinarily will not rule unless the distribution:

(a) is a non pro rata distribution to enable a significant shareholder or shareholder group to concentrate on a particular business ( see example (2) of § 1.355–2(b)(5)), or

(b) effects an internal restructuring within an affiliated group (members of an affiliated group are determined in accordance with § 1.355–3(b)(4)(iv)). (3) Significant shareholder defined . A significant shareholder is any person who is directly or indirectly, or together with related persons, the owner of 5 percent or more of any class of stock of Distributing or Controlled and who actively participates in the management or operation of Distributing or Controlled. If the taxpayer contends that a person meeting or exceeding this 5 percent threshold does not actively participate in management or operations, the taxpayer should submit details supporting the taxpayer’s contention.

(4) Substantiation . Documentary substantiation satisfactory to the Service is essential. The documentation should describe in detail the problems associated with the current corporate structure and demonstrate why the distribution will lessen or eliminate these problems. Internal reports and studies, and analyses based upon the professional judgment of persons qualified to speak to such matters (such as investment bankers or management consultants), are examples of documentation that may provide adequate substantiation. Reports by securities analysts or similar materials may also be helpful. However, in the case of a non pro rata distribution made to enable a significant shareholder or shareholder group to concentrate on a particular business, the Service ordinarily will not require third party documentation or detailed studies.

(5) Special scrutiny . In evaluating the ruling request, the Service will scrutinize closely the following situations:

(a) Continuing relationship . Any continuing relationship between Distributing and Controlled to determine if such relationship is consistent with the stated business purpose. Examples of continuing relationships include common directors, officers, or key employees, the provision of goods or services to the other company, or commonly-owned property.

(b) Cross ownership . Except for cases involving an internal restructuring of an affiliated group, any direct or indirect continuing interest in both Distributing and Controlled by a significant shareholder or, in the case of a nonpublicly traded corporation, any other shareholder. For example, if the purpose of the distribution is to allow a significant shareholder to concentrate on a particular business, the Service ordinarily will require, as a condition of ruling, that the separating shareholders not maintain interests (including interests as employees or directors) in both Distributing and Controlled after the distribution. Exceptions will be made on a case-by-case basis, taking into account the extent and nature of the interest in each corporation.

(c) Certain internal restructurings . Any internal restructuring in which the distributee is not entitled to eliminate, exclude, or receive a 100 percent dividends-received deduction with respect to, a distribution from Distributing, such as a transaction involving a foreign corporation. .06 Competition.

(1) General. To establish that a Corporate Business Purpose for the distribution is to resolve the taxpayer’s problems with customers or suppliers who object to Distributing or Controlled being associated with a business that competes with the customer or supplier, ordinarily, the taxpayer must demonstrate to the satisfaction of the Service that:

(a) One or more customers or suppliers have significantly reduced (or will significantly reduce) their purchases from, or sales to (or, for potential customers or suppliers, have not made any purchases from, or sales to), Distributing or Controlled because of the competing business.

(b) Because of the distribution, these customers or suppliers will significantly increase (or not implement a planned significant reduction in) their purchases from, or sales to, Distributing or Controlled after the distribution.

(c) These customers or suppliers do not object to the Distributing shareholders’ ownership of stock of Controlled after the distribution.

(d) Sales to these customers, or purchases from these suppliers, will represent a meaningful amount of sales or purchases by Distributing or Controlled after the distribution. (2) Substantiation . The taxpayer must submit substantiating evidence. In most cases, corroboration from customers or suppliers will be required.

.07 Facilitating an acquisition of Distributing. To establish that a Corporate Business Purpose for the distribution is to tailor Distributing’s assets to facilitate a subsequent tax-free acquisition of Distributing by another corporation (the ‘‘ acquiring corporation ’’), ordinarily, the taxpayer must demonstrate to the satisfaction of the Service that:

(1) The acquisition will not be completed unless Distributing and Controlled are separated. (2) The acquisition cannot be accomplished by an alternative nontaxable transaction that does not involve the distribution of Controlled stock and is neither impractical nor unduly expensive.

(3) The acquiring corporation is not related to Distributing or Controlled. If the taxpayer contends that the Service should rule favorably, notwithstanding the fact that the acquiring corporation is related to Distributing or Controlled, explain the relationship and why the Service should disregard the relationship.

(4) The acquisition will be completed, and, except in unusual circumstances, will be completed within one year of the distribution. .08 Facilitating an acquisition by Distributing or Controlled. To establish that a Corporate Business Purpose for the distribution is to tailor Distributing’s assets or Controlled’s corporate structure to facilitate a subsequent tax-free acquisition of another corporation (the ‘‘ target corporation ’’) by Distributing or Controlled, ordinarily, the taxpayer must demonstrate to the satisfaction of the Service that:

(1) The combination of the target corporation with Distributing or Controlled will not be undertaken unless Distributing and Controlled are separated.

(2) The acquisition cannot be accomplished by an alternative nontaxable transaction that does not involve the distribution of Controlled stock and is neither impractical nor unduly expensive.

(3) The target corporation is not related to Distributing or Controlled. If the taxpayer contends that the Service should rule favorably, notwithstanding the fact that the target corporation is related to Distributing or Controlled, explain the relationship and why the Service should disregard the relationship.

(4) The acquisition will be completed, and, except in unusual circumstances, will be completed within one year of the distribution. .09 Risk Reduction. If a Corporate Business Purpose for the distribution is to significantly enhance the protection of one or more businesses (the ‘‘ other businesses ’’) from the risks of another business (the ‘‘ risky business ’’), the factors the Service will consider, and the taxpayer should address, include:

(1) The nature and magnitude of the risks faced by the risky business. The taxpayer must submit information regarding the claims history of the risky business, or of the typical risk experience of similar businesses in that industry.

(2) Whether the assets and insurance associated with the risky business are sufficient to meet reasonably expected claims arising from the conduct of the risky business. The taxpayer must submit the book value and approximate fair market value of the net assets, including intangibles, of the risky business. Describe any other factors, such as liabilities that are not included on the taxpayer’s balance sheet, that affect the value of the net assets of the risky business. The taxpayer must submit information as to the taxpayer’s current insurance coverage and discuss the availability and cost of additional insurance. Facts regarding the cost and availability of insurance generally will require third party substantiation. If affordable insurance is available, but a separation of the businesses would reduce the cost, see section 2.04 of this Appendix A, relating to cost savings.

(3) Whether, under applicable law, the distribution will significantly enhance the protection of the other businesses from the risks of the risky business and, whether, under applicable law, an alternative nontaxable transaction that does not involve the distribution of Controlled stock and which is neither impractical nor unduly expensive (for example, creating a parent/subsidiary or holding company structure) would provide similar protection. See example (3) of § 1.355–2(b)(5). The taxpayer’s submission should include an analysis of the law and the application of the law to the relevant facts of the proposed transaction. An opinion of counsel may be required. It is not necessary for the taxpayer to establish conclusively that, under applicable law, the proposed transaction will afford adequate protection or that an alternative transaction would not afford adequate protection. However, the taxpayer must convince the Service that, based on objective analysis of the law and its application to the facts, risk reduction is a real and substantial purpose for the transaction.

APPENDIX B