Section 355.—Distributions of Stock and Securities of a Controlled Corporation

26 CFR 1.355–2: Limitations.

Section 355; stock distribution. This ruling examines whether a distribution that is expected to increase aggregate stock value satisfies the business purpose requirement of section 355 of the Code when the increased value is expected to serve both a corporate business purpose and a shareholder purpose.

Rev. Rul. 2004–23

ISSUE

Whether a distribution that is expected to cause the aggregate value of the stock of a distributing corporation and the stock of a controlled corporation to exceed the pre-distribution value of the distributing corporation’s stock satisfies the corporate business purpose requirement of § 355 of the Internal Revenue Code and § 1.355–2(b) of the Income Tax Regulations when the increased value is expected to serve a corporate business purpose of either the distributing corporation or the controlled corporation (or both), even if it benefits the shareholders of the distributing corporation.

Employee acquired beneficial ownership of the shares of Employer stock in Year 2 because, at that time, Employee acquired both the right to enjoy any increase in the value of the shares and the risk of a decline in the value of the shares. Accordingly, for purposes of § 83, the shares were transferred to Employee in Year 2. Employee’s Note, with an issue price of $75,000, constituted the amount paid by Employee for the shares under § 1.83–3(g) in Year 2. Employee included $25,000 in gross income under § 83(a) in Year 2, the excess of the fair market value of Employer stock at the time of transfer over the amount paid.

Under § 1.83–4(c), if an indebtedness that has been treated as an “amount paid” for purposes of § 83 is subsequently cancelled, forgiven, or satisfied for an amount less than the amount of such indebtedness, the amount that is not, in fact, paid is includible in the gross income of the service provider for the taxable year in which such cancellation, forgiveness, or satisfaction occurs. Thus, if the reduction of the stated principal amount of the Note is a cancellation, forgiveness, or satisfaction of the indebtedness for an amount less than the amount of such indebtedness, the reduction of the stated principal amount is a medium for payment of compensation by Employer to Employee, and any income resulting from the reduction is not income to Employee from the discharge of indebtedness subject to the provisions of section 108. Accordingly, the tax consequences of the reduction are governed by § 83 and § 1.83–4(c), and not by § 108(a)(1)(B) or § 108(e)(5).

Whether the reduction of the stated principal amount of the Note is a cancellation, forgiveness, or satisfaction for an amount less than the amount of the Note, and, thus, whether an amount is includible in income under § 1.83–4(c), is determined in accordance with § 1.1001–3. Under § 1.1001–3(e)(2), if a modification to the stated principal amount of a note produces a significant change in the note’s yield, the modification is significant. A significant modification results in an exchange of the unmodified note for the modified note, which, depending on the issue price of the modified note and the adjusted issue price of the unmodified note, may have tax consequences for both the issuer and holder of the note.

In this case, the reduction in the stated principal amount of the Note is a significant modification under § 1.1001–3(e)(2). As a result, there is an exchange of the unmodified Note for the modified Note between Employee and Employer and a satisfaction of the original indebtedness. Under § 1.83–4(c), the amount that is not, in fact, paid, and thus the amount includible as compensation by Employee, is the excess of the adjusted issue price of the unmodified Note over the issue price of the modified Note.

The modified Note has adequate stated interest under § 483. Under § 1273(b)(4), the modified Note has an issue price of $50,000. The adjusted issue price of the unmodified Note is $75,000. See § 1.1275–1(b). As a result, under § 1.83–4(c), Employee recognizes compensation income of $25,000 (the excess of the adjusted issue price of the unmodified Note ($75,000) over the issue price of the modified Note ($50,000)). This amount is recognized in Year 4, the taxable year in which the modification occurred.

HOLDING

If an employee issued a recourse note to his or her employer in satisfaction of the exercise price of an option to acquire the employer’s stock and the employer and employee subsequently agree to reduce the stated principal amount of the note, the employee generally recognizes compensation income under § 83 at the time of the reduction. Thus, under the facts described above, Employee recognizes $25,000 of compensation income on January 1 of Year 4 under § 1.83–4(c). If Employer and Employee instead were, for example, to reduce the interest rate on the Note or change the Note from recourse to nonrecourse, that modification also generally would result in compensation income for Employee.

In addition, the compensation is wages for purposes of FICA, FUTA, and income tax withholding.

DRAFTING INFORMATION

The principal authors of this revenue ruling are Jean M. Casey of the Office of the Division Counsel/Associate Chief Counsel (Tax Exempt and Government Entities) and Rebecca Asta of the Associate Chief Counsel (Financial Institutions

2004-11 I.R.B. 585 March 15, 2004

ing corporation, the controlled corporation, or the affiliated group (as defined in § 1.355–3(b)(4)(iv)) to which the distributing corporation belongs. Section 1.355–2(b)(2). The principal reason for the business purpose requirement is to provide nonrecognition treatment only to distributions that are incident to readjustments of corporate structures required by business exigencies and that effect only readjustments of continuing interests in property under modified corporate forms. Section 1.355–2(b)(1). If a corporate business purpose can be achieved through a nontaxable transaction that does not involve the distribution of stock of a controlled corporation and that is neither impractical nor unduly expensive, then the separation is not carried out for that corporate business purpose. Section 1.355–2(b)(3). A shareholder purpose (for example, the personal planning purposes of a shareholder) is not a corporate business purpose. Section 1.355–2(b)(2). Depending upon the facts of a particular case, however, a shareholder purpose for a transaction may be so nearly coextensive with a corporate business purpose as to preclude any distinction between them. Id . In such a case, the transaction is carried out for one or more corporate business purposes. Id . A transaction motivated in substantial part by a corporate business purpose does not fail the business purpose requirement merely because it is motivated in part by non-Federal tax shareholder purposes. See § 1.355–2(b)(5), Example (2).

ANALYSIS

Situation 1 . Because D believes that the increased value of its stock expected to result from the separation will enhance the value of its employee compensation, providing a real and substantial benefit to D, the distribution is motivated by a real and substantial non-Federal tax purpose germane to the business of D. Section 1.355–2(b)(1) and (2). Further, because this purpose cannot be achieved through another nontaxable transaction that is neither impractical nor unduly expensive, the distribution is carried out for a corporate business purpose. Section 1.355–2(b)(2) and (3). Although the increase in stock value is expected to benefit the shareholders by increasing the amount they would

FACTS

D is a corporation that indirectly conducts Business 1 and Business 2 through its subsidiaries. Some subsidiaries engage only in Business 1 and others only in Business 2. D’s common stock is widely held and publicly traded.

The two businesses attract different investors, some of which are averse to investing in D because of the presence of the other business. Therefore, D believes, and D’s investment banker has advised D, that if each business were conducted in a separate and independent corporation, the stock of the two corporations likely would trade publicly for a higher price, in the aggregate, than the stock of D if it continued to represent an interest in both businesses. The expected increase in the aggregate trading price of the stock of D and C over the pre-distribution trading price of D would not, however, derive in any significant respect from any Federal tax advantage made available to either D or C by the transaction.

With the intent and expectation of increasing the aggregate trading price of the common stock representing Business 1 and Business 2, D transfers the subsidiaries that engage in Business 2 to a newly formed corporation, C, in exchange for all of the C stock and distributes the C stock to its common shareholders, pro rata . D’s remaining subsidiaries will continue to conduct Business 1.

Increasing the aggregate trading price of the D and C common stock over the trading price of the pre-distribution D common stock is expected to confer a benefit to existing shareholders. In deciding whether to undertake the distribution, D’s directors consider this expected benefit to the shareholders, as well as the expected benefits to the corporation described below. However, D’s directors do not effect the distribution to facilitate any particular shareholder’s disposition of the stock of either D or C.

Apart from the issue of whether the business purpose requirement of § 1.355–2(b) is satisfied, the distribution meets the requirements of §§ 368(a)(1)(D) and 355.

Situation 1 . D uses equity-based incentives as a significant part of its program to compensate a significant number of employees of both Business 1 and Busi

ness 2. D’s directors wish to enhance the value of employee compensation and have considered either granting additional equity-based incentives or making cash payments in lieu of additional equity incentives. However, granting additional equity-based incentives would unacceptably dilute D’s existing shareholders’ interests, and making cash payments would be unduly expensive. Therefore, D undertakes the separation of Business 2 from Business 1 with the expectation that its stock value will increase and such increase will enhance the value of its equity-based compensation, providing D with a real and substantial benefit.

Situation 2 . As part of its overall strategic planning, D has expanded both Business 1 and Business 2 through acquisitions of assets and the stock of other corporations. In some of these acquisitions, D has used its stock, either in whole or in part, as consideration. D’s directors expect to continue expanding Business 1 as appropriate acquisition opportunities are identified in the future. D expects to offer its common stock as consideration, either in whole or in part, in connection with future acquisitions. Therefore D undertakes the separation of Business 2 from Business 1 with the expectation that its stock value will increase and such increase may permit D to effect such acquisitions in a manner that preserves capital with significantly less dilution of the existing shareholders’ interests, providing D with a real and substantial benefit.

LAW

Section 355 provides that if certain requirements are met, a corporation may distribute stock and securities in a controlled corporation to its shareholders and security holders without causing the distributees to recognize gain or loss.

In addition to the statutory requirements, the regulations provide that § 355 will apply to a transaction only if it is carried out for one or more corporate business purposes. Section 1.355–2(b)(1). A transaction is carried out for a corporate business purpose if it is motivated, in whole or substantial part, by one or more corporate business purposes. Id . A corporate business purpose is a real and substantial non-Federal tax purpose germane to the business of the distribut

March 15, 2004 586 2004-11 I.R.B.