SECTION 2. BACKGROUND

.01 Section 355(a)(1) provides that, if certain requirements are met, a corporation may distribute stock and securities of a controlled corporation to its shareholders and security holders without recognition of gain or loss by the shareholders or security holders.

.02 Section 355(a)(1)(A) provides that, for a distribution to qualify for nonrecognition treatment, the distributing corporation must distribute stock or securities of a corporation (the controlled corporation) it controls immediately before the distribution. For this purpose, “control” is defined by cross-reference to § 368(c) as ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of each other class of stock of the corporation.

.03 In Rev. Rul. 56–117, 1956–1 C.B. 180, corporation M owned all of the voting common stock and 12 percent of the non-voting preferred stock of corporation N. Disputes arose among the M shareholders, and it was decided that M would distribute its N stock to one group of M shareholders (the departing shareholders) in exchange for all their M stock. To qualify N as a controlled corporation for purposes of § 355(a)(1)(A), N issued shares of voting common stock to the preferred shareholders other than M, in exchange for all their non-voting preferred shares in

a recapitalization within the meaning of § 368(a)(1)(E). After the recapitalization, M owned 93 percent of the outstanding N voting common stock and all of the outstanding N non-voting preferred stock. M then distributed all of its common and preferred N stock to the departing shareholders in exchange for all their M stock. After the distribution, the departing shareholders controlled N, and N’s business was carried on under their management. The ruling holds that, under § 355(a)(1), no gain or loss was recognized to the departing shareholders upon their receipt of N stock.

.04 In Rev. Rul. 63–260, 1963–2 C.B. 147, A owned all the stock of corporation X, which owned 70 shares of the stock of corporation Y. A also owned the remaining 30 shares of Y stock. A contributed 10 shares of his Y stock to X, and, immediately thereafter, X distributed all of its 80 shares of Y stock to A. The ruling holds that the distribution did not qualify under § 355, because X, the distributing corporation, did not have control of Y immediately before the distribution except in a transitory and illusory sense.

.05 In Rev. Rul. 69–407, 1969–2 C.B. 50, corporation X owned 70 percent, and A and B owned the remaining 30 percent, of the single outstanding class of stock of corporation Y. In exchange for the surrender of all the Y stock, Y issued Class A voting stock to A and B and Class B voting stock to X. The Class A stock issued to A and B represented 20 percent, and the Class B stock issued to X represented 80 percent, of the total combined voting power of all classes of Y voting stock. The exchange qualified as a recapitalization under § 368(a)(1)(E). Following the recapitalization, X distributed all of the Class B stock to its shareholders. The ruling holds that, immediately prior to the distribution, X had control of Y, and that, under § 355, no gain or loss was recognized to X’s shareholders on the distribution to them of the Y stock. The transaction was distinguished from the transaction described in Rev. Rul. 63–260, because the recapitalization resulted in a permanent realignment of voting control.

.06 Rev. Rul. 98–27, 1998–1 C.B. 1159, states that the IRS will not apply

Commissioner v. Court Holding Co., 324 U.S. 331 (1945) (or any formulation of the step transaction doctrine) to determine whether the distributed corporation was a controlled corporation immediately before a distribution under § 355(a) solely because of any post-distribution acquisition or restructuring of the distributed corporation, whether prearranged or not. The ruling also states that, otherwise, in applying the step transaction doctrine, all facts and circumstances will be considered (citing Rev. Rul. 63–260, 1963–2 C.B. 147), and an independent shareholder vote is only one relevant factor.

.07 Rev. Rul. 98–27 is based, in part, on § 1012(c) of the Taxpayer Relief Act of 1997, Pub. L. No. 105–34, 111 Stat. 788, 916–17, which added § 355(e) to the Code. Under § 355(e), gain is recognized to the distributing corporation on a distribution of stock or securities of a controlled corporation in connection with a planned acquisition of stock representing a 50-percent or greater interest, by vote or value, in the distributing corporation or the controlled corporation. The Conference Report accompanying the legislation states in part:

The . . . bill does not change the present-law requirement under section 355 that the distributing corporation must distribute 80 percent of the voting power and 80 percent of each other class of stock of the controlled corporation . . . . [T]he 80percent control requirement is expected to be administered in a manner that would prevent the taxfree spin-off of a less-than-80percent controlled subsidiary, but would not generally impose additional restrictions on postdistribution restructurings of the controlled corporation if such restrictions would not apply to the distributing corporation. H.R. Rep. No. 105–220, at 529-30 (1997); 1997–4 C.B. 1457, at 1999–2000.

.08 As illustrated in Rev. Rul. 56–117 and Rev. Rul. 69–407, the control requirement of § 355(a)(1)(A) may be satisfied by an acquisition of control that occurs immediately before a distribution for the purpose of qualifying the distribution under § 355. However, as illustrated

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the stock of C. For purposes of the preceding sentence, ownership is determined by application of the constructive ownership rules of § 318(a) as modified by § 304(c)(3), except that for purposes of applying § 318(a)(3)(A) and (B), the principles of § 304(c)(3)(B)(ii) (without regard to § 304(c)(3)(B)(ii)(I)) apply. In the case of a corporation the stock of which is listed on an established market (within the meaning of § 1.355–7(h)(7)), the persons referred to in the first sentence of this section 4.02(2) are limited to controlling shareholders (within the meaning of § 1.355–7(h)(3)(i), taking into account § 1.355–7(h)(8) but without regard to whether stock of a corporation is transferred) and ten-percent shareholders (within the meaning of § 1.355–7(h)(14) but without regard to the second sentence thereof or whether stock of a corporation is transferred).