[Federal Register Volume 72, Number 88 (Tuesday, May 8, 2007)]
[Proposed Rules]
[Pages 26012-26037]
From the Federal Register Online via the Government Publishing Office [www.gpo.gov]
[FR Doc No: 07-2269]


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DEPARTMENT OF THE TREASURY

Internal Revenue Service

26 CFR Part 1

[REG-123365-03]
RIN 1545-BC94


Guidance Regarding the Active Trade or Business Requirement Under 
Section 355(b)

AGENCY: Internal Revenue Service (IRS), Treasury.

ACTION: Notice of proposed rulemaking.

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SUMMARY: This document contains proposed regulations that provide 
guidance regarding the active trade or business requirement under 
section 355(b) of the Internal Revenue Code. These proposed regulations 
provide guidance on issues involving the active trade or business 
requirement under section 355(b), including guidance resulting from the 
enactment of section 355(b)(3). These proposed regulations will affect 
corporations and their shareholders.

DATES: Written or electronic comments and requests for a public hearing 
must be received by August 6, 2007.

ADDRESSES: Send submissions to: CC:PA:LPD:PR (REG-123365-03), room 
5203, Internal Revenue Service, PO Box 7604, Ben Franklin Station, 
Washington, DC 20044. Submissions may be hand-delivered Monday through 
Friday between the hours of 8 a.m. and 4 p.m. to CC:PA:LPD:PR (REG-
123365-03), Courier's Desk, Internal Revenue Service, 1111 Constitution 
Avenue, NW., Washington, DC, or sent electronically via the Federal 
eRulemaking Portal at www.regulations.gov (IRS REG-123365-03).

FOR FURTHER INFORMATION CONTACT: Concerning the proposed regulations, 
Russell P. Subin, (202) 622-7790; concerning submissions and the 
hearing, Kelly Banks, (202) 622-7180 (not toll-free numbers).

SUPPLEMENTARY INFORMATION:

Background and Explanation of Provisions

A. Background and Overview of the Key Aspects of the Proposed 
Regulations

1. Background
    Section 355(a) of the Internal Revenue Code (Code) provides that, 
under certain circumstances, a corporation may distribute stock and 
securities of a corporation it controls to its shareholders and 
security holders without causing either the corporation or its 
shareholders and security holders to recognize income, gain or loss. 
Sections 355(a)(1)(C) and 355(b)(1) generally require that the 
distributing corporation (distributing) and controlled corporation 
(controlled) each be engaged, immediately after the distribution, in 
the active conduct of a trade or business. Section 355(b)(2)(A) 
provides that a corporation shall be treated as engaged in the active 
conduct of a trade or business if and only if it is engaged in the 
active conduct of a trade or business, or substantially all of its 
assets consist of stock and securities of a corporation controlled by 
it (immediately after the distribution) which is so engaged. For this 
purpose, control is defined under section 368(c). All references to 
control in this preamble are references to control as defined in 
section 368(c).
    Section 202 of the Tax Increase Prevention and Reconciliation Act 
of 2005, Public Law 109-222 (120 Stat. 345, 348) (TIPRA) amended 
section 355(b) by adding section 355(b)(3). Section 355(b)(3)(A), as 
amended by Division A, Section 410 of the Tax Relief and Health Care 
Act of 2006, Public Law 109-432 (120 Stat. 2922, 2963), provides that 
in the case of any distribution made after May 17, 2006, a corporation 
shall be treated as meeting the requirement of section 355(b)(2)(A) if 
and only if such corporation is engaged in the active conduct of a 
trade or business. Section 355(b)(3)(B) provides that for purposes of 
section 355(b)(3)(A) (and, consequently, section 355(b)(2)(A)), all 
members of such corporation's separate affiliated group (SAG) shall be 
treated as one corporation (SAG rule). For purposes of the preceding 
sentence, a corporation's SAG is the affiliated group which would be 
determined under section 1504(a) if such corporation were the common 
parent and section 1504(b) did not apply.
    Thus, the separate affiliated group of distributing (DSAG) is the 
affiliated group that consists of distributing as the common parent and 
all corporations affiliated with distributing through stock ownership 
described in section 1504(a)(1)(B) (regardless of whether the 
corporations are includible corporations under section 1504(b)). The 
separate affiliated group of controlled (CSAG) is determined in a 
similar manner (with controlled as the common parent). Accordingly, 
unlike prior law, a corporation is not treated as engaged in the active 
conduct of a trade or business solely as a result of substantially all 
of its assets consisting of stock, or stock and securities, of one or 
more

[[Page 26013]]

corporations that are merely controlled by it (immediately after the 
distribution) each of which is engaged in the active conduct of a trade 
or business.
    Section 355(b)(2)(B) requires that the trade or business have been 
actively conducted throughout the five-year period ending on the date 
of the distribution (pre-distribution period). Section 355(b)(2)(C) 
provides that the 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 pre-distribution period. Section 355(b)(2)(D), as amended in 
1987 and 1988, provides that control of a corporation which (at the 
time of acquisition of control) was conducting the trade or business 
must not have been directly or indirectly acquired by any distributee 
corporation or by distributing during the pre-distribution period in a 
transaction in which gain or loss was recognized, in whole or in part. 
See Public Law 100-203 (101 Stat. 1330, 1330-411 (1987)) and Public Law 
100-647 (102 Stat. 3342, 3605 (1988)). For purposes of section 
355(b)(2)(D), all distributee corporations which are members of the 
same affiliated group (as defined in section 1504(a) without regard to 
section 1504(b)) shall be treated as one distributee corporation. The 
requirements under section 355(b) are collectively referred to in this 
preamble as either the active trade or business requirement or the 
requirements of section 355(b).
    Accordingly, the requirements of section 355(b) are generally 
satisfied if distributing and controlled each have engaged in the 
active conduct of a trade or business throughout the pre-distribution 
period, are so engaged immediately after the distribution, and there 
have been no acquisitions of control of distributing or controlled 
during such period.
    The active trade or business requirement is one of several 
requirements that must be satisfied in order for a distribution to 
qualify under section 355. For example, section 355(a)(1)(B) states 
that a transaction must not be used principally as a device for 
distributing the earnings and profits of distributing, controlled, or 
both. In addition, Sec.  1.355-2(b)(1) provides that section 355 will 
apply to a transaction only if it is carried out for one or more 
corporate business purposes.
    The active trade or business requirement, in tandem with the device 
prohibition and business purpose requirement, limits a corporation's 
ability to convert dividend income into capital gain through the use of 
a section 355 distribution. See S. Rep. No. 83-1622, at 50-51 (1954) 
and Coady v. Commissioner, 33 TC 771, 777 (1960), acq., 1965-2 CB 4, 
aff'd, 289 F.2d 490 (6th Cir. 1961). In Coady, the Tax Court stated 
that one purpose of section 355(b) is ``to prevent the tax-free 
separation of active and inactive assets into active and inactive 
corporate entities.'' The court also stated that a tax-free separation 
under section 355 ``will involve the separation only of those assets 
attributable to the carrying on of an active trade or business * * *.'' 
Coady, 33 TC at 777.
    The IRS and Treasury Department are aware of a number of issues 
that have arisen regarding the active trade or business requirement, 
including issues arising as a result of the enactment of section 
355(b)(3). The following sections describe the active trade or business 
requirement and the significant issues that are addressed in these 
proposed regulations. No inference should be drawn from these proposed 
regulations regarding the definition of trade or business or active 
trade or business under any other provision of the Code or Treasury 
regulations, even if such provision specifically references section 
355. Comments are requested as to whether or the extent to which these 
proposed regulations should apply to other provisions that specifically 
reference section 355.
2. Overview of the Key Aspects of the Proposed Regulations
    Principally, these proposed regulations provide guidance regarding 
the application of section 355(b)(3), the application of the 
acquisition rules in section 355(b)(2)(C) and (D) and the impact 
thereon of section 355(b)(3), and the determination of whether a 
corporation is engaged in a trade or business through the attribution 
of trade or business assets and activities from a partnership.
    As discussed in section A.1. of this preamble, section 355(b)(3) 
treats all SAG members as one corporation. Accordingly, as discussed in 
detail in section B. of this preamble, these proposed regulations 
provide that subsidiary SAG members (SAG members that are not the 
common parent of such SAG) are treated like divisions of distributing 
or controlled, as the case may be. These proposed regulations also 
clarify that controlled may be a DSAG member during the pre-
distribution period. Most significantly, these provisions treat a stock 
acquisition that results in a corporation becoming a subsidiary SAG 
member as an asset acquisition. As a result, the applicability of 
section 355(b)(2)(D) is substantially reduced. Further, as discussed in 
section E. of this preamble, this treatment alters the analysis 
regarding whether an existing business may be expanded as a result of a 
stock acquisition.
    Notwithstanding that these proposed regulations provide that 
certain stock acquisitions may be treated as asset acquisitions under 
section 355(b)(3), purchases of stock of controlled during the pre-
distribution period may be subject to section 355(a)(3)(B). See section 
F. of this preamble.
    As discussed in detail in section C. and section D. of this 
preamble, these proposed regulations interpret section 355(b)(2)(C) and 
(D) to mean that a corporation generally cannot use its assets to 
acquire a trade or business to be relied on to facilitate a 
distribution under section 355. Accordingly, these proposed regulations 
generally prohibit acquisitions made in exchange for distributing's 
assets even if no gain or loss is recognized in connection with the 
acquisition. Further, these proposed regulations provide certain 
exceptions to the literal application of section 355(b)(2)(C) and (D) 
for acquisitions in which gain or loss is recognized where the purposes 
of that section are not violated. However, these proposed regulations 
do not disregard the recognition of gain or loss in transactions 
between affiliates unless the affiliates are members of the same SAG. 
See section G. of this preamble.
    Section I. of this preamble explains how these proposed regulations 
clarify a corporation's ability to be attributed the trade or business 
assets and activities of a partnership. Most significantly, these 
partnership provisions yield results similar to the rules regarding the 
satisfaction of the continuity of business enterprise requirement, and 
thus allow a partner to be attributed the partnership's trade or 
business assets and activities where the partner owns a significant 
interest in the partnership.

B. TIPRA

    Congress enacted section 355(b)(3) because it was concerned that, 
prior to a distribution under section 355, corporate groups conducting 
business in separate corporate entities often had to undergo elaborate 
restructurings to place active businesses in the proper entities to 
satisfy the active trade or business requirement. See, for example, 
H.R. Rep. No. 109-304, at 53, 54 (2005). By treating a SAG as one 
corporation, Congress believed that it would greatly reduce the need 
for such restructurings. However, the introduction of the affiliation-
based SAG rule into the active trade or business requirement

[[Page 26014]]

significantly impacts the application of section 355(b)(2) in certain 
situations.
    Accordingly, consistent with congressional intent, these proposed 
regulations provide several rules interpreting section 355(b)(3) in a 
manner that diminishes the need for pre-distribution restructurings 
while fully integrating the various provisions in section 355(b). These 
rules are intended to more closely reflect the way corporate groups 
structure their businesses while, at the same time, ensuring that the 
purposes underlying section 355(b)(2)(C) and (D) are not circumvented.
    Specifically, to accomplish these objectives the IRS and Treasury 
Department believe that it is appropriate to apply the SAG rule by 
disregarding the separate existence of all subsidiary SAG members for 
purposes of determining whether distributing and controlled satisfy the 
requirements of section 355(b).
1. SAG Rule Applicable During the Pre-Distribution Period
    The IRS and Treasury Department believe that it is appropriate to 
apply the SAG rule for purposes of determining whether the trade or 
business was actively conducted throughout the pre-distribution period 
and whether the requirements of section 355(b)(2)(C) or (D) have been 
violated.
    The SAG rule applies for purposes of determining whether 
distributing and controlled are engaged in the active conduct of a 
trade or business immediately after the distribution. Specifically, the 
legislative history to section 355(b)(3) describes the corporations 
included in the DSAG and CSAG by reference to post-distribution 
affiliation. See H.R. Rep. No. 109-455, at 88 (2006) (Conf. Rep.); H.R. 
Rep. No. 109-304, at 54 (2005). However, there is nothing in the 
statute or legislative history that precludes the SAG rule from 
applying throughout the pre-distribution period.
    The IRS and Treasury Department believe that applying the SAG rule 
throughout the pre-distribution period is consistent with the single-
entity approach. If the SAG rule is not applied during the pre-
distribution period, there may be unintended consequences. For example, 
assume that an active trade or business is segmented among the SAG 
members in a manner that precludes any one member from individually 
being treated as engaged in an active trade or business. Under the SAG 
rule the segments are aggregated and may be treated as a single active 
trade or business immediately after the distribution. However, if the 
SAG rule is not applied throughout the pre-distribution period, there 
would be no five-year active trade or business because no one member 
would be engaged in that trade or business. The IRS and Treasury 
Department do not believe there is any policy reason to apply the SAG 
rule in such a disparate manner. Accordingly, these proposed 
regulations apply the SAG rule throughout the pre-distribution period. 
This approach is consistent with Congressional intent to view SAGs as 
an aggregate for purposes of the active trade or business requirement.
    Because the SAG rule treats all SAG members as one corporation, the 
separate existence of subsidiary SAG members are disregarded and all 
assets (and activities) owned (and performed) by SAG members are 
treated as owned (and performed) by distributing or controlled, as the 
case may be, for purposes of determining whether distributing or 
controlled is engaged in a five-year active trade or businesses. 
Therefore, where one DSAG or CSAG member satisfies the active trade or 
business requirement, distributing or controlled, as the case may be, 
satisfies the active trade or business requirement.
    Consistent with the foregoing, these proposed regulations provide 
that the SAG rule also applies for purposes of determining whether 
there has been an impermissible acquisition, as discussed in section C. 
of this preamble, of a trade or business during the pre-distribution 
period under section 355(b)(2)(C) or (D). Because the SAG rule 
disregards the separate existence of subsidiary SAG members, these 
proposed regulations generally treat stock acquisitions that result in 
a corporation becoming a subsidiary SAG member as a direct acquisition 
of any assets (or activities) owned (or performed) by the acquired 
corporation. Further, these proposed regulations generally disregard 
transfers of assets (or activities) that are owned (or performed) by 
the SAG immediately before and immediately after the transfer. Such 
transfers cannot result in an acquisition. Under the SAG rule, such 
transfers have the effect of a transfer between divisions of a single 
corporation.
2. The DSAG May Include CSAG Members Throughout the Pre-Distribution 
Period
    The IRS and Treasury Department believe that it is appropriate to 
include the CSAG members in the DSAG during the pre-distribution period 
if the applicable affiliation requirements are satisfied. The IRS and 
Treasury Department believe this approach is consistent with the 
purposes of section 355(b)(3) and the SAG rule's general single-entity 
approach, and provides flexibility for the division of SAG members 
between distributing and controlled.
    For example, assume that during the pre-distribution period, 
segments or portions of the business to be conducted by controlled are 
held by distributing (or other subsidiaries that are not directly or 
indirectly owned by controlled) and that distributing intends to 
transfer those portions of the business to controlled immediately prior 
to the distribution. If the DSAG does not include the CSAG members 
throughout the pre-distribution period, it is possible that neither SAG 
would be engaged in the active conduct of that trade or business 
throughout the pre-distribution period, because neither SAG would have 
all the appropriate segments of that business to satisfy the active 
trade or business requirement. The IRS and Treasury Department believe 
that such a result is inconsistent with the purposes of section 
355(b)(3). Accordingly, by including the CSAG members in the DSAG 
throughout the pre-distribution period if the ownership requirements 
are satisfied, these proposed regulations give appropriate credit to 
five-year active trades or businesses regardless of how the assets and 
activities may be owned (and performed) by the SAG members throughout 
the pre-distribution period.
3. Acquisitions of Stock in Subsidiary SAG Members
    Section 355(b)(3) treats SAG members as one corporation for 
purposes of satisfying the requirements of section 355(b). As a result, 
the SAG rule alters the application of section 355(b)(2)(C) and (D) 
with respect to the acquisition of stock of a corporation that is or 
becomes a subsidiary SAG member. Further, because section 355(b)(3) 
supplanted the holding company rule in section 355(b)(2)(A), section 
355(b)(2)(D) is now only applicable to certain acquisitions of stock of 
distributing and certain acquisitions of stock of controlled.
    The SAG rule alters the application of section 355(b)(2)(C) and (D) 
with respect to the acquisition of stock of a corporation that is or 
becomes a subsidiary SAG member. Section 355(b)(3) treats SAG members 
as one corporation for purposes of satisfying section 355(b). 
Consequently, a transaction that results in a corporation--including 
controlled--becoming a subsidiary SAG member is treated as a direct 
acquisition of all the assets (and activities) owned (and performed) by 
the acquired corporation

[[Page 26015]]

at the time of the acquisition. Thus, such an acquisition is tested 
under section 355(b)(2)(C) rather than section 355(b)(2)(D). 
Nevertheless, as discussed in sections B.4 and C.3.a.ii. of this 
preamble, section 355(b)(2)(D) has continuing limited application.
    In addition, an acquisition that results in a corporation becoming 
a subsidiary SAG member in a transaction in which gain or loss is 
recognized might satisfy the requirements of section 355(b)(2)(C) as an 
expansion of one of the acquiring SAG's existing businesses, as 
discussed in section E. of this preamble. Finally, because the SAG rule 
treats subsidiary SAG members like divisions, the acquisition of 
additional stock of a current subsidiary SAG member has no effect for 
purposes of applying section 355(b)(2)(C).
4. Acquisitions of Control of Controlled Where It Is Not a DSAG Member
    While section 355(b)(2)(D) is not applicable to acquisitions of 
stock of subsidiary SAG members, the requirements of section 
355(b)(2)(D) must be satisfied where the DSAG acquires control of 
controlled where controlled is not and does not become a DSAG member 
prior to the distribution. This rule applies where distributing 
acquires stock constituting control of controlled but not stock meeting 
the requirements of section 1504(a)(2).

C. Acquisitions of a Trade or Business

    Section 355(b)(2)(C) and (D) generally provide that a trade or 
business acquired, directly or indirectly, during the pre-distribution 
period will not satisfy the active trade or business requirement unless 
it was acquired in a transaction in which no gain or loss was 
recognized. The IRS and Treasury Department believe that these 
provisions have been and should continue to be interpreted and applied 
in a manner consistent with the overall purposes of section 355. For 
example, in certain situations, transactions in which gain or loss is 
recognized have been found not to violate the purposes of section 
355(b)(2)(C) and (D). See, for example, C.I.R. v. Gordon, 382 F.2d 499 
(2d Cir.1967), rev'd on other grounds, 391 U.S. 83 (1968) (discussed in 
section C.2. of this preamble). Additionally, while the enactment of 
section 355(b)(3) substantially revised how distributing and controlled 
may satisfy the active trade or business requirement, TIPRA did not 
contain conforming amendments to section 355(b)(2)(C) and (D). As such, 
the IRS and Treasury Department also believe that a purpose-based 
interpretation of section 355(b)(2) is essential to harmonize these 
provisions. Accordingly, these proposed regulations interpret and apply 
section 355(b)(2)(C) and (D), and section 355(b)(3), in a manner 
consistent with their purpose, even if not always consistent with the 
literal language of the statute.
1. Purpose of Section 355(b)(2)(C) and (D)
    Section 355 ``contemplates that a tax-free separation shall involve 
only the separation of assets attributable to the carrying on of an 
active business.'' S. Rep. No. 83-1622, at 50 (1954). The active trade 
or business requirement is intended to ensure that only these types of 
separations qualify under section 355. Further, it operates as an 
additional safeguard to the device prohibition (a prohibition against 
disguised dividends) in section 355(a)(1)(B).
    As discussed in section A. of this preamble, the active trade or 
business requirement is designed to limit the potential for the 
conversion of dividend income into capital gain through a section 355 
distribution. Specifically, section 355(b)(2)(C) and (D) is intended to 
prevent dividend avoidance otherwise available through the purchase of 
a new business in order to facilitate a tax-free distribution under 
section 355. See Gordon, 382 F.2d at 506-507 (stating that ``[t]o 
safeguard against this possibility, subsections (b)(2)(C) and (D) 
prohibit acquisition of a trade or business, or of a corporation, in a 
transaction in which gain or loss was recognized.''). Thus, the statute 
prohibits acquisitions of a trade or business in which gain or loss is 
recognized. Nevertheless, the recognition of gain or loss, in and of 
itself, does not violate the purposes of section 355. Rather, 
recognition of gain or loss is generally indicative of the type of 
consideration used in the transaction. Typically, a transaction in 
which gain or loss is recognized consists of an acquisition in exchange 
for assets. On the other hand, a transaction in which no gain or loss 
is recognized typically consists of an acquisition in exchange for the 
corporation's equity.
    Accordingly, the IRS and Treasury Department believe that the 
common purpose of section 355(b)(2)(C) and (D) is to prevent 
distributing from using assets--instead of its stock or stock of a 
corporation in control of distributing--to acquire a new trade or 
business in anticipation of distributing that trade or business (or 
facilitating the distribution of another trade or business) to its 
shareholders in a tax-free distribution. A distribution of a 
corporation holding assets that would have been used to effect a 
purchase generally would be treated as a dividend and section 355 was 
not intended to allow a tax-free separation of such assets. Acquiring a 
new trade or business using these assets and distributing it (or an 
existing trade or business) would effectively accomplish such a 
separation, and should not qualify under section 355.
    Complementing the principle that the common purpose of section 
355(b)(2)(C) and (D) is to prevent distributing from using it assets--
instead of its stock, or stock of a corporation in control of 
distributing--to acquire a new trade or business is the notion that 
section 355 is intended to apply to separations of active trades or 
businesses with which the participants have a historic relationship. 
Section 355, like the reorganization provisions, involves the 
maintenance by the shareholders of a continuing interest in their 
business or businesses in modified corporate forms. For section 355 to 
apply to a divisive transaction, it is essential that distributing and 
its shareholders have a historic relationship with the active trades or 
businesses in the two resulting corporations. See, for example, Sec.  
1.355-1(b) (``[section 355] applies only to the separation of existing 
businesses that have been in active operation for at least five years * 
* * and which, in general, have been owned, directly or indirectly, for 
at least five years by the distributing corporation''). These 
requirements ensure that the historic owners of the acquired trade or 
business are participants in the divisive transaction and minimize the 
potential for transactions that violate the common purpose of section 
355(b)(2)(C) and (D).
    Where distributing issues its own equity (or uses the equity of a 
corporation in control of distributing) to acquire an active trade or 
business in a transaction in which no gain or loss is recognized, 
distributing is not acquiring the trade or business in exchange for its 
assets and the historic owners of the trade or business will be 
participants in the divisive transaction. In such cases, the common 
purpose of section 355(b)(2)(C) and (D) is carried out.
    Finally, an additional purpose of section 355(b)(2)(D) is to 
prevent a distributee corporation from acquiring control of 
distributing in anticipation of a distribution to which section 355 
would otherwise apply, enabling the disposition of controlled without 
the proper recognition of corporate level gain. See H.R. Rep. No. 100-
391, at 1080, 1082-1083 (1987).

[[Page 26016]]

2. Current Law and the Sec.  1.355-3(b)(4) Regulations
    Under current law, several authorities depart from the literal 
language of section 355(b)(2)(C) and (D) in order to carry out the 
common purpose underlying section 355(b)(2)(C) and (D). For example, in 
Gordon, gain was recognized when distributing transferred a trade or 
business to controlled. The Second Circuit concluded that, even though 
gain was recognized, section 355(b)(2)(C) was not violated because new 
assets were not brought within the combined corporate shells of 
distributing and controlled. Therefore, the common purpose of section 
355(b)(2)(C) and (D) was not violated. Furthermore, Rev. Rul. 69-461 
(1969-2 CB 52) held that a first-tier subsidiary's taxable distribution 
of stock of a second-tier subsidiary to its parent did not violate 
section 355(b)(2)(D). The ruling stated that section 355(b)(2)(D) is 
intended to prevent the acquisition of control of a corporation from a 
party not within the direct or indirect control of distributing. In 
addition, Rev. Rul. 78-442 (1978-2 CB 143) held that gain under section 
357(c) on the transfer from distributing to controlled does not violate 
section 355(b)(2)(C). Rev. Rul. 78-442 stated that section 355(b)(2)(C) 
is intended to prevent the acquisition of a trade or business by 
distributing or controlled from an outside party in a taxable 
transaction within five years of a distribution.
    Similarly, Sec.  1.355-3(b)(4) (generally applicable to 
distributions on or before December 15, 1987, but applied in various 
situations by the IRS administratively to distributions occurring after 
that date) provides an exception from the literal language of section 
355(b)(2)(C) and (D) for the direct or indirect acquisition of a trade 
or business by one member of an affiliated group from another member of 
the group, stating that an acquisition from another member of the 
affiliated group ``is not the type of transaction to which section 
355(b)(2)(C) and (D) is intended to apply.'' See Sec.  1.355-
3(b)(4)(iii).
    Section 1.355-3(b)(4) also departs from the literal language of 
section 355(b) in providing that a trade or business acquired, directly 
or indirectly, within the pre-distribution period in a transaction in 
which the basis of the assets acquired was not determined in whole or 
in part by reference to the transferor's basis does not qualify under 
section 355(b)(2), even though no gain or loss was recognized by the 
transferor. See Sec.  1.355-3(b)(4)(i). The reason for this departure 
is that in some circumstances a transaction in which no gain or loss is 
recognized may nevertheless constitute a prohibited acquisition of a 
trade or business in exchange for assets.
3. The Proposed Regulations
    Consistent with current law (and Sec.  1.355-3(b)(4)), these 
proposed regulations generally prohibit acquisitions in which gain or 
loss was recognized but apply section 355(b)(2)(C) and (D) in a manner 
consistent with their purposes. Accordingly, these proposed regulations 
provide for certain exceptions for acquisitions in which gain or loss 
is recognized, and prohibit certain transactions in which no gain or 
loss is recognized.
a. Certain Transactions in Which Recognized Gain or Loss Is Disregarded
    Under these proposed regulations, certain acquisitions are excepted 
from the general rule under section 355(b)(2)(C) and (D) that a trade 
or business, or control of a corporation engaged in a trade or 
business, cannot satisfy the active trade or business requirement if it 
was acquired during the pre-distribution period in a transaction in 
which gain or loss was recognized. These transactions are so excepted 
because they do not violate the purposes of section 355(b)(2)(C) and 
(D).
i. Certain Acquisitions by the DSAG or CSAG
    These proposed regulations provide a number of exceptions to the 
application of section 355(b)(2)(C) and (D) not contained in the 
current regulations (or Sec.  1.355-3(b)(4)). One of these exceptions 
disregards any gain or loss recognized in connection with an 
acquisition by the CSAG from the DSAG of a trade or business, an 
interest in a partnership engaged in a trade or business, or stock of a 
corporation engaged in a trade or business. This exception is 
appropriate because it is not a use of distributing's assets to acquire 
the trade or business
    Another exception disregards gain or loss recognized in an 
acquisition solely as a result of the payment of cash to shareholders 
for fractional shares where the cash paid represents a mere rounding 
off of the fractional shares in the exchange and is not separately 
bargained for consideration. The IRS and Treasury Department believe 
that this is not the type of transaction to which section 355(b)(2)(C) 
or (D) is intended to apply. Although such a transaction involves a 
small use of assets, these proposed regulations except such 
acquisitions because the small amount of assets are not separately 
bargained for and are used merely to simplify the exchange. Other 
authorities reach similar conclusions in the context of 
reorganizations. See Rev. Rul. 66-365 (1966-2 CB 116), amplified by 
Rev. Rul. 81-81 (1981-1 CB 122) (concluding that cash in lieu of 
fractional shares does not violate the solely for voting stock 
requirement of section 368(a)(1)(B) and (C) because it was merely a 
mathematical rounding off for simplicity, and the transaction ``was for 
all practical purposes ``solely in exchange for voting stock''').
    In addition, as discussed in section G. of this preamble, these 
proposed regulations provide a limited exception for taxable 
acquisitions from affiliates that are members of the same SAG. 
Specifically, acquisitions between SAG members (where the assets (or 
activities) are owned (or performed) by the SAG immediately before and 
immediately after the transfer) are disregarded whether they are 
taxable or not.
    Like the current regulations, these proposed regulations provide 
that acquisitions that expand a pre-existing business are generally 
exempted from the nonrecognition requirement. See Sec.  1.355-
3(b)(3)(ii). While these transactions may involve the use of the DSAG's 
or CSAG's assets, they are not acquisitions of a new or different trade 
or business. Because the DSAG or CSAG, as the case may be, is already 
in the business, such transactions are not considered acquisitions of a 
trade or business under section 355(b)(2)(C) and (D).
ii. Certain Acquisitions by a Distributee Corporation
    Consistent with the principles of Rev. Rul. 74-5 (1974-1 CB 82), 
obsoleted by Rev. Rul. 89-37 (1989-1 CB 107), these proposed 
regulations disregard the recognition of gain or loss in applying 
section 355(b)(2)(D) to certain acquisitions of the stock of 
distributing by a distributee corporation. Prior to the 1987 and 1988 
amendments noted in section A.1 of this preamble, section 355(b)(2)(D) 
was not violated in a case where distributing distributed the stock of 
controlled even though a purchaser acquired distributing's stock during 
the pre-distribution period in a transaction in which gain or loss was 
recognized. See Rev. Rul. 74-5 (reasoning that the purpose of section 
355(b)(2)(D) was to prevent distributing, rather than the shareholder 
of distributing, from accumulating excess funds to purchase the stock 
of a corporation engaged in an active trade or business). However, Rev. 
Rul. 74-5 held that the purchaser could not then further distribute the 
stock of controlled until five years after such

[[Page 26017]]

purchase, reasoning that the purchaser, the distributing corporation in 
the second distribution, indirectly acquired the stock of controlled 
through another corporation, the distributing corporation in the first 
distribution.
    The 1987 and 1988 amendments to section 355(b)(2)(D) prohibited 
such transactions because of a concern that such acquisitions were 
similar to transactions that permitted a corporation to dispose of an 
appreciated subsidiary without the proper recognition of gain contrary 
to the repeal of the General Utilities doctrine. For example, assume P, 
a corporation, acquired the stock of D in a transaction in which gain 
or loss was recognized and D immediately distributed the stock of C to 
P in a section 355 transaction. P would allocate its basis in the newly 
acquired D stock between the D stock and the C stock received in the 
distribution. P could then potentially sell the C stock without the 
appropriate recognition of gain. See H.R. Rep. No. 100-391, at 1080, 
1082-1083 (1987).
    However, there are transactions that violate the literal 
requirements of section 355(b)(2)(D) but do not violate the purpose of 
the 1987 and 1988 amendments. For example, assume that for more than 
five years, T, a corporation, owned all of the stock of D, which in 
turn owned all the stock of C. Throughout this period, D and C have 
each engaged in the active conduct of a trade or business. In year 6, P 
acquires the stock of T in a transaction in which gain or loss is 
recognized, and holds the T stock with a cost basis determined under 
section 1012. In year 7, P liquidates T in a transaction to which 
section 332 applies and in which no gain or loss is recognized, thereby 
eliminating its cost basis in the T stock. Thereafter, P holds the D 
stock with a basis equal to T's basis in the D stock. In year 8, D 
distributes the C stock to P. Under these facts, P cannot dispose of 
the D or C stock without recognizing the same amount of gain or loss 
that T would have recognized.
    Similarly, assume the same facts as the previous example, except 
that in year 6 P acquires all of T's assets, including the D stock, in 
exchange for P stock and cash in a reorganization described in section 
368(a)(1)(A). Because all of the cash is distributed to the T 
shareholders, T does not recognize any gain, and P's basis in the D 
stock is equal to T's basis in the D stock. See section 362(b). In year 
7, D distributes the C stock to P. Under these facts, P cannot dispose 
of the D or C stock without recognizing the same amount of gain or loss 
that T would have recognized.
    The IRS and Treasury Department believe that the distributee 
corporation language in section 355(b)(2)(D)(i) is intended only to 
prevent transactions that are contrary to the repeal of the General 
Utilities doctrine. In both of the examples just described, neither the 
D stock nor C stock can be disposed of in a manner that is contrary to 
the repeal of the General Utilities doctrine. Accordingly, these 
proposed regulations provide that section 355(b)(2)(D) is not violated 
where there is a direct or indirect acquisition by a distributee 
corporation of control of distributing in one or more transactions in 
which gain or loss is recognized where the basis of the acquired 
distributing stock in the hands of the distributee corporation is 
determined in whole by reference to the transferor's basis. However, 
consistent with the principles of Rev. Rul. 74-5, this rule is only 
applicable with respect to a distribution by the acquired distributing, 
and does not apply for purposes of any subsequent distribution by any 
distributee corporation.
b. Certain Nonrecognition Transactions Treated as Recognition 
Transactions
    Because the IRS and Treasury Department believe that acquisitions 
made in exchange for assets violate the common purpose of section 
355(b)(2)(C) and (D) even if no gain or loss is recognized, these 
proposed regulations provide that such transactions are treated as 
transactions in which gain or loss is recognized.
i. Acquisitions in Exchange for Assets
    As discussed in section C.1 of this preamble, the common purpose 
underlying section 355(b)(2)(C) and (D) is that distributing generally 
should not be able to use its assets to acquire a new trade or business 
in anticipation of distributing that trade or business (or facilitating 
the distribution of another trade or business) to its shareholders in a 
tax-free transaction. Similarly, and also discussed in section C.1. of 
this preamble, section 355(b), by permitting the use of distributing 
stock to acquire a trade or business, ensures a historic relationship 
between the distributing shareholders and the trades or businesses 
relied upon to satisfy the active trade or business requirement.
    The following examples illustrate distributing's use of its assets 
to acquire a new trade or business.
    First, assume that D, a corporation that does not directly conduct 
a five-year active trade or business, owns all of the stock of C, a 
corporation with a five-year active trade or business. D wishes to 
spin-off C to its shareholders, but to do so D must satisfy the active 
trade or business requirement. Accordingly, D contributes assets to an 
unrelated partnership that is engaged in a five-year active trade or 
business in a transaction to which section 721 applies in exchange for 
an interest in the partnership that otherwise satisfies the 
requirements for D to be attributed the trade or business assets and 
activities of the partnership, as discussed in section I. of this 
preamble. Two years after the transfer, when D's only active trade or 
business is the business conducted by the partnership, D distributes 
the C stock pro rata to the D shareholders.
    Alternatively, assume that D, a corporation with a five-year active 
trade or business, transfers assets to unrelated T, a corporation with 
a five-year active trade or business, in a transaction to which section 
351 applies in exchange for an amount of T stock constituting control. 
Two years after the transfer, when T's only active trade or business is 
the business T conducted before D's transfer, D distributes the T stock 
pro rata to the D shareholders.
    Similarly, assume that D, a corporation with a five-year active 
trade or business, owns all of the stock of C, a corporation that does 
not have a five-year active trade or business but has other assets. To 
cause C to satisfy the active trade or business requirement, D arranges 
for C to acquire a five-year active trade or business from T, an 
unrelated corporation, in a reorganization described in section 
368(a)(1)(A). In the reorganization, the shareholders of T receive 
solely common stock of C representing 20 percent or less of the voting 
power of all classes of C stock. Two years after the reorganization, D 
distributes the C stock pro rata to the D shareholders.
    In each of these examples, D has directly or indirectly acquired a 
trade or business in exchange for assets. See and compare Situation 2 
of Rev. Rul. 2002-49 (2002-2 CB 288) (corporation's use of appreciated 
securities to acquire a trade or business of a partnership in a 
transaction to which section 721 applies is treated as an acquisition 
in which gain or loss was recognized); section 4.01(29) of Rev. Proc. 
2007-3 (2007-1 IRB 108) (the IRS will not ordinarily rule where 
distributing acquires control of controlled by transferring inactive 
assets in a transaction meeting the requirements of section 351(a) or 
section 368(a)(1)(D) and in which no gain or loss is recognized). While 
these transactions satisfy the literal requirements of section 
355(b)(2)(C) or (D), the underlying common purpose of those provisions 
has been violated. In each case, distributing has acquired in exchange 
for distributing's assets, either

[[Page 26018]]

directly or indirectly through the issuance of controlled stock the 
trade or business to be relied on by distributing or controlled.
    Furthermore, in each of these examples, the historic owners have 
supplied a trade or business for distributing or controlled, but they 
are not participants in the divisive transaction. Not being 
shareholders of D, the position of the historic owners of the acquired 
business is not altered by the distribution of the controlled stock. 
Accordingly, neither distributing nor the distributing shareholders 
have a historic relationship with the separated businesses, and the 
distribution of the controlled stock is not the type of transaction to 
which section 355 was intended to apply.
    By contrast, had D issued its own stock in the reorganization in 
the last example, the substance of the transaction would be different. 
D would not have indirectly acquired a trade or business in exchange 
for assets but rather for its own equity. Because D would not be 
purchasing a business for its shareholders, the distribution is not a 
substitute for a taxable distribution of the consideration that would 
have been used in the purchase. Furthermore, where D stock is used as 
the consideration the former T shareholders would have joined D's 
shareholder base, and become participants in the divisive 
reorganization.
    These proposed regulations prohibit the acquisition of a trade or 
business directly or indirectly in exchange for assets in order to 
ensure that the common purpose of section 355(b)(2)(C) and (D) are 
satisfied. Such an acquisition also would include a swap of an interest 
in an existing five-year active trade or business for an interest in a 
new active trade or business. This type of an acquisition could occur 
through the formation of a joint venture structure.
    For example, assume D and X form a partnership joint venture in 
which D contributes a five-year active trade or business (ATBD) and X 
contributes a different five-year active trade or business (ATBX). D 
and X each receive a 50-percent interest in the partnership. D's 
interest is sufficient to satisfy the requirements for D to be 
attributed the partnership's trade or business assets and activities 
(as discussed in section I. of this preamble). Prior to a potential 
section 355 distribution by D, and within five years of the 
contribution, the partnership sells ATBD.
    D cannot rely on ATBX until five years after the acquisition of its 
interest in the partnership because, in effect, at the time of the 
contributions D exchanged a 50-percent undivided interest in ATBD for a 
50-percent undivided interest in ATBX. Therefore, D acquired its 
interest in ATBX in exchange for its assets. While this was a 
transaction in which no gain or loss was recognized, the exchange of 
assets violates the common purpose of section 355(b)(2)(C) and (D). 
Further, the historic owner of ATBX would not participate in any 
distribution of controlled stock by D. Accordingly, such a distribution 
would not be the type of transaction to which section 355 was intended 
to apply.
    Similarly, a corporation can effectively swap its assets through 
the issuance of stock of a subsidiary (including controlled). 
Accordingly, these proposed regulations provide a specific rule to 
address tax-free acquisitions involving the issuance of subsidiary 
stock. These proposed regulations provide that if a SAG directly or 
indirectly owns stock of a subsidiary (including a subsidiary SAG 
member) and the subsidiary directly or indirectly acquires a trade or 
business, an interest in a partnership engaged in a trade or business, 
or stock of a corporation engaged in a trade or business from a person 
other than such SAG in exchange for stock of such subsidiary in a 
transaction in which no gain or loss is recognized (the acquisition), 
solely for purposes of applying section 355(b)(2)(C) or (D) with 
respect to the trade or business, partnership interest, or stock 
acquired by the subsidiary in the acquisition, the subsidiary's stock 
directly or indirectly owned by the SAG immediately after the 
acquisition is treated as acquired at the time of the acquisition in a 
transaction in which gain or loss is recognized.
    This rule reflects the fact that although the acquiring subsidiary 
did not make the acquisition in exchange for its assets (it issued its 
own stock), the SAG that owns stock of the subsidiary has exchanged an 
indirect interest in the subsidiary's assets for an indirect interest 
in the trade or business acquired by the subsidiary in the acquisition. 
Thus, the SAG has indirectly acquired a portion of the subsidiary's 
newly acquired trade or business (equal to the shareholder's stock 
interest in the subsidiary immediately after the acquisition) in 
exchange for assets. Further, the IRS and Treasury Department believe 
that it would be inappropriate to allow such acquired trade or business 
to be relied on to satisfy the active trade or business requirement 
within five years of its acquisition because the historic owners of 
that trade or business would not participate in any distribution of 
controlled stock.
    However, because such a transaction does not result in an 
acquisition of any pre-existing trade or business of the subsidiary, 
this rule merely treats the SAG's stock in the subsidiary immediately 
after the acquisition as acquired in a gain or loss transaction for 
purposes of applying section 355(b)(2)(C) or (D) to the newly acquired 
trade or business. Further, the impact of such a transaction on the 
ability to rely on the newly acquired trade or business to satisfy the 
requirements of section 355(b) depends upon how much subsidiary stock 
the SAG owns immediately after the transaction.
    For example, assume D owns all of the sole class of stock of S, a 
corporation that does not conduct a five-year active trade or business. 
T, an unrelated corporation with a five-year active trade or business 
(ATBT), merges into S in a reorganization described in section 
368(a)(1)(A) and (D) solely in exchange for 80 percent of the S stock, 
and no gain or loss is recognized. Immediately after the merger, D owns 
only 20 percent of the sole class of S stock. Solely for purposes of 
determining whether ATBT can be relied on to satisfy the active trade 
or business requirement, D is treated as having acquired its 20 percent 
of the S stock at the time of the merger of T into S in a transaction 
in which gain or loss was recognized. Accordingly, as described in 
section D.2.a. of this preamble regarding certain multi-step 
acquisitions of a subsidiary SAG member, if D subsequently acquired the 
80 percent of the S stock held by the other shareholders solely in 
exchange for D voting stock in a reorganization described in section 
368(a)(1)(B) in which no gain or loss was recognized, S would become a 
DSAG member and D could rely on ATBT to satisfy the active trade or 
business requirement.
    Accordingly, in light of all of these concerns, these proposed 
regulations generally provide that acquisitions paid for in whole or in 
part, directly or indirectly, with assets of the DSAG will be treated 
as acquisitions in which gain or loss is recognized. However, if a DSAG 
member or controlled acquires the trade or business solely in exchange 
for distributing stock, distributing acquires control of controlled 
solely in exchange for distributing stock, or controlled acquires the 
trade or business from distributing solely in exchange for stock of 
controlled, in a transaction in which no gain or loss is recognized, 
the requirements of section 355(b)(2)(C) and (D) are satisfied. Such 
acquisitions are

[[Page 26019]]

not made in exchange for assets of the DSAG.
    An additional question arising under section 355(b)(2)(C) and (D) 
is whether the assumption of liabilities is treated as a payment of 
money or other property, and hence the use of assets. See United States 
v. Hendler, 303 U.S. 564, reh'g denied, 304 U.S. 588 (1938) (viewing an 
assumption of a liability by a transferee as in substance a payment to 
the transferor). Congress has indicated that the assumption of 
liabilities is not to be treated as the payment of money or other 
property in certain transactions in which no gain or loss is 
recognized. For example, the assumption of liabilities is not treated 
as the payment of money or other property in certain exchanges to which 
section 351 or 361 applies. See section 357(a). Further, the assumption 
of liabilities does not violate the solely for voting stock requirement 
in a reorganization described in section 368(a)(1)(C) where the 
acquiring corporation does not otherwise exchange money or other 
property. See section 368(a)(1)(C) and (a)(2)(B). Because Congress has 
granted this special treatment for liability assumptions in certain 
nonrecognition transactions, the IRS and Treasury Department believe 
that similar treatment is generally appropriate for purposes of section 
355(b)(2)(C) and (D). Accordingly, these proposed regulations provide 
that the assumption by the DSAG or CSAG of liabilities of a transferor 
shall not, in and of itself, be treated as the payment of assets if 
such assumption is not treated as the payment of money or other 
property under any other applicable provision.
    Finally, these proposed regulations clarify that an acquisition to 
which section 304(a)(1) applies does not satisfy the requirements of 
section 355(b)(2)(C) or (D). The IRS and Treasury Department believe 
that a stock acquisition to which section 304 applies is a transaction 
in which gain or loss is recognized for purposes of section 
355(b)(2)(C) and (D) even if it merely results in the transferor's 
receipt of dividend income. These proposed regulations clarify that, 
regardless of the tax consequences to the transferor, such a 
transaction is an acquisition made in exchange for assets, and 
therefore does not satisfy the requirements of section 355(b)(2)(C) and 
(D).
ii. Partnership Distributions
    These proposed regulations provide that an acquisition consisting 
of a distribution from a partnership is generally treated as a 
transaction in which gain or loss is recognized because it constitutes 
an acquisition in exchange for assets. That is, the distributee partner 
is generally exchanging an indirect interest in all the assets of the 
partnership for a direct interest in the property distributed. However, 
these proposed regulations provide that if the corporation is already 
attributed the trade or business assets and activities of a 
partnership, the corporation's acquisition of such trade or business 
assets and activities from the partnership is not, in and of itself, 
the acquisition of a new trade or business. Further, these proposed 
regulations provide that an acquisition consisting of a pro rata 
distribution from a partnership of stock or an interest in a lower-tier 
partnership is not an acquisition in exchange for assets to the extent 
the distributee partner did not acquire the interest in the 
distributing partnership during the pre-distribution period in a 
transaction in which gain or loss was recognized and to the extent the 
distributing partnership did not acquire the distributed stock or 
partnership interest within such period. In such a case, the 
distributee partner has merely exchanged an indirect interest for a 
direct interest in the distributed stock or partnership interest, and 
continues to possess the same indirect interest in the remaining assets 
of the partnership.
iii. Lack of Transferred Basis
    Section 1.355-3(b)(4)(i) provides that a trade or business 
acquired, directly or indirectly, within the pre-distribution period in 
a transaction in which the basis of the assets acquired was not 
determined in whole or in part by reference to the transferor's basis 
does not qualify under section 355(b)(2), even though no gain or loss 
was recognized by the transferor. These proposed regulations do not 
include a similar provision. The IRS and Treasury Department believe 
that the prohibition against acquisitions in exchange for assets fully 
addresses such acquisitions.
c. Application of Section 355(b)(2)(C) and (D) to Predecessors
    Unlike Sec.  1.355-3(b)(4)(i), which only took ``a predecessor in 
interest'' into account for purposes of applying section 355(b)(2)(D), 
these proposed regulations provide that any reference to a corporation 
includes a reference to a predecessor of such corporation in applying 
both section 355(b)(2)(C) and (D). The IRS and Treasury Department 
believe that predecessors should be taken into account in applying both 
section 355(b)(2)(C) and (D) because the same policy concerns exist 
regardless of whether the transaction involves the acquisition of 
assets or stock. For this purpose, the proposed regulations define a 
predecessor of a corporation as a corporation that transfers its assets 
to such corporation in a transaction to which section 381 applies. The 
IRS and Treasury Department believe that it is appropriate to take 
predecessors into account in applying these provisions in order to 
appropriately minimize the significance of which corporation is the 
acquiror and which corporation is the target.
    Further, because the SAG rule effectively treats SAG members as a 
singly-entity for purposes of section 355(b), these proposed 
regulations also apply section 355(b)(2)(C) and (D) to acquisitions 
during the pre-distribution period by corporations that later become 
DSAG or CSAG members. These types of acquisitions are similar to 
predecessor asset acquisitions.
4. Requests for Comments Regarding Exceptions to Section 355(b)(2)(C) 
and (D)
    The IRS and Treasury Department request comments regarding whether 
any additional exceptions to section 355(b)(2)(C) and (D) are 
appropriate. In particular, the IRS and Treasury Department request 
comments regarding whether acquisitions in which gain is recognized 
solely as a result of the application of section 367 should be treated 
as violating section 355(b)(2)(C) or (D). The IRS and Treasury 
Department also request comments regarding whether an exception should 
exist for taxable acquisitions made by distributing solely in exchange 
for distributing stock because such acquisitions are not made in 
exchange for distributing's assets and do not appear to violate the 
common purpose of section 355(b)(2)(C) and (D).
    In addition, the IRS and Treasury Department request comments 
regarding whether a redemption of stock should be a transaction to 
which section 355(b)(2)(C) or (D) applies. Under current law, no relief 
is provided for such transactions. See McLaulin v. Commissioner, 276 
F.3d 1269 (11th Cir. 2001) (concluding that section 355(b)(2)(D) 
applies when distributing acquires control of a subsidiary through a 
redemption of subsidiary stock). Compare Rev. Rul. 57-144 (1957-1 CB 
123). Specifically, comments are requested on whether all types of 
redemptions should be subject to the same rule, whether the treatment 
of redemptions should be determined by the source of payment, whether 
the redemption constitutes an indirect exchange for assets of 
distributing or controlled, and the method of making these 
determinations. Alternatively, the

[[Page 26020]]

IRS and Treasury Department request comments on whether an exception 
should be provided for redemptions of shareholders that exercise 
dissenters' rights. Compare Rev. Rul. 68-285 (1968-1 CB 147) 
(concluding that cash paid to dissenting target corporation 
shareholders by the target corporation does not violate the solely for 
voting stock requirement of section 368(a)(1)(B)) with Rev. Rul. 73-102 
(1973-1 CB 186) (concluding that cash paid to dissenting target 
corporation shareholders by the acquiring corporation is treated as 
money or other property paid by the acquiring corporation for the 
properties of the target corporation in a reorganization under section 
368(a)(1)(C)). These proposed regulations do not include an exception 
for redemptions generally or for those in connection with the exercise 
of dissenters' rights.
    Finally, the IRS and Treasury Department request comments regarding 
whether a transaction in which a distributee corporation acquires in a 
transaction in which no gain or loss is recognized newly issued stock 
of distributing in exchange for money or property previously acquired 
for cash during the pre-distribution period should be treated as a 
transaction in which gain or loss is recognized. For example, assume D 
and C have each engaged in the active conduct of a trade or business 
for more than five years. During the pre-distribution period, P, an 
unrelated corporation, purchases trucks and transfers them to D in 
exchange for D stock meeting the requirements of section 368(c) in a 
transaction to which section 351 applies. No gain or loss is 
recognized. D subsequently distributes all the C stock to P in a 
separate transaction within five years of P's acquisition of the D 
stock. Notwithstanding that this transaction satisfies the literal 
requirements of section 355(b)(2)(D), it appears to violate the General 
Utilities doctrine because it permits the distributee corporation, P, 
to receive a fair market value basis (or close to a fair market value 
basis) in the distributing stock, enabling the potential sale of 
controlled stock without the appropriate recognition of gain. 
Additionally, the IRS and Treasury Department are studying whether the 
principles of the foregoing rule should be extended to any distributee 
in regulations under section 355(d), and request comments on this 
point.

D. Treatment of Certain Multi-Step Acquisitions

    These proposed regulations provide specific rules regarding the 
application of section 355(b)(2)(C) and (D) to certain multi-step 
acquisitions. Based on the interpretation of section 355(b)(2)(D), and 
the enactment of section 355(b)(3), the IRS and Treasury Department 
believe that it is appropriate to apply section 355(b)(2)(C) and (D) to 
multi-step acquisitions in a consistent manner. Further, the IRS and 
Treasury Department believe that it is appropriate to treat certain 
multi-step acquisitions of target corporation stock as satisfying the 
requirements of section 355(b)(2)(C) or (D) (as applicable) 
notwithstanding that some portion of the stock may have been acquired 
in a separate transaction in which gain or loss was recognized.
1. Multi-Step Acquisition of Control of Distributing or Controlled
a. Direct Acquisitions
    Section 355(b)(2)(D) provides that control of distributing or 
controlled may be acquired within the pre-distribution period provided 
that ``in each case in which such control was so acquired, it was so 
acquired, only by reason of transactions in which gain or loss was not 
recognized in whole or in part, or only by reason of such transactions 
combined with acquisitions before the beginning of such period.'' The 
IRS and Treasury Department interpret this language to mean that at the 
time control is first acquired, the acquiring corporation (or its SAG) 
is required to own stock meeting the requirements of section 368(c) 
that was acquired in one or more transactions in which no gain or loss 
was recognized or by reason of such transactions combined with 
acquisitions before the beginning of the pre-distribution period. Thus, 
at the time an acquiring corporation (or its SAG) first satisfies the 
section 368(c) control requirement, the acquiring corporation (or its 
SAG) must possess section 368(c) control without relying on any stock 
acquired in a transaction in which gain or loss was recognized during 
the pre-distribution period.
    For example, assume that C has two classes of stock outstanding. X 
owns all 95 shares of the class A stock of C representing 95 percent of 
the voting power and 70 percent of the value and Y owns all of the 
class B stock of C representing five percent of the voting power and 30 
percent of the value. In year 1, unrelated D acquires 10 shares of the 
class A C stock from X in a transaction in which gain or loss is 
recognized. In year 2, D acquires an additional 80 shares of class A C 
stock from X in a separate transaction in which no gain or loss is 
recognized. In year 3, D acquires the remaining five shares of class A 
C stock from X in a separate transaction in which gain or loss is 
recognized. In year 4, D distributes the 95 shares of class A C stock 
to the D shareholders. Assuming all of the other requirements of 
section 355(b) are satisfied, the requirements of section 
355(b)(2)(D)(ii) are satisfied because at the time D first acquired 
control of C (immediately after the year 2 acquisition), D owned an 
amount of C stock constituting control that was acquired in a 
transaction in which no gain or loss was recognized (the 80 shares of 
class A C stock acquired in year 2). (However, the 10 shares of class A 
C stock acquired in year 1 and the five shares of class A C stock 
acquired in year 3 may be treated as moot under section 355(a)(3)(B).)
    On the other hand, assume the same facts as the previous example, 
except that, in year 2, D acquires only 75 shares of class A C stock 
from X. The requirements of section 355(b)(2)(D)(ii) are not satisfied 
because at the time D first acquired control of C (immediately after 
the year 2 acquisition), D did not own an amount of C stock 
constituting control that was acquired in one or more transactions in 
which no gain or loss was recognized or acquired prior to the pre-
distribution period. D only owns C voting stock representing 75 percent 
of the total voting power that was acquired in a transaction in which 
no gain or loss was recognized. The result would be the same if the 
year 3 acquisition was also a transaction in which no gain or loss was 
recognized.
b. Indirect Acquisitions
    These proposed regulations also provide that the principles of this 
rule will be applied with respect to an indirect acquisition of 
distributing or controlled stock. For example, assume T corporation 
owns stock of C (an unaffiliated subsidiary) constituting control (and 
no more). Unrelated D acquires 10 percent of the sole outstanding class 
of stock of T in a transaction in which gain or loss is recognized. In 
a separate transaction, T merges into D solely in exchange for D stock 
in a transaction in which no gain or loss is recognized. In applying 
this multi-step acquisition rule to D's subsequent acquisition of 
control of C in the merger, the prior acquisition of T stock in the 
transaction in which gain or loss was recognized is treated as an 
acquisition of 10 percent of the C stock owned by T (representing 8 
percent of the total combined voting power of the C stock) in a 
transaction in which gain or loss is recognized. Accordingly, the 
requirements of section 355(b)(2)(D)(ii) are not satisfied because at 
the time D first acquires control of C, D does not own an amount of C 
stock constituting

[[Page 26021]]

control that was acquired in one or more transactions in which no gain 
or loss is recognized or acquired prior to the pre-distribution period. 
At that time, D had only acquired C stock representing 72 percent of 
the total combined voting power of the C stock in a transaction in 
which no gain or loss is recognized.
2. Other Multiple-Step Acquisitions
    As discussed in sections A.1., B.1., and B.3. of this preamble, if 
D acquires section 1504(a)(2) stock of a corporation, the acquired 
corporation will become a DSAG member and the corporation will be 
treated like a division of D for purposes of the active trade or 
business requirement. As such, D is treated as if it acquired the 
assets and activities of the new subsidiary SAG member, and the 
acquisition must satisfy the requirements of section 355(b)(2)(C) 
rather than section 355(b)(2)(D). If D subsequently acquires the 
remaining stock of the corporation in a separate transaction, such 
acquisition is disregarded for purposes of satisfying the active trade 
or business requirement (regardless of whether gain or loss was 
recognized in the separate transaction) because the subsidiary is 
already treated as a division of D for this purpose. The IRS and 
Treasury Department believe that the order of these acquisitions should 
not be determinative in applying section 355(b)(2)(C), provided that at 
the time the corporation first becomes a subsidiary SAG member, the SAG 
owns section 1504(a)(2) stock in the corporation without relying on any 
stock acquired in a transaction in which gain or loss was recognized 
during the pre-distribution period.
a. Direct SAG Acquisitions
    Consistent with the treatment of multi-step acquisitions of control 
of a corporation discussed in section D.1. of this preamble, these 
proposed regulations provide that multi-step acquisitions of stock 
resulting in a corporation becoming a subsidiary SAG member will 
satisfy the requirements of section 355(b)(2)(C), provided that at the 
time the corporation first becomes a subsidiary SAG member, the SAG 
owns section 1504(a)(2) stock in the corporation without relying on any 
stock acquired in a transaction in which gain or loss was recognized 
during the pre-distribution period.
    For example, assume that in year 1, D does not conduct an active 
trade or business and has owned control of C for more than five years. 
C and T, an unrelated corporation, have each engaged in the active 
conduct of a trade or business for more than five years. In year 1, D 
acquires 10 percent of T's sole outstanding class of stock in a 
transaction in which gain or loss was recognized. In year 2, D acquires 
an additional 80 percent of T's stock in a separate transaction in 
which no gain or loss was recognized. T becomes a DSAG member as a 
result of the year 2 stock acquisition. In year 3, D distributes the C 
stock to the D shareholders. Assuming all of the other requirements of 
section 355(b) are satisfied, the requirements of section 355(b)(2)(C) 
are satisfied because at the time T first became a DSAG member 
(immediately after the year 2 acquisition), D owned an amount of T 
stock meeting the requirements of section 1504(a)(2) that was acquired 
in a transaction in which no gain or loss was recognized (the T stock 
acquired in year 2).
    On the other hand, assume the same facts as the previous example 
except that, in year 2, D only acquires an additional 75 percent of T's 
stock. The requirements of section 355(b)(2)(C) are not satisfied 
because at the time T first became a DSAG member (immediately after the 
year 2 acquisition), D did not own an amount of T stock meeting the 
requirements of section 1504(a)(2) that was acquired in one or more 
transactions in which no gain or loss was recognized or acquired prior 
to the pre-distribution period. D owns only 75 percent of T's stock 
that was acquired in a transaction in which no gain or loss was 
recognized. The result would be the same even if, in year 3 prior to 
the distribution of the C stock, D acquired the remaining 15 percent of 
the T stock in a transaction in which no gain or loss is recognized.
b. Indirect SAG Acquisitions
    Similar to the rule regarding multi-step acquisitions of control of 
distributing or controlled, these proposed regulations also provide 
that the principles of this rule will be applied with respect to an 
indirect acquisition by the SAG of stock of a corporation that becomes 
a SAG member. For example, assume a DSAG member acquires 25 percent of 
the sole outstanding class of stock of T, a corporation that wholly 
owns S, in a transaction in which gain or loss is recognized. In a 
separate transaction, another DSAG member acquires all of the stock of 
S from T solely in exchange for D voting stock in a reorganization 
described in section 368(a)(1)(B) in which no gain or loss is 
recognized. As a result, S becomes a DSAG member. In applying this 
multi-step acquisition rule to the DSAG's subsequent acquisition of S 
stock, the acquisition of 25 percent of the T stock in the transaction 
in which gain or loss was recognized will be treated as an acquisition 
of 25 percent of the S stock in a transaction in which gain or loss is 
recognized. Accordingly, the requirements of section 355(b)(2)(C) are 
not satisfied because at the time S first becomes a DSAG member, the 
DSAG does not own section 1504(a)(2) stock of S that was acquired in 
one or more transactions in which no gain or loss is recognized or 
acquired prior to the pre-distribution period.
c. Multi-Step Asset Acquisitions
    Because stock acquisitions that result in a corporation becoming a 
subsidiary SAG member are treated as direct acquisitions of the target 
corporation's assets for purposes of applying section 355(b), these 
proposed regulations apply a comparable multi-step acquisition rule to 
acquisitions of stock in non-SAG members where such non-members' assets 
are subsequently directly acquired by a SAG member. Specifically, these 
proposed regulations provide that if immediately before a SAG's direct 
acquisition of a trade or business (or an interest in a partnership 
engaged in a trade or business) held by a corporation (owner) in a 
transaction to which section 381 applies and in which no gain or loss 
is recognized, the SAG owns an amount of stock of the owner that it 
acquired in one or more transactions during the pre-distribution period 
in which gain or loss was recognized such that all of the other stock 
of the owner does not meet the requirements of section 1504(a)(2), such 
direct acquisition shall be treated as a transaction in which gain or 
loss was recognized. Thus, these proposed regulations apply section 
355(b)(2)(C) to multi-step acquisitions in the same manner regardless 
of whether the separate steps result in the target corporation becoming 
a subsidiary SAG member or result in a direct acquisition of the target 
corporation's assets.
    For example, assume that in year 1, D does not conduct an active 
trade or business, and has owned control of C for more than five years. 
C and T, an unrelated corporation, have each engaged in the active 
conduct of a trade or business for more than five years. In year 1, D 
acquires 10 percent of T's sole outstanding class of stock in a 
transaction in which gain or loss was recognized. In year 2, in a 
separate reorganization described in section 368(a)(1)(A), T merges 
into D and the T shareholders receive solely D stock in exchange for 
their T stock. No gain or loss is recognized in the merger. In year 3, 
D distributes the stock of C to the D shareholders. Assuming all of the 
other requirements of section 355(b) are satisfied, the requirements of 
section

[[Page 26022]]

355(b)(2)(C) are satisfied because, at the time D acquires T's active 
trade or business, D did not own an amount of T stock that was acquired 
in one or more transactions during the pre-distribution period in which 
gain or loss was recognized such that all of the other T stock does not 
meet the requirements of section 1504(a)(2).
    On the other hand, assume the same facts as the previous example 
except that in year 1 D acquires 21 percent of T's stock. The 
requirements of section 355(b)(2)(C) are not satisfied because, at the 
time D acquires T's active trade or business, D owned an amount of T 
stock that was acquired in one or more transactions during the pre-
distribution period in which gain or loss was recognized such that all 
of the other T stock does not meet the requirements of section 
1504(a)(2).
    These proposed regulations also provide that the principles of this 
rule will be applied with respect to an indirect acquisition of the 
target corporation's stock by the SAG.

E. Expansion Acquisitions

    The legislative history, the courts, and the current regulations 
acknowledge that a trade or business can undergo many changes during 
the pre-distribution period and still satisfy the requirements of 
section 355(b). See H.R. No. 83-2543, at 37, 38 (1954) (Conf. Rep.); 
Estate of Lockwood v. Commissioner, 350 F.2d 712 (8th Cir. 1965); and 
Sec.  1.355-3(b)(3)(ii). Furthermore, Sec.  1.355-3(b)(3)(ii) provides 
``if a corporation engaged in the active conduct of one trade or 
business during that five-year period purchased, created, or otherwise 
acquired another trade or business in the same line of business, then 
the acquisition of that other business is ordinarily treated as an 
expansion of the original business, all of which is treated as having 
been actively conducted during that five-year period, unless that 
purchase, creation, or other acquisition effects a change of such a 
character as to constitute the acquisition of a new or different 
business.'' Therefore, an acquired trade or business that is an 
expansion of the original trade or business inherits the business 
history of the expanded business.
    None of these authorities, however, addresses whether an existing 
trade or business can be expanded by acquiring the stock of a 
corporation engaged in a trade or business in the same line of business 
as the acquiror. Because the SAG rule causes a stock acquisition in 
which the acquired corporation becomes a subsidiary SAG member to be 
treated as an asset acquisition, a corporation engaged in a trade or 
business should be able to expand its existing trade or business by 
acquiring stock of a corporation (including controlled) engaged in a 
trade or business in the same line of business provided the acquisition 
results in the acquired corporation becoming a subsidiary SAG member.
    On the other hand, section 355(b)(3) does not allow a corporation 
to rely on the trade or business of a non-SAG subsidiary--even if the 
corporation controls the subsidiary--to satisfy the active trade or 
business requirement. As such, it effectively precludes stock 
expansions where the acquired corporation does not become a subsidiary 
SAG member. The IRS and Treasury Department believe that section 
355(b)(3) is the exclusive means by which a corporation is attributed 
the assets (or activities) owned (or conducted) by another corporation. 
Accordingly, a stock acquisition that does not result in the acquired 
corporation becoming a subsidiary SAG member should not be an expansion 
of the SAG's original business.
    In addition, these proposed regulations provide certain facts and 
circumstances to be considered in determining whether one trade or 
business is in the same line of business as another trade or business. 
The inclusion of these facts and circumstances in these proposed 
regulations is not intended to be a substantive change, but merely to 
clarify and restate the current law regarding expansions. See Rev. Rul. 
2003-18 (2003-1 CB 467) and Rev. Rul. 2003-38 (2003-1 CB 811). Some of 
the examples from the current regulations have been altered in these 
proposed regulations to reflect this inclusion (as well as certain 
stylistic changes).

F. Rules Related to Hot Stock

    Section 355(a)(3)(B) provides that stock of controlled acquired by 
distributing during the pre-distribution period in a transaction in 
which gain or loss is recognized is treated as boot. Section 1.355-2(g) 
provides guidance regarding the application of section 355(a)(3)(B). 
The IRS and Treasury Department request comments regarding whether 
Sec.  1.355-2(g) should be amended to adopt rules under section 
355(a)(3)(B) similar to those provided in these proposed regulations 
for determining whether an acquisition is one in which gain or loss is 
recognized for purposes of section 355(b)(2)(C) or (D).
    In particular, the IRS and Treasury Department request comments 
concerning the application of section 355(a)(3)(B) to acquisitions of 
stock of controlled in gain or loss transactions that, under these 
proposed regulations, are not treated as violating the requirements of 
section 355(b). For example, where distributing acquires stock of 
controlled in a gain or loss transaction that is treated as an 
expansion of distributing's existing trade or business (because 
controlled is in distributing's line of business and becomes a DSAG 
member), what portion, if any, of the acquired stock should be subject 
to section 355(a)(3)(B)?
    The current authorities may suggest a linkage between the 
interpretation of sections 355(a)(3)(B) and 355(b). See Sec.  1.355-
2(g)(1) (not applying section 355(a)(3)(B) to a taxable acquisition 
from an affiliate); Rev. Rul. 78-442 (stating ``[l]ikewise, for the 
same reasons [that section 355(b)(2)(C) does not apply], section 
355(a)(3)[(B)] of the Code is not applicable''). However, section 
355(b)(3) by its literal terms does not appear to apply for purposes 
section 355(a)(3)(B).
    The IRS and Treasury Department continue to study how to coordinate 
the application of these provisions and request comments in this 
regard. Accordingly, these proposed regulations contain no proposal to 
change Sec.  1.355-2(g) at this time.

G. Limited Affiliate Exception

    Other than with respect to transfers of assets (or activities) that 
are owned (or performed) by the SAG immediately before and immediately 
after the transfer, these proposed regulations do not include the 
special treatment accorded affiliated group members in Sec.  1.355-
3(b)(4)(iii). Thus, these proposed regulations treat non-SAG member 
affiliates of distributing or controlled in the same manner as 
unrelated persons for purposes of applying section 355(b)(2)(C) and 
(D). While distributing is the common parent of its SAG, distributing 
may be a subsidiary member of a larger affiliated group. Therefore, not 
all members of distributing's affiliated group are DSAG members.
    Section 1.355-3(b)(4)(iii) provides that acquisitions by one member 
of an affiliated group from another member of the group are disregarded 
in applying section 355(b)(2)(C) and (D), even if gain or loss is 
recognized. Section 1.355-3(b)(4)(iii) provides for this treatment for 
affiliates because although ``[t]he requirements of section 
355(b)(2)(C) and (D) are intended to prevent the direct or indirect 
acquisition of a trade or business by a corporation in anticipation of 
a distribution by the

[[Page 26023]]

corporation of that trade or business in a distribution to which 
section 355 would otherwise apply[,]'' acquisitions from affiliates are 
not the type of transaction to which these provisions were intended to 
apply. Section 1.355-3(b)(4)(iv) defines the term ``affiliated group'' 
as an affiliated group as defined in section 1504(a) (without regard to 
section 1504(b)), except that the term ``stock'' includes nonvoting 
stock described in section 1504(a)(4).
    The IRS and Treasury Department believe that limiting this special 
treatment to transfers in which the assets (or activities) remain in 
the SAG (as opposed to the larger affiliated group) is more consistent 
with the purposes of section 355(b)(3). As discussed in section A.1. of 
this preamble, section 355(b)(3) states, in effect, that in determining 
whether distributing or controlled is engaged in a trade or business 
all DSAG or CSAG members, as the case may be, are treated as one 
corporation. Therefore, a transfer of trade or business assets (or 
activities) from one SAG member to another SAG member is disregarded, 
and is not an acquisition for purposes of section 355(b)(2)(C) (or 
section 355(b)(2)(D) in the case of stock of controlled that is not a 
DSAG member). The SAG rule implies a corollary, which is that if the 
trade or business assets (or activities) are not owned (or performed) 
by the SAG, such assets (or activities) should generally not be able to 
be acquired from outside the SAG in a transaction in which gain or loss 
is recognized. Thus, these proposed regulations generally do not permit 
taxable acquisitions of an active trade or business from outside the 
SAG.
    The IRS and Treasury Department recognize that not providing this 
special treatment for non-SAG member affiliates is a change from how 
the law has been administered in various situations. Further, the IRS 
and Treasury Department recognize that this change can represent a 
relaxing or tightening of the law in this area, depending upon the 
circumstances. For example, under these proposed regulations the 
requirements of section 355(b)(2)(C) are satisfied where P, a higher-
tier affiliate of distributing, purchases a trade or business for cash 
and contributes it to distributing solely in exchange for distributing 
stock in a transaction in which no gain or loss is recognized. On the 
other hand, under these proposed regulations, the requirements of 
section 355(b)(2)(C) are not satisfied where P has actively conducted a 
trade or business for more than five years and sells it to D in 
exchange for cash.

H. Activities Performed by Certain Related Parties

    Current Sec.  1.355-3(b)(2)(iii) provides, in part, that to satisfy 
the active trade or business requirement, the corporation itself 
generally is required to perform active and substantial management and 
operational functions. That regulation further provides that activities 
performed by the corporation itself generally do not include activities 
performed by independent contractors. In this regard, ``a corporation 
must engage in entrepreneurial endeavors of such a nature and to such 
an extent as to qualitatively distinguish its operations from mere 
investments [, and] * * * there should be objective indicia of such 
corporate operations.'' Rafferty v. Commissioner, 452 F.2d 767, 772 
(1st Cir. 1971) cert. denied 408 U.S. 922 (1972) (concluding that a 
corporation that did not pay salaries or rent, did not employ 
independent contractors, and merely collected rent, paid taxes, and 
kept separate books, failed to satisfy these requirements). The IRS and 
Treasury Department believe that a corporation may rely on the 
activities performed by certain related parties in conducting its 
``entrepreneurial endeavors,'' and such activities can constitute 
``objective indicia'' of corporate operations.
    While section 355(b)(3) treats all SAG members as one corporation, 
the IRS and Treasury Department are aware that affiliated groups of 
corporations that include non-SAG member affiliates might use employees 
of one member of the group to perform management or operational 
functions for another member of the group. The IRS and the Treasury 
Department believe that a corporation can satisfy the active trade or 
business requirement even if all the management and operational 
functions are performed by employees of affiliates that are not members 
of either the DSAG or CSAG. In other words, the DSAG or CSAG can be 
engaged in ``entrepreneurial endeavors'' that are distinguishable from 
mere passive investment even if the management and operational 
functions are performed for the DSAG or CSAG by employees of non-SAG 
affiliates. Such individuals bear a close enough relationship to the 
DSAG or CSAG to be distinguished from mere independent contractors for 
purposes of the active trade or business requirement. The IRS and 
Treasury Department believe that this treatment is appropriate and 
consistent with previously published guidance.
    Issued prior to the enactment of section 355(b)(3), Rev. Rul. 79-
394 (1979-2 CB 141), amplified by Rev. Rul. 80-181 (1980-2 CB 121), 
concludes that controlled satisfies the active trade or business 
requirement even though all of the operational activities of its 
business are conducted by an affiliate's employees before the 
distribution. The IRS and Treasury Department believe that extending 
the principles of Rev. Rul. 79-394 and Rev. Rul. 80-181 to the 
performance of management (in addition to operational) functions by 
employees of an affiliate is consistent with the purposes underlying 
the active trade or business requirement. Accordingly, these proposed 
regulations provide that, in determining whether a corporation is 
engaged in the active conduct of a trade or business, activities 
(including management and operational functions) performed by employees 
of the corporation's affiliates (including non-SAG members) are taken 
into account.
    Furthermore, the IRS and Treasury Department believe that a 
corporation can satisfy the active trade or business requirement even 
if all the management and operational functions are performed by 
shareholders of the corporation if it is closely held. The shareholders 
of closely held corporations possess a close relationship with the 
corporation, similar to employees of affiliates. Accordingly, these 
proposed regulations provide that, in determining whether a corporation 
is engaged in the active conduct of a trade or business, activities 
(including management and operational functions) performed by 
shareholders of a closely held corporation are taken into account in 
certain cases.
    The IRS and Treasury Department do not believe that the absence of 
an exception for acquisitions from non-SAG member affiliates is 
inconsistent with concluding that a corporation can satisfy the active 
trade or business requirement by relying on the management and 
operational functions performed by employees of non-SAG member 
affiliates. Relying on the activities of such employees does not 
involve the acquisition of a trade or business. As such, it is not the 
type of transaction or arrangement section 355(b)(2) was intended to 
address. Accordingly, the IRS and Treasury Department believe it is 
appropriate to apply a broader standard with respect to relying on 
employees of non-SAG member affiliates.
    While it is appropriate to consider the management and operational 
activities of employees of all affiliates in determining whether a 
corporation satisfies the active trade or business requirement, the IRS 
and Treasury Department believe that a corporation should satisfy the 
active trade or

[[Page 26024]]

business requirement only if it (or another SAG member, or a 
partnership from which the trade or business assets and activities are 
attributed) is the principal owner of the goodwill and significant 
assets of the trade or business for Federal income tax purposes. 
Accordingly, a corporation will be treated as engaged in the active 
conduct of a trade or business only if, for Federal income tax 
purposes, it (or its SAG member, or a partnership from which the trade 
or business assets and activities are attributed) is the principal 
owner of the goodwill and significant assets of the trade or business. 
Accordingly, some of the examples from the current regulations have 
been altered in these proposed regulations to reflect this goodwill and 
significant asset standard (as well as certain stylistic changes).

I. Activities Conducted by a Partnership

    Revenue Ruling 92-17 (1992-1 CB 142) and Rev. Rul. 2002-49 (2002-2 
CB 288) address in a number of fact situations whether a corporation 
that is a partner in a partnership can satisfy the active trade or 
business requirement by reason of its ownership of the partnership 
interest where the partnership conducts a trade or business. Those 
rulings illustrate that a corporation owning a 20-percent interest in a 
state law partnership or limited liability company (LLC) that is 
classified as a partnership for Federal income tax purposes can be 
treated as engaged in the active conduct of the trade or business of 
the partnership if the corporation performs active and substantial 
management functions for the partnership's business. In addition, Rev. 
Rul. 2002-49 concludes that such a corporation can be treated as 
engaged in the active conduct of a partnership's trade or business, 
even if another partner also performs active and substantial management 
functions for the partnership's trade or business.
    Consistent with the principles set forth in Rev. Rul. 92-17 and 
Rev. Rul. 2002-49 regarding satisfying the active trade or business 
requirement through an interest in a partnership, these proposed 
regulations provide that for purposes of section 355(b) a partner will 
be attributed the trade or business assets and activities of a 
partnership if the partner (1) Performs active and substantial 
management functions for the partnership with respect to the trade or 
business assets or activities (for example, makes decisions regarding 
significant business issues of the partnership and regularly 
participates in the overall supervision, direction, and control of the 
employees performing the operational functions for the partnership), 
and (2) owns a meaningful interest in the partnership. Further, because 
a partnership might only conduct a portion of a trade or business, the 
IRS and Treasury Department believe that a partner that satisfies these 
requirements can be attributed the portions of a trade or business (or 
assets and activities) that are conducted by a partnership. Under these 
circumstances the IRS and Treasury Department believe that it is 
appropriate to aggregate the partnership's trade or business assets and 
activities with those of the partner for purposes of determining 
whether the partner satisfies the active trade or business requirement. 
However, the stock of a corporation held by the partnership is not 
attributed to a partner.
    The IRS and Treasury Department understand that the facts presented 
in Rev. Rul. 92-17 and Rev. Rul. 2002-49 do not necessarily reflect the 
exclusive methods by which corporations engage in a trade or business 
through a partnership. In particular, the IRS and Treasury Department 
understand that both the management and operational activities of an 
LLC are often conducted by the LLC itself, rather than by its members, 
to protect its members from liability for the LLC's activities. In 
these cases, Rev. Rul. 92-17 and Rev. Rul. 2002-49 do not explicitly 
support the conclusion that a corporation may rely on the trade or 
business assets and activities of an LLC to satisfy the active trade or 
business requirement, since no activities are performed by the 
corporate partner.
    The IRS and Treasury Department believe that, in certain cases, a 
partner that owns a significant interest in an entity that is treated 
as a partnership for Federal income tax purposes should be attributed 
the trade or business assets and activities of a partnership, even if 
the partner does not directly conduct any activities relating to the 
business of the partnership. By comparison, the IRS and Treasury 
Department have promulgated regulations regarding the treatment of 
acquired assets held by a partnership for purposes of satisfying the 
continuity of business enterprise requirement applicable to 
reorganizations. Those regulations provide that a partner will be 
treated as owning the acquired target business assets used in the 
business of a partnership in satisfaction of the continuity of business 
enterprise requirement if the members of the qualified group, in the 
aggregate, own an interest in the partnership representing a 
significant interest in that partnership business. See Sec.  1.368-
1(d)(4)(iii)(B)(1). Those regulations include an example concluding 
that the continuity of business enterprise requirement is satisfied 
where a partner owns a one-third interest in a partnership that 
continues the business of the target corporation, even though the 
partner performs no management or operational functions for that 
business. See Sec.  1.368-1(d)(5) Example 9.
    These proposed regulations yield results similar to the continuity 
of business enterprise rule in determining whether the active trade or 
business requirement is satisfied when a corporation conducts a trade 
or business or portions of a trade or business through a partnership 
but does not participate in the partnership's activities. Specifically, 
these proposed regulations provide that for purposes of section 355(b) 
a partner will be attributed the trade or business assets and 
activities of a partnership provided the partner owns a significant 
interest in the partnership. The IRS and Treasury Department intend 
that the term ``significant interest'' requires an ownership interest 
that is greater than that suggested by the term ``meaningful 
interest,'' which is the level of ownership required for a partner to 
be attributed the trade or business assets and activities of a 
partnership in cases where the partner performs active and substantial 
management functions for the partnership.
    However, a partner will be attributed the trade or business assets 
and activities of a partnership only during the period it owns a 
significant interest or alternatively owns a meaningful interest and 
performs active and substantial management functions.

J. Additional Requests for Comments

    The IRS and Treasury Department request comments regarding whether 
the regulations should include a rule that would treat an acquisition 
in which no gain or loss is recognized as an acquisition in which gain 
or loss is recognized if that would be the treatment had the 
transaction been executed in the opposite direction. For example, 
assume that, in year 1, P, a corporation not engaged in an active trade 
or business, acquires 50 percent of all of the outstanding stock of D 
(which is engaged in an active trade or business, and owns control of 
C, which is also engaged in an active trade or business) in a 
transaction in which gain or loss is recognized, and then, in a 
separate transaction in year 3, D merges into P solely in exchange for 
P stock in a transaction described in section 368(a)(1)(A) in which no 
gain or loss is recognized. P then distributes the C

[[Page 26025]]

stock to its shareholders in year 4. Under these proposed regulations, 
P is treated as having acquired D's trade or business and control of C 
during the pre-distribution period in a transaction in which gain or 
loss is recognized because P acquired more than 20 percent of D's stock 
during the pre-distribution period in a transaction in which gain or 
loss was recognized (see sections D.1.b. and D.2.c of this preamble). 
However, if P merges downstream into D solely in exchange for D stock 
in a reorganization described in section 368(a)(1)(A) and (D) in which 
no gain or loss is recognized, there literally is not an acquisition in 
which gain or loss is recognized under these proposed regulations, 
because D did not acquire any interest in an active trade or business 
from P. Comments are requested regarding whether the result should 
differ depending upon the direction of the merger. See and compare 
Sec.  1.355-3(b)(4)(ii) (predecessor of distributing acquiring control 
of distributing).
    Further, the IRS and Treasury Department request comments regarding 
the appropriate methods of measuring indirect acquisitions of stock for 
purposes of the rules regarding multi-step acquisitions, as discussed 
in section D. of this preamble. Specifically, comments are requested 
regarding how the indirect acquisition should be measured where the 
acquired corporation has multiple classes of stock outstanding, or 
where the acquired entity is a partnership. For example, assume T is a 
corporation that owns all of the stock of a subsidiary, S, and T has 
class A common stock, class B common stock, and preferred stock 
outstanding. If D acquires 10 percent of the T class A common stock, 
how should one determine what percentage of S stock D has indirectly 
acquired? Should it be based on the value of the T stock D acquired 
relative to the value of all of the T stock or other factors? How 
should the voting power of the acquired T stock be taken into account 
in applying these rules to potential indirect acquisitions of control?
    In addition, the IRS and Treasury Department request comments 
regarding whether the parameters of the good faith and inadvertence 
exceptions in Notice 2004-37 (2004-1 CB 947) regarding the value 
requirement in section 1504(a)(2)(B) should apply for purposes of 
determining whether corporations are SAG members even if they are not 
members of a consolidated group. That is, the IRS and Treasury 
Department request comments regarding whether the policies underlying 
the SAG rule and the reference to section 1504(a) in section 
355(b)(3)(B) suggest that the good faith and inadvertence exceptions 
should apply and be interpreted in the same way for SAG membership as 
for affiliation for purposes of filing consolidated returns.
    The IRS and Treasury Department also request comments regarding 
whether the regulations should clarify the circumstances under which 
the separation of a segment of an active trade or business should be 
treated as a separate active trade or business after it is spun off 
and, if so, what the governing principle should be. See, for example, 
Sec.  1.355-3(c) Example (9) (separation of a corporation's research 
department from the rest of its manufacturing business).
    Although these regulations are generally proposed to be applicable 
to distributions that occur after the date these regulations are 
published as final regulations in the Federal Register, the IRS and 
Treasury Department invite comments regarding whether it would be 
appropriate and desirable to allow taxpayers to elect to apply these 
provisions retroactively (subject to the applicability of section 
355(b)(3)).

Proposed Effective Date

    These proposed regulations are proposed to apply to distributions 
that occur after the date these regulations are published as final 
regulations in the Federal Register.

Special Analyses

    It has been determined that this notice of proposed rulemaking is 
not a significant regulatory action as defined in Executive Order 
12866. Therefore, a regulatory assessment is not required. It has also 
been determined that section 553(b) of the Administrative Procedure Act 
(5 U.S.C. chapter 5) does not apply to these regulations, and, because 
these regulations do not impose a collection of information on small 
entities, the Regulatory Flexibility Act (5 U.S.C. chapter 6) does not 
apply. Pursuant to section 7805(f) of the Code, these regulations have 
been submitted to the Chief Counsel for Advocacy of the Small Business 
Administration for comment on its impact on small businesses.

Comments and Requests for Public Hearing

    Before these proposed regulations are adopted as final regulations, 
consideration will be given to any written (a signed original and eight 
(8) copies) or electronic comments that are submitted timely to the 
IRS. The IRS and Treasury Department request comments on the clarity of 
the proposed rules and how they can be made easier to understand. All 
comments will be available for public inspection and copying. A public 
hearing will be scheduled if requested in writing by any person that 
timely submits written comments. If a public hearing is scheduled, 
notice of the date, time, and place for the public hearing will be 
published in the Federal Register.

Drafting Information

    The principal author of these proposed regulations is Russell P. 
Subin of the Office of Associate Chief Counsel (Corporate). However, 
other personnel from the IRS and Treasury Department participated in 
their development.

Availability of IRS Documents

    IRS revenue rulings, procedures, and notices cited in this preamble 
are made available by the Superintendent of Documents, U.S. Government 
Printing Office, Washington, DC 20402.

List of Subjects in 26 CFR Part 1

    Income taxes, Reporting and recordkeeping requirements.

Proposed Amendments to the Regulations

    Accordingly, 26 CFR part 1 is proposed to be amended as follows:

PART 1--INCOME TAXES

    Paragraph 1. The authority citation for part 1 continues to read in 
part as follows:

    Authority: 26 U.S.C. 7805 * * *

    Par. 2. Section 1.355-0 is amended by revising the entries under 
Sec.  1.355-3.
    The revisions are as follows:


Sec.  1.355-0  Outline of sections.

* * * * *


Sec.  1.355-3  Active conduct of a trade or business.

    (a) General requirements.
    (b) Active conduct of a trade or business defined.
    (1) In general.
    (i) Directly engaged in a trade or business.
    (ii) Treatment of a separate affiliated group.
    (iii) Separate affiliated group defined.
    (2) Active conduct of a trade or business immediately after the 
distribution.
    (i) In general.
    (ii) Trade or business.
    (iii) Active conduct.
    (iv) Limitations.
    (v) Partner attributed the trade or business assets and 
activities of a partnership.
    (A) In general.
    (B) Significant interest.
    (C) Meaningful interest.
    (D) Other factors.
    (3) Active conduct for the pre-distribution period.
    (i) In general.
    (ii) Change and expansion.

[[Page 26026]]

    (iii) Certain transactions with partnerships that do not 
constitute acquisitions.
    (4) Special rules for an acquisition of a trade or business.
    (i) In general.
    (A) Application of section 355(b)(2)(C).
    (B) Application of section 355(b)(2)(D).
    (C) Gain or loss recognized.
    (ii) Certain transactions treated as transactions in which gain 
or loss is recognized.
    (A) Certain tax-free acquisitions made in exchange for assets.
    (B) Distributions from partnerships.
    (iii) Certain transactions in which recognized gain or loss is 
disregarded.
    (A) Transfers to controlled.
    (B) Cash for fractional shares.
    (C) Certain acquisitions of control of distributing.
    (iv) Operating rules for acquisitions.
    (A) Predecessors.
    (B) Certain multi-step acquisitions of control of distributing 
or controlled.
    (C) Certain multi-step acquisitions of a subsidiary SAG member.
    (D) Certain multi-step asset acquisitions.
    (E) Acquisitions involving the issuance of subsidiary stock.
    (F) Acquisitions of controlled stock where controlled is or 
becomes a DSAG member.
    (G) Treatment of stock received in certain tax-free exchanges.
    (H) Situations where the separate existence of a subsidiary SAG 
member is respected.
    (c) Definitions.
    (1) Affiliate.
    (2) Controlled.
    (3) Distributing.
    (4) Pre-distribution period.
    (d) Conventions and examples.
    (1) Conventions.
    (2) Examples.
* * * * *
    Par. 3. Section 1.355-1 is amended by revising paragraph (a) to 
read as follows:


Sec.  1.355-1  Distribution of stock and securities of a controlled 
corporation.

    (a) Effective date of certain sections. Except as otherwise 
provided, Sec. Sec.  1.355-1, 1.355-2, and 1.355-4 apply to 
transactions occurring after February 6, 1989. Section 1.355-3 applies 
to distributions after the date these regulations are published as 
final regulations in the Federal Register. For transactions occurring 
on or before that date but after February 6, 1989, see 26 CFR 1.355-3 
(revised as of April 1, 2007). For all transactions occurring on or 
before February 6, 1989, see 26 CFR 1.355-1 through 1.355-4 (revised as 
of April 1, 1987). Sections 1.355-1, 1.355-2, and 1.355-4 do not 
reflect the amendments to section 355 made by the Revenue Act of 1987 
and the Technical and Miscellaneous Revenue Act of 1988. For the 
effective date of Sec. Sec.  1.355-6 and 1.355-7, see Sec. Sec.  1.355-
6(g) and 1.355-7(k), respectively.
* * * * *
    Par. 4. Section 1.355-3 is revised to read as follows:


Sec.  1.355-3  Active conduct of a trade or business.

    (a) General requirements. Under section 355(b)(1), a distribution 
of stock, or stock and securities, of controlled (as defined in 
paragraph (c)(2) of this section) qualifies under section 355 only if--
    (1) Distributing (as defined in paragraph (c)(3) of this section) 
and controlled are each engaged in the active conduct of a trade or 
business immediately after the distribution (section 355(b)(1)(A)); or
    (2) Immediately before the distribution, distributing had no assets 
other than stock or securities of the controlled corporations (without 
regard to paragraph (b)(1)(ii) of this section), and each of the 
controlled corporations is engaged in the active conduct of a trade or 
business immediately after the distribution (section 355(b)(1)(B)). A 
de minimis amount of assets held by distributing shall be disregarded 
for purposes of this paragraph (a)(2).
    (b) Active conduct of a trade or business defined--(1) In general--
(i) Directly engaged in a trade or business. Section 355(b)(2) provides 
rules for determining whether a corporation is treated as engaged in 
the active conduct of a trade or business under section 355(b)(1). 
Sections 355(b)(2)(A) and (b)(3)(A) provide that a corporation is 
treated as engaged in the active conduct of a trade or business if and 
only if such corporation is engaged in the active conduct of a trade or 
business. Accordingly, except as provided in paragraph (b)(1)(ii) of 
this section, a corporation is not treated as engaged in the active 
conduct of a trade or business under such Internal Revenue Code 
sections solely as a result of substantially all of its assets 
consisting of stock, or stock and securities, of one or more 
corporations controlled by it (immediately after the distribution) each 
of which is engaged in the active conduct of a trade or business.
    (ii) Treatment of a separate affiliated group. Under section 
355(b)(3)(B), solely for purposes of determining whether a corporation 
is engaged in the active conduct of a trade or business, all members of 
a corporation's separate affiliated group (SAG) (as defined in 
paragraph (b)(1)(iii) of this section) shall be treated as one 
corporation. This treatment applies for all purposes of determining 
whether a corporation is engaged in the active conduct of a trade or 
business. Accordingly, for this purpose, transfers of assets (or 
activities) that are owned (or performed) by the SAG immediately before 
and immediately after the transfer are disregarded and are not 
acquisitions under paragraph (b)(4) of this section. Further, a 
transaction that results in a corporation becoming a subsidiary SAG 
member (a SAG member that is not the common parent of such SAG) is 
treated as an acquisition of any assets (or activities) that are owned 
(or performed) by the acquired corporation at such time. Therefore, the 
acquisition of additional stock of a current subsidiary SAG member has 
no effect for purposes of applying paragraph (b)(4)(i)(A) of this 
section.
    (iii) Separate affiliated group defined. A corporation's SAG is the 
affiliated group which would be determined under section 1504(a) if 
such corporation were the common parent and section 1504(b) did not 
apply. Thus, the separate affiliated group of distributing (DSAG) is 
the affiliated group that consists of distributing as the common parent 
and all corporations affiliated with distributing through stock 
ownership described in section 1504(a)(1)(B) (regardless of whether the 
corporations are includible corporations under section 1504(b)). The 
separate affiliated group of controlled (CSAG) is determined in a 
similar manner (with controlled as the common parent). Accordingly, 
prior to a distribution, the DSAG may include CSAG members if the 
applicable ownership requirements are met. Further, the determination 
of whether a corporation is a DSAG or CSAG member shall be made 
separately for each distribution, and without regard to whether such 
corporation is a SAG member with respect to any other distribution. Any 
reference to DSAG or CSAG is a reference to distributing or controlled, 
respectively, if such corporation is not the common parent of a SAG 
(that is, such corporation does not own stock in any corporation that 
is a subsidiary member of its SAG). Further, any reference to a SAG is 
a reference to distributing or controlled, as the context may require, 
if such corporation is not the common parent of a SAG.
    (2) Active conduct of a trade or business immediately after the 
distribution--(i) In general. For purposes of section 355(b), a 
corporation shall be treated as engaged in the active conduct of a 
trade or business immediately after the distribution if the assets and 
activities of the corporation satisfy the requirements and limitations 
described in paragraphs (b)(2)(ii), (b)(2)(iii), and (b)(2)(iv) of this 
section. See paragraph (b)(2)(v) of this section for additional special 
rules that apply to determine whether a

[[Page 26027]]

corporation is attributed the trade or business assets and activities 
of a partnership.
    (ii) Trade or business. A corporation shall be treated as engaged 
in a trade or business immediately after the distribution if a specific 
group of activities is being carried on by the corporation for the 
purpose of earning income or profit, and the activities included in 
such group include every operation that 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.
    (iii) Active conduct. For purposes of section 355(b), 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. Activities performed by a 
corporation include activities performed by employees of an affiliate 
(as defined in paragraph (c)(1) of this section), and in certain cases 
by shareholders of a closely held corporation, if such activities are 
performed for the corporation. For example, activities performed by a 
corporation include activities performed for the corporation by its 
sole shareholder. However, the activities of employees of affiliates 
(or, in certain cases, shareholders) are only taken into account during 
the period such corporations are affiliates (or persons are 
shareholders) of the corporation. A corporation will not be treated as 
engaged in the active conduct of a trade or business unless it (or its 
SAG, or a partnership from which the trade or business assets and 
activities are attributed) is the principal owner of the goodwill and 
significant assets of the trade or business for Federal income tax 
purposes. Activities performed by a corporation generally do not 
include activities performed by persons outside the corporation, 
including independent contractors, unless those activities are 
performed by employees of an affiliate (or, in certain cases, by 
shareholders). However, a corporation may satisfy the requirements of 
this paragraph (b)(2)(iii) through the activities that it performs 
itself, even though some of its activities are performed by persons 
that are not its employees, or employees of an affiliate (or, in 
certain cases, shareholders). Separations of real property all or 
substantially all of which is occupied before the distribution by the 
DSAG or CSAG will be carefully scrutinized in applying the requirements 
of section 355(b) and this section.
    (iv) Limitations. The active conduct of a trade or business does 
not include--
    (A) The holding for investment purposes of stock, securities, land, 
or other property; or
    (B) 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.
    (v) Partner attributed the trade or business assets and activities 
of a partnership--(A) In general. For purposes of section 355(b), a 
partner in a partnership will be attributed the trade or business 
assets and activities of that partnership during the period that such 
partner satisfies the requirements of paragraph (b)(2)(v)(B) or 
(b)(2)(v)(C) of this section. However, for purposes of this paragraph 
(b)(2)(v), the stock of a corporation owned by the partnership is not 
attributed to a partner. For purposes of determining the activities 
that are conducted by the partnership that may be attributed to the 
partner under this paragraph (b)(2)(v), the activities of independent 
contractors, and partners that are not affiliates (or, in certain 
cases, shareholders) of the partner, are not taken into account. For 
this purpose, the activities of partners that are affiliates (or, in 
certain cases, shareholders) of the partner are only taken into account 
during the period that such partners are affiliates (or, in certain 
cases, shareholders) of the partner.
    (B) Significant interest. The trade or business assets and 
activities of a partnership will be attributed to a partner if the 
partner (or its SAG) directly (or indirectly through one or more other 
partnerships) owns a significant interest in the partnership.
    (C) Meaningful interest. The trade or business assets and 
activities of a partnership will be attributed to a partner if the 
partner or affiliates (or, in certain cases, shareholders) of the 
partner performs active and substantial management functions for the 
partnership with respect to the trade or business assets and activities 
(for example, makes decisions regarding significant business issues of 
the partnership and regularly participates in the overall supervision, 
direction, and control of the employees performing the operational 
functions for the partnership), and the partner (or its SAG) directly 
(or indirectly through one or more other partnerships) owns a 
meaningful interest in the partnership. Whether such active and 
substantial management functions are performed with respect to the 
trade or business assets and activities of the partnership will be 
determined from all of the facts and circumstances. The number of 
partners providing management functions will not be determinative.
    (D) Other factors. In deciding whether the requirements of 
paragraph (b)(2)(v)(B) or (b)(2)(v)(C) of this section are satisfied, 
the formal description of the partnership interest (for example, 
general or limited) will not be determinative and the extent to which 
the partner is responsible for liabilities of the partnership will not 
be relevant.
    (3) Active conduct for the pre-distribution period--(i) In general. 
Under section 355(b)(2), a trade or business that is relied upon to 
meet the requirements of section 355(b) must have been actively 
conducted throughout the pre-distribution period (as defined in 
paragraph (c)(4) of this section) by the DSAG or CSAG, or actively 
conducted throughout the pre-distribution period and acquired during 
such period by the DSAG or CSAG in a transaction in which no gain or 
loss is recognized as provided in paragraph (b)(4) of this section. For 
purposes of section 355(b)(2)(B), activities that constitute a trade or 
business under paragraph (b)(2) of this section shall be treated as 
described in the preceding sentence if such activities were actively 
conducted throughout the pre-distribution period.
    (ii) Change and expansion. The fact that a trade or business 
underwent change during the pre-distribution period (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. In particular, if a SAG 
engaged in the active conduct of one trade or business during the pre-
distribution period (the original business) purchased, created, or 
otherwise acquired (either directly, through an interest in a 
partnership, or as a result of a corporation becoming a subsidiary SAG 
member) another trade or business (the acquired business) in the same 
line of business, the acquisition of the acquired business is 
ordinarily treated as an expansion of the original business, all of 
which is treated as having been actively conducted by the acquiring SAG 
during the pre-distribution period, unless the acquired business 
effects a change of such a character as to constitute the acquisition 
of a new or different business. For purposes of this paragraph 
(b)(3)(ii), in determining whether an acquired business is in the same 
line of business as the original business, all facts and

[[Page 26028]]

circumstances shall be considered, including the following--
    (A) Whether the product of the acquired business is similar to that 
of the original business;
    (B) Whether the business activities associated with the operation 
of the acquired business are the same as the business activities 
associated with the operation of the original business; and
    (C) Whether the operation of the acquired business involves the use 
of the experience and know-how that the owner of the original business 
developed in the operation of the original business or, alternatively, 
whether the operation of the acquired business draws to a significant 
extent on the existing experience and know-how of the owner of the 
original business and the success of the acquired business will depend 
in large measure on the goodwill associated with the original business 
and the name of the original business.
    (iii) Certain transactions with partnerships that do not constitute 
acquisitions. If a partner is attributed the trade or business assets 
and activities of a partnership under paragraph (b)(2)(v) of this 
section, the partner's acquisition of such trade or business assets and 
activities from the partnership is not, in and of itself, the 
acquisition of a new or different trade or business. In addition, if a 
partner transfers to a partnership trade or business assets and 
activities that the partner actively conducted immediately before the 
transfer and, immediately after the transfer, the partner is attributed 
the trade or business assets and activities of the partnership under 
paragraph (b)(2)(v) of this section, such transfer is not, in and of 
itself, the acquisition of a new or different trade or business by the 
transferor partner.
    (4) Special rules for an acquisition of a trade or business--(i) In 
general--(A) Application of section 355(b)(2)(C). Under sections 
355(b)(2)(C) and (b)(3), a trade or business or an interest in a 
partnership engaged in a trade or business relied on to meet the 
requirements of section 355(b) must not have been acquired by either 
the DSAG or CSAG during the pre-distribution period unless it was 
acquired in a transaction in which no gain or loss was recognized. 
Further, a trade or business must not have been acquired by either the 
DSAG or CSAG during the pre-distribution period as a result of a 
corporation becoming a subsidiary SAG member unless such corporation 
became a subsidiary SAG member as a result of one or more transactions 
in which no gain or loss was recognized or by reasons of such 
transactions combined with acquisitions before the pre-distribution 
period. This paragraph (b)(4)(i)(A) also applies with respect to any 
acquisition during the pre-distribution period of a trade or business, 
an interest in a partnership engaged in a trade or business, or stock 
of a corporation engaged in a trade or business by a corporation that 
later becomes a subsidiary SAG member. See paragraphs (b)(4)(iv)(C) and 
(b)(4)(iv)(D) of this section regarding the application of this 
paragraph (b)(4)(i)(A) to certain multi-step acquisitions.
    (B) Application of section 355(b)(2)(D). Under section 
355(b)(2)(D), control of distributing must not have been acquired (at 
the time it was conducting the trade or business to be relied on) 
directly or indirectly by any distributee corporation, and control of 
controlled must not have been acquired (at the time it was conducting 
the trade or business to be relied on) directly or indirectly by the 
DSAG, during the pre-distribution period in one or more transactions in 
which gain or loss was recognized. This paragraph (b)(4)(i)(B) also 
applies with respect to any acquisition of stock of controlled during 
the pre-distribution period by a corporation that later becomes a DSAG 
member. For purposes of this paragraph (b)(4)(i)(B), and paragraphs 
(b)(4)(iii)(C) and (b)(4)(iv)(B) of this section, all distributee 
corporations that are affiliates shall be treated as one distributee 
corporation. This paragraph (b)(4)(i)(B) does not apply with respect to 
an acquisition of stock of any corporation other than distributing or 
controlled. See paragraph (b)(4)(iv)(B) of this section regarding the 
application of this paragraph (b)(4)(i)(B) to certain multi-step 
acquisitions of control. Further, see paragraph (b)(4)(iv)(F) of this 
section regarding certain acquisitions of stock in controlled to which 
paragraph (b)(4)(i)(A) of this section (and not this paragraph 
(b)(4)(i)(B)) applies.
    (C) Gain or loss recognized. Any reference to gain or loss 
recognized includes gain or loss treated as recognized under paragraphs 
(b)(4)(ii) or (b)(4)(iv) of this section.
    (ii) Certain transactions treated as transactions in which gain or 
loss is recognized. The common purpose of section 355(b)(2)(C) and (D) 
is to prevent the direct or indirect acquisition of the trade or 
business to be relied on by a corporation in exchange for assets in 
anticipation of a distribution to which section 355 would otherwise 
apply. Generally, if a DSAG member or controlled acquires the trade or 
business solely in exchange for distributing stock, distributing 
acquires control of controlled solely in exchange for distributing 
stock, or controlled acquires the trade or business from distributing 
solely in exchange for stock of controlled, in a transaction in which 
no gain or loss was recognized, the requirements of section 
355(b)(2)(C) and (D) are satisfied. On the other hand, if the trade or 
business is acquired in exchange for assets of distributing (other than 
stock of a corporation in control of distributing used in a 
reorganization) the requirements of section 355(b)(2)(C) and (D) are 
generally not satisfied. For example, acquisitions by controlled (while 
controlled by distributing) from an unrelated party made in exchange 
for controlled stock have the effect of an indirect acquisition by 
distributing in exchange for distributing's assets. Such acquisitions 
violate the purpose of section 355(b)(2)(C) even if no gain or loss is 
recognized. Therefore, as provided in paragraphs (b)(4)(ii)(A) and 
(b)(4)(ii)(B) of this section, if the DSAG or CSAG acquires a trade or 
business, an interest in a partnership engaged in a trade or business, 
or stock of a corporation engaged in a trade or business in exchange 
for assets of the DSAG in a transaction in which no gain or loss is 
recognized, for purposes of paragraph (b)(4)(i) of this section such 
acquisition will be treated as one in which gain or loss is recognized.
    (A) Certain tax-free acquisitions made in exchange for assets. An 
acquisition paid for in whole or in part, directly or indirectly, with 
assets of the DSAG will be treated as an acquisition in which gain or 
loss is recognized even if no gain or loss is actually recognized. 
Acquisitions described in this paragraph (b)(4)(ii)(A) include for 
example, a transaction in which the DSAG or CSAG acquires stock of a 
corporation engaged in the trade or business to be relied on by 
transferring assets not constituting the trade or business to be relied 
on to such corporation in exchange for stock of such corporation, the 
DSAG or CSAG acquires an interest in a partnership engaged in the trade 
or business to be relied on by contributing assets not constituting the 
trade or business to be relied on to the partnership, the DSAG or CSAG 
acquires stock of a corporation engaged in the trade or business in an 
exchange to which section 304(a)(1) applies, or distributing acquires a 
trade or business in exchange for its stock and assets in a transaction 
in which no loss is recognized by virtue of section 351(b). See also 
paragraph (b)(4)(iv)(E) of this section regarding the extent to which 
an acquisition involving the issuance of subsidiary stock constitutes 
an acquisition paid for with assets.

[[Page 26029]]

However, the assumption by the DSAG or CSAG of liabilities of a 
transferor shall not, in and of itself, be treated as the payment of 
assets if such assumption is not treated as the payment of money or 
other property under any other applicable provision. In addition, an 
acquisition in which no gain or loss is recognized consisting of a pro 
rata distribution to which section 355 applies (to the extent the stock 
with respect to which the distribution is made was not acquired during 
the pre-distribution period in a transaction in which gain or loss was 
recognized), a distribution from a partnership that is explicitly 
excluded from paragraph (b)(4)(ii)(B) of this section, a reorganization 
described in section 368(a)(1)(E) or (F), and an exchange to which 
section 1036 applies, are not acquisitions described in this paragraph 
(b)(4)(ii)(A).
    (B) Distributions from partnerships. An acquisition consisting of a 
distribution from a partnership is generally an acquisition paid for 
with assets of the DSAG, and will be treated as an acquisition in which 
gain or loss is recognized even if no gain or loss is actually 
recognized. However, an acquisition consisting of a pro rata 
distribution from a partnership of stock or an interest in lower-tier 
partnership is not an acquisition described in this paragraph 
(b)(4)(ii)(B) (and consequently not described in paragraph 
(b)(4)(ii)(A) of this section) to the extent the distributee partner 
did not acquire the interest in the distributing partnership during the 
pre-distribution period in a transaction in which gain or loss was 
recognized and to the extent the distributing partnership did not 
acquire the distributed stock or partnership interest within such 
period. This paragraph (b)(4)(ii)(B) (and consequently paragraph 
(b)(4)(ii)(A) of this section) does not apply to any partnership 
distribution to which paragraph (b)(3)(iii) of this section (regarding 
distributions from partnerships that are not, in and of themselves, the 
acquisition of a new or different trade or business) applies.
    (iii) Certain transactions in which recognized gain or loss is 
disregarded. The common purpose of section 355(b)(2)(C) and (D) is to 
prevent the direct or indirect acquisition of the trade or business to 
be relied on by a corporation in exchange for assets in anticipation of 
a distribution to which section 355 would otherwise apply. An 
additional purpose of section 355(b)(2)(D) is to prevent a distributee 
corporation from acquiring control of distributing in anticipation of a 
distribution to which section 355 would otherwise apply, enabling the 
disposition of controlled stock without recognizing the appropriate 
amount of gain. The acquisitions described in paragraphs (b)(4)(iii)(A) 
through (b)(4)(iii)(C) of this section are not the types of 
acquisitions to which section 355(b)(2)(C) or (D) is intended to apply. 
Therefore, for purposes of paragraph (b)(4)(i) of this section, the 
recognition of gain or loss is disregarded if a trade or business, an 
interest in a partnership engaged in a trade or business, or stock of a 
corporation engaged in a trade or business is acquired in a transaction 
described in any of paragraphs (b)(4)(iii)(A) through (b)(4)(iii)(C) of 
this section.
    (A) Transfers to controlled. An acquisition by the CSAG from the 
DSAG provided the DSAG controls controlled immediately after the 
acquisition.
    (B) Cash for fractional shares. An acquisition that would satisfy 
the requirements of paragraph (b)(4)(i) of this section but for the 
payment of cash to shareholders for fractional shares in the 
transaction, provided that the cash paid represents a mere rounding off 
of the fractional shares in the exchange and is not separately 
bargained for consideration.
    (C) Certain acquisitions of control of distributing. A direct or 
indirect acquisition by a distributee corporation of control of 
distributing, in one or more transactions, where the basis of the 
acquired distributing stock in the hands of the distributee corporation 
is determined in whole by reference to the transferor's basis. This 
paragraph (b)(4)(iii)(C) is only applicable with respect to a 
distribution by the acquired distributing, and does not apply for 
purposes of any subsequent distribution by any distributee corporation.
    (iv) Operating rules for acquisitions--(A) Predecessors. References 
to a corporation shall include references to a predecessor of such 
corporation. For this purpose, a predecessor of a corporation is a 
corporation that transfers its assets to such corporation in a 
transaction to which section 381 applies.
    (B) Certain multi-step acquisitions of control of distributing or 
controlled. A distributee corporation's acquisition of stock in 
distributing or a DSAG's acquisition of stock in controlled in one or 
more transactions in which gain or loss was recognized during the pre-
distribution period will not prevent a distributee corporation's 
acquisition of distributing stock or a DSAG's acquisition of controlled 
stock constituting control of distributing or controlled in one or more 
separate transactions in which no gain or loss is recognized from 
satisfying the requirements of paragraph (b)(4)(i)(B) of this section, 
provided that, at the time control of distributing or controlled is 
first acquired, the acquiring distributee corporation owns an amount of 
distributing stock or the acquiring DSAG owns an amount of controlled 
stock, as the case may be, constituting control that was acquired in 
one or more transactions in which no gain or loss was recognized or by 
reason of such transactions combined with acquisitions before the pre-
distribution period. The principles of this paragraph (b)(4)(iv)(B) 
will be applied with respect to an indirect acquisition of distributing 
or controlled stock.
    (C) Certain multi-step acquisitions of a subsidiary SAG member. An 
acquisition of stock in a corporation (target) by a SAG in one or more 
transactions in which gain or loss was recognized during the pre-
distribution period will not prevent a SAG's acquisition of target 
stock resulting in target becoming a subsidiary SAG member in one or 
more separate transactions in which no gain or loss is recognized from 
satisfying the requirements of paragraph (b)(4)(i)(A) of this section, 
provided that, at the time that target first becomes a subsidiary SAG 
member, the SAG owns an amount of target stock meeting the requirements 
of section 1504(a)(2) that was acquired in one or more transactions in 
which no gain or loss was recognized or by reason of such transactions 
combined with acquisitions before the pre-distribution period. The 
principles of this paragraph (b)(4)(iv)(C) will be applied with respect 
to an indirect acquisition of target stock by the SAG.
    (D) Certain multi-step asset acquisitions. Notwithstanding 
paragraph (b)(4)(i)(A) of this section, if immediately before a SAG's 
direct acquisition of a trade or business (or an interest in a 
partnership engaged in a trade or business) held by a corporation 
(owner) in a transaction to which section 381 applies and in which no 
gain or loss is recognized, the SAG owns an amount of stock of the 
owner that it acquired in one or more transactions during the pre-
distribution period in which gain or loss was recognized such that all 
of the other stock of the owner does not meet the requirements of 
section 1504(a)(2), such direct acquisition shall be treated as a 
transaction in which gain or loss was recognized. The principles of 
this paragraph (b)(4)(iv)(D) will be applied with respect to an 
indirect acquisition of the owner stock by the SAG.

[[Page 26030]]

    (E) Acquisitions involving the issuance of subsidiary stock. If a 
SAG directly or indirectly owns stock of a subsidiary (including a 
subsidiary SAG member) and the subsidiary directly or indirectly 
acquires a trade or business, an interest in a partnership engaged in a 
trade or business, or stock of a corporation engaged in a trade or 
business from a person other than such SAG in exchange for stock of 
such subsidiary in a transaction in which no gain or loss is recognized 
(the acquisition), solely for purposes of applying this paragraph 
(b)(4) with respect to the trade or business, partnership interest, or 
stock acquired by the subsidiary in the acquisition, the subsidiary's 
stock directly or indirectly owned by the SAG immediately after the 
acquisition is treated as acquired at the time of the acquisition in a 
transaction in which gain or loss is recognized.
    (F) Acquisitions of controlled stock where controlled is or becomes 
a DSAG member. With respect to an acquisition of stock in controlled, 
if controlled is or becomes a DSAG member, paragraph (b)(4)(i)(A) of 
this section applies and paragraph (b)(4)(i)(B) of this section does 
not apply for purposes of determining whether the requirements of 
section 355(b) are satisfied with respect to controlled.
    (G) Treatment of stock received in certain tax-free exchanges. Any 
stock received in a reorganization described in section 368(a)(1)(E) or 
(F), or in an exchange to which section 1036 applies, in which no gain 
or loss is recognized is treated as acquired in the same manner as the 
stock surrendered.
    (H) Situations where the separate existence of a subsidiary SAG 
member is respected. The separate existence of a subsidiary SAG member 
will be respected for purposes of determining whether a transaction 
qualifies for nonrecognition treatment under other provisions of the 
Internal Revenue Code. For example, for purposes of determining whether 
section 351 applies or whether the transaction qualifies as a 
reorganization described in section 368(a), the separate existence of 
the subsidiary SAG member is respected.
    (c) Definitions. For purposes of this section the following 
definitions apply:
    (1) Affiliate. An affiliate is any member of an affiliated group as 
defined in section 1504(a) (without regard to section 1504(b)).
    (2) Controlled. Controlled is the controlled corporation.
    (3) Distributing. Distributing is the distributing corporation.
    (4) Pre-distribution period. The pre-distribution period is the 
five-year period ending on the date of the distribution.
    (d) Conventions and examples--(1) Conventions. The examples in 
paragraph (d)(2) of this section illustrate section 355(b) and this 
section. No inference should be drawn from any of these examples as to 
whether any requirements of section 355 other than those of section 
355(b), as specified, are satisfied. Throughout these examples, C, D, 
D2, P, S, S1, S2, S3, T, X, Y, and Z are corporations, and Partnership 
is an entity that is treated as a partnership for Federal income tax 
purposes under Sec.  301.7701-3 of this chapter. Further, assume any 
transfer described in Examples 1 through 25 that is not identified as a 
purchase (defined in paragraph (d)(1)(iii) of this section) satisfies 
all the requirements of paragraph (b)(4) of this section as a 
transaction in which no gain or loss is recognized. Except as otherwise 
provided, for more than five years D has owned section 368(c) stock (as 
defined in paragraph (d)(1)(iv) of this section) but not section 
1504(a)(2) stock (as defined in paragraph (d)(1)(v) of this section) of 
C. Furthermore, the following definitions apply:
    (i) ATB. ATB is any active trade or business. ATB1 and ATB2 are not 
in the same line of business under paragraph (b)(3)(ii) of this 
section.
    (ii) New subsidiary. A new subsidiary is a newly formed wholly 
owned corporation.
    (iii) Purchase. A purchase is an acquisition for cash.
    (iv) Section 368(c) stock. Section 368(c) stock is stock 
constituting control within the meeting of section 368(c).
    (v) Section 1504(a)(2) stock. Section 1504(a)(2) stock is stock 
meeting the requirements of section 1504(a)(2).
    (2) Examples. Generally, Examples 1 and 2 illustrate the general 
requirements in paragraph (a) of this section, Examples 3 through 9 
illustrate the SAG rules in paragraphs (b)(1)(ii) and (b)(1)(iii) of 
this section, Examples 10 through 25 illustrate the rules regarding the 
active trade or business and active conduct for the pre-distribution 
period in paragraphs (b)(2) and (b)(3) of this section, Examples 26 
through 40 illustrate the acquisition rules in paragraphs (b)(4)(i) 
through (b)(4)(iii) of this section, and Examples 41 through 51 
illustrate the operating rules for acquisitions in paragraph (b)(4)(iv) 
of this section. The examples are as follows:

    Example 1. Spin-off. For more than five years, D and C have 
engaged in the active conduct of ATB1 and ATB2, respectively. D 
distributes the C stock to the D shareholders, and each corporation 
continues the active conduct of its respective trade or business. 
Because both D and C are engaged in the active conduct of a trade or 
business immediately after the distribution and such trades or 
businesses have been actively conducted by such corporations 
throughout the pre-distribution period, the requirements of section 
355(b) have been satisfied. See paragraphs (a)(1) and (b)(3) of this 
section.
    Example 2. Split-up. The facts are the same as Example 1 except 
that D transfers all of its assets (including ATB1) other than the C 
stock to new subsidiary S, and then distributes the C stock and S 
stock to the D shareholders. Because C and S are respectively 
engaged in the active conduct of ATB2 and ATB1 immediately after the 
distribution, ATB2 has been actively conducted by C throughout the 
pre-distribution period, and together D (prior to the transfer to S) 
and S (after the transfer to S) have actively conducted ATB1 
throughout the pre-distribution period, the requirements of section 
355(b) have been satisfied. See paragraphs (a)(2) and (b)(3) of this 
section.
    Example 3. Subsidiary SAG member's business. For more than five 
years, D has owned section 1504(a)(2) stock but not section 368(c) 
stock of S . Throughout this period, C and S have engaged in the 
active conduct of ATB1 and ATB2, respectively. In year 8, D 
distributes the C stock to the D shareholders. Because D owns 
section 1504(a)(2) stock of S, S is a DSAG member. See paragraph 
(b)(1)(iii) of this section. D and S are treated as one corporation 
for purposes of determining whether D is engaged in an active trade 
or business. See paragraph (b)(1)(ii) of this section. Therefore, D 
is engaged in the active conduct of ATB2 both throughout the pre-
distribution period and immediately after the distribution. 
Accordingly, D and C both satisfy the requirements of section 
355(b).
    Example 4. Additional subsidiary SAG member shares acquired. The 
facts are the same as Example 3 except that in year 6, D acquires 
the remaining S stock. D's acquisition of the remaining S stock in 
year 6 has no effect for purposes of determining whether D satisfies 
the requirements of section 355(b)(2)(C) because the DSAG is already 
engaged in the active conduct of ATB2. See paragraph (b)(1)(ii) of 
this section. Section 355(b)(2)(D) does not apply to D's acquisition 
of S stock. See paragraph (b)(4)(i)(B) of this section. Accordingly, 
D and C both satisfy the requirements of section 355(b).
    Example 5. Segmented CSAG business. For more than five years, C 
has owned all the stock of S1, S2, and S3. Throughout this period, D 
has engaged in the active conduct of ATB1. Throughout this same 
period, S1, S2, and S3 have each engaged in a different essential 
segment of ATB2. While the three segments of ATB2 would together 
constitute the active conduct of a trade or business, none of S1, 
S2, or S3 would be considered engaged in the active conduct of an 
ATB individually. In year 6, D distributes the C stock to the D 
shareholders. C owns section 1504(a)(2) stock of S1, S2, and S3, 
therefore,

[[Page 26031]]

C, S1, S2, and S3 are CSAG members. See paragraph (b)(1)(iii) of 
this section. C, S1, S2, and S3 are treated as one corporation for 
purposes of determining whether C is engaged in the active conduct 
of a trade or business. See paragraph (b)(1)(ii) of this section. 
Therefore, C is engaged in the active conduct of ATB2 both 
throughout the pre-distribution period and immediately after the 
distribution. Accordingly, D and C both satisfy the requirements of 
section 355(b).
    Example 6. Segmented DSAG business. The facts are the same as 
Example 5 except that D owns all of the C stock and all of the S3 
stock, and D transfers the S3 stock to C immediately prior to the 
distribution. Prior to D's transfer of the S3 stock to C, D owns 
section 1504(a)(2) stock of S3 and C, and C owns section 1504(a)(2) 
stock of S1 and S2, therefore, D, C, S1, S2, and S3 are DSAG 
members. See paragraph (b)(1)(iii) of this section. D, C, S1, S2, 
and S3 are treated as one corporation for purposes of determining 
whether D and C are engaged in the active conduct of a trade or 
business, and accordingly the transfer of the S3 stock to C is 
disregarded. See paragraph (b)(1)(ii) of this section. After the 
transfer, C owns section 1504(a)(2) stock of S3, and the CSAG 
includes C, S1, S2, and S3. See paragraph (b)(1)(iii) of this 
section. C, S1, S2, and S3 are treated as one corporation for 
purposes of determining whether C is engaged in the active conduct 
of a trade or business. See paragraph (b)(1)(ii) of this section. 
Throughout the pre-distribution period, D, C, S1, S2, and S3 are 
treated as one corporation and both D and C are engaged in the 
active conduct of ATB1 and ATB2. See paragraphs (b)(1) and (b)(2) of 
this section. Immediately after the distribution, D is engaged in 
the active conduct of ATB1 and C is engaged in the active conduct of 
ATB2. Because D and C were engaged in the active conduct of ATB1 and 
ATB2 throughout the pre-distribution period and, immediately after 
the distribution, D is engaged in the active conduct of ATB1 and C 
is engaged in the active conduct of ATB2, D and C both satisfy the 
requirements of section 355(b).
    Example 7. Failed segmented business. The facts are the same as 
Example 6 except that D owns section 368(c) stock but not section 
1504(a)(2) stock of C. Prior to D's transfer of the S3 stock, the 
DSAG includes only D and S3, and the CSAG includes only C, S1, and 
S2. See paragraph (b)(1)(iii) of this section. Therefore, prior to 
the transfer of the S3 stock, ATB2 does not exist because no one SAG 
conducts all three of the essential segments of the trade or 
business. Accordingly, C does not satisfy the requirements of 
section 355(b) because ATB2 was not actively conducted throughout 
the pre-distribution period. See paragraph (b)(3)(i) of this 
section.
    Example 8. Jointly owned partnership. For more than five years, 
D has owned all of the stock of C, and D and C each have owned a 17-
percent interest in Partnership. Throughout this period, D and 
Partnership have engaged in the active conduct of ATB1 and ATB2, 
respectively. In year 6, D transfers its 17-percent interest in 
Partnership to C and distributes all of the C stock to the D 
shareholders. Because D owns section 1504(a)(2) stock of C, C is a 
DSAG member. See paragraph (b)(1)(iii) of this section. D and C are 
treated as one corporation for purposes of determining whether D and 
C are engaged in the active conduct of a trade or business. See 
paragraph (b)(1)(ii) of this section. Accordingly, throughout the 
pre-distribution period, D and C are each treated as owning a 34-
percent interest in Partnership. As such, both D and C are treated 
as engaged in the active conduct of both ATB1 and ATB2 throughout 
the pre-distribution period. See paragraphs (b)(2)(v)(A) and 
(b)(2)(v)(B) of this section. The transfer of the Partnership 
interest is disregarded because it is between SAG members. See 
paragraph (b)(1)(ii) of this section. After the distribution, C owns 
34 percent of Partnership and is therefore engaged in the active 
conduct of ATB2. See paragraphs (b)(2)(v)(A) and (b)(2)(v)(B) of 
this section. Therefore, D and C both satisfy the requirements of 
section 355(b).
    Example 9. Sequential application of the SAG rule--(i) Facts. 
For more than five years, D2 has owned all of the stock of D, and D 
has owned all of the stock of C. Throughout this period, D2 has 
engaged in the active conduct of ATB1 and ATB2, and D has engaged in 
the active conduct of ATB1. C, individually, has not engaged in the 
active conduct of any ATB. In year 6, D distributes all of the C 
stock to D2 (first distribution). Immediately thereafter, D2 
transfers ATB2 to C and distributes all of the C stock to the D2 
shareholders (second distribution).
    (ii) Analysis--first distribution. Because D owns section 
1504(a)(2) stock of C, C is a DSAG member prior to the first 
distribution. See paragraph (b)(1)(iii) of this section. D and C are 
treated as one corporation for purposes of determining whether D and 
C are engaged in the active conduct of a trade or business with 
respect to the first distribution. See paragraphs (b)(1)(ii) and 
(b)(1)(iii) of this section. Accordingly, throughout the pre-
distribution period, D and C are each treated as engaged in ATB1 
with respect to the first distribution. However, for purposes of 
determining whether D's distribution of the C stock to D2 satisfies 
the requirements of section 355(b) immediately after the first 
distribution, C is the only CSAG member (D2 is not a member of any 
SAG with respect to the first distribution). See paragraph 
(b)(1)(iii) of this section. Accordingly, C does not satisfy the 
requirements of section 355(b) with respect to the first 
distribution because C is not engaged in the active conduct of an 
ATB immediately after the first distribution.
    (iii) Analysis--second distribution. Because D2 owns section 
1504(a)(2) stock of D and C (and D owned section 1504(a)(2) stock of 
C before the first distribution), D2, D, and C are D2 SAG members 
throughout the pre-distribution period with respect to the second 
distribution. See paragraph (b)(1)(iii) of this section. Further, 
for purposes of the second distribution D's distribution of the C 
stock to D2 is disregarded because it is between D2 SAG members. See 
paragraphs (b)(1)(ii) and (b)(1)(iii) of this section. D2, D, and C 
are treated as one corporation for purposes of determining whether 
D2 and C are engaged in the active conduct of a trade or business 
with respect to the second distribution. See paragraphs (b)(1)(ii) 
and (b)(1)(iii) of this section. Accordingly, throughout the pre-
distribution period, D2 and C are each treated as engaged in the 
active conduct of ATB1 and ATB2 with respect to the second 
distribution. The transfer of ATB2 to C is disregarded because it is 
between D2 SAG members. See paragraph (b)(1)(ii) of this section. 
Immediately after the second distribution, C is engaged the active 
conduct of ATB2. Therefore, D2 and C both satisfy the requirements 
of section 355(b) with respect to the second distribution.
    Example 10. Limitations--securities and vacant land. For more 
than five years, D has owned investment securities and vacant land. 
D has conducted no activities with respect to the vacant land, but D 
will subsequently subdivide the vacant land, install streets and 
utilities, and sell the developed lots to various homebuilders. D 
cannot currently satisfy the requirements of section 355(b) because 
the holding of investment securities does not constitute the active 
conduct of a trade or business. See paragraph (b)(2)(iv)(A) of this 
section. Furthermore, no significant development activities have 
been conducted with respect to the vacant land. See paragraph (b)(3) 
of this section.
    Example 11. Limitations--occupied real estate--active. For more 
than five years, D, a bank, has owned an eleven-story office 
building, the ground floor of which D has occupied while engaged in 
the active conduct of its banking business. The remaining ten floors 
are rented to various tenants. Throughout this period, the building 
has been managed, operated, repaired, and maintained by employees of 
D. D transfers the building along with the significant assets used 
to operate the building and the goodwill associated with the 
building to new subsidiary C and distributes the C stock to the D 
shareholders. Henceforth, C's employees will manage, operate, 
repair, and maintain the building. D and C both satisfy the 
requirements of section 355(b). See paragraph (b)(3) of this 
section.
    Example 12. Limitations--occupied real estate--not active. For 
more than five years, D, a bank, has owned a two-story building, the 
ground floor and one half of the second floor of which D has 
occupied while engaged in the active conduct of its banking 
business. The other half of the second floor has been rented as 
storage space to a neighboring retail merchant. D transfers the 
building and the goodwill associated with the building to new 
subsidiary C and distributes the C stock to the D shareholders. 
After the distribution, D leases from C the space in the building 
that it formerly occupied. Under the lease, D will repair and 
maintain its portion of the building and pay property taxes and 
insurance. C does not satisfy the requirements of section 355(b) 
because it is not engaged in the active conduct of a trade or 
business immediately after the distribution. See paragraph 
(b)(2)(iv)(A) of this section. This example does not address the 
question of whether the activities of D with respect to the building 
prior to the separation would constitute the active conduct of a 
trade or business.
    Example 13. No significant activities. For more than five years, 
D owned land on which

[[Page 26032]]

it has engaged in the active conduct of the ranching business. Oil 
has been discovered in the area, and it is apparent that oil may be 
found under the land on which the ranching business is conducted. D 
has engaged in no significant activities in connection with its 
mineral rights. D transfers its mineral rights to new subsidiary C 
and distributes the C stock to the D shareholders. C will actively 
pursue the development of the oil producing potential of the 
property. C does not satisfy the requirements of section 355(b) 
after the distribution because D was not engaged in significant 
exploitation activities with respect to the mineral rights 
throughout the pre-distribution period. See paragraph (b)(3) of this 
section.
    Example 14. Vertical division--state contracts. For more than 
five years, D has engaged in the active conduct of a single business 
of constructing sewage disposal plants and other facilities. D 
transfers one half of its assets to new subsidiary C. These assets 
include a contract for the construction of a sewage disposal plant 
in State M, construction equipment, cash, goodwill, and other 
tangible and significant assets. D retains a contract for the 
construction of a sewage disposal plant in State N, construction 
equipment, cash, goodwill, and other tangible and significant 
assets. D distributes the C stock to one of D's shareholders in 
exchange for all of his D stock. D and C both satisfy the 
requirements of section 355(b). See paragraphs (b)(2) and (b)(3)(i) 
of this section.
    Example 15. Vertical division--location. For more than five 
years, D has engaged in the active conduct of owning and operating 
two men's retail clothing stores, one in the downtown area of the 
City of G and one in a suburban area of G. D transfers the store 
building, fixtures, inventory, and other significant assets related 
to the operations of the suburban store and the goodwill 
attributable to that store to new subsidiary C. D also transfers to 
C the delivery trucks and delivery personnel that formerly served 
both stores. Henceforth, D will contract with a local public 
delivery service to make its deliveries. D retains the warehouses 
that formerly served both stores. Henceforth, C will lease warehouse 
space from an unrelated public warehouse company. D then distributes 
the C stock to the D shareholders. D and C both satisfy the 
requirements of section 355(b). See paragraphs (b)(2) and (b)(3)(i) 
of this section.
    Example 16. Horizontal division--research. For more than five 
years, D has engaged in the active conduct of manufacturing and sale 
of household products. Throughout this period, D has maintained a 
research department for use in connection with its manufacturing 
activities. The research department has 30 employees actively 
engaged in the development of new products. D transfers the research 
department (which has significant assets and goodwill) to new 
subsidiary C and distributes the C stock to the D shareholders. 
After the distribution, C continues its research operations on a 
contractual basis with several corporations, including D. D and C 
both satisfy the requirements of section 355(b). See paragraphs 
(b)(2) and (b)(3)(i) of this section. The result is the same if, 
after the distribution, C continues its research operations but 
furnishes its services only to D. See paragraphs (b)(2) and 
(b)(3)(i) of this section. However, see Sec.  1.355-2(d)(2)(iv)(C) 
(related function device factor) for possible evidence of device.
    Example 17. Horizontal division--sales. For more than five 
years, D has engaged in the active conduct of processing and selling 
meat products. D derives income from no other source. D separates 
the sales function from the processing function by transferring the 
significant business assets related to the sales function, the 
goodwill associated with the sales function, and cash for working 
capital to new subsidiary C. D then distributes the C stock to the D 
shareholders. After the distribution, C purchases for resale the 
meat products processed by D. D and C both satisfy the requirements 
of section 355(b). See paragraphs (b)(2) and (b)(3)(i) of this 
section. However, see Sec.  1.355-2(d)(2)(iv)(C) (related function 
device factor) for possible evidence of device.
    Example 18. Expansion and vertical division--location. For more 
than five years, D has engaged in the active conduct of owning and 
operating hardware stores in several states. In year 6, D purchased 
all of the assets of a hardware store in State M, where D had not 
previously conducted business. In year 8, D transfers the State M 
hardware store and related significant assets and goodwill to new 
subsidiary C and distributes the C stock to the D shareholders. 
After the distribution, the State M hardware store has its own 
manager and is operated independently of the other stores. Because--
    (i) The product of the State M hardware store is similar to the 
product of D's hardware stores in the other states;
    (ii) The business activities associated with the operation of 
the State M hardware store are the same as the business activities 
associated with the operation of D's hardware stores in the other 
states; and
    (iii) The operation of a hardware store in State M involves the 
use of the experience and know-how that D developed in the operation 
of the hardware stores in the other states, the hardware store in 
State M is in the same line of business as the hardware stores in 
the other states. Therefore, the acquisition of the State M hardware 
store constitutes an expansion of D's existing business and its 
acquisition does not constitute the acquisition of a new or 
different business under paragraph (b)(3)(ii) of this section. 
Accordingly, D and C both satisfy the requirements of section 
355(b).
    Example 19. Expansion and horizontal division--Internet. For 
more than five years, D has engaged in the active conduct of 
operating a retail shoe store business, under the name D. Throughout 
this period, D's sales are made exclusively to customers who 
frequent its retail stores in shopping malls and other locations. 
D's business enjoys favorable name recognition, customer loyalty, 
and other elements of goodwill in the retail shoe market. D creates 
an Internet Web site and begins selling shoes at retail on the Web 
site. To a significant extent, the operation of the Web site draws 
upon D's existing experience and know-how. The Web site is named 
``D.com'' to take advantage of the name recognition, customer 
loyalty, and other elements of goodwill associated with D and the D 
name and to enhance the Web site's chances for success in its 
initial stages. Eight months after beginning to sell shoes on the 
Web site, D transfers all of the Web site's assets and liabilities 
(all of which include the significant assets and goodwill associated 
with the Web site's business) to new subsidiary C and distributes 
the C stock to the D shareholders. The product of the retail shoe 
store business and the product of the Web site are the same (shoes), 
and the principal business activities of the retail shoe store 
business are the same as those of the Web site (purchasing shoes at 
wholesale and reselling them at retail). Although selling shoes on a 
Web site requires some know-how not associated with operating a 
retail store, such as familiarity with different marketing 
approaches, distribution chains, and technical operations issues, 
the Web site's operation does draw to a significant extent on D's 
existing experience and know-how, and the Web site's success will 
depend in large measure on the goodwill associated with D and the D 
name. Therefore, the creation by D of the Internet Web site does not 
constitute the acquisition of a new or different business under 
paragraph (b)(3)(ii) of this section. Accordingly, it is an 
expansion of D's retail shoe store business, all of which is treated 
as having been actively conducted throughout the pre-distribution 
period. Therefore, D and C both satisfy the requirements of section 
355(b).
    Example 20. Expansion--acquiring a SAG member. For more than 
five years, D has owned all of the stock of C. Throughout this 
period, C and unrelated T have engaged in the active conduct of 
ATB1. In year 6, D purchases all of the T stock. In year 8, D 
distributes all of the C stock to the D shareholders. Throughout the 
period that C is a DSAG member, D is engaged in the active conduct 
of ATB1. See paragraph (b)(1)(ii) of this section. Moreover, because 
D acquired section 1504(a)(2) stock of T, D is treated as having 
acquired T's assets (and activities), and that acquisition 
constitutes an expansion of ATB1. See paragraphs (b)(1)(ii) and 
(b)(3)(ii) of this section. Therefore, D and C both satisfy the 
requirements of section 355(b). The result would be the same if D 
had owned all of the T stock for more than five years, and purchased 
all of the C stock in year 6. See paragraphs (b)(1)(ii), (b)(3)(ii), 
(b)(4)(i), and (b)(4)(iv)(F) of this section.
    Example 21. No expansion--acquiring only control of controlled. 
For more than five years, D and unrelated C have engaged in the 
active conduct of ATB1. In year 6, D purchases section 368(c) stock 
but not section 1504(a)(2) stock of C. In year 8, D distributes the 
C stock to the D shareholders. While D and C are in the same line of 
business, the acquisition does not result in an expansion of D's 
business under paragraph (b)(3)(ii) of this section because D is not 
treated as having acquired C's assets (and activities). Accordingly, 
D has acquired control of C in violation of section 355(b)(2)(D). 
See paragraph (b)(4)(i)(B) of this section. However, if D acquires 
additional C

[[Page 26033]]

stock thereby causing C to become a DSAG member, D would be treated 
as having acquired C's assets (and activities) and the acquisition 
would constitute an expansion of ATB1. See paragraphs (b)(1)(ii), 
(b)(3)(ii), (b)(4)(i), and (b)(4)(iv)(F) of this section. In such a 
case, D and C both would satisfy the requirements of section 355(b).
    Example 22. Partnership--meaningful but not significant. For 
more than five years, unrelated X and Y have owned a 20-percent and 
33 1/3-percent interest, respectively, in Partnership. The remaining 
interests in Partnership are owned by unrelated parties. For more 
than five years, Partnership has manufactured power equipment. But 
for the performance of all its management functions by employees of 
X, Partnership would satisfy all the requirements of paragraph 
(b)(2)(i) of this section. X and/or Y will be attributed the trade 
or business assets and activities of Partnership only if the 
corporation satisfies the requirements of paragraph (b)(2)(v)(B) or 
(b)(2)(v)(C) of this section. See paragraph (b)(2)(v)(A) of this 
section. While X does not satisfy the requirements of paragraph 
(b)(2)(v)(B) of this section because X's interest in Partnership is 
not significant, under paragraph (b)(2)(v)(C) of this section, X 
owns a meaningful interest in Partnership and performs active and 
substantial management functions for the trade or business assets 
and activities of Partnership. Therefore, X is attributed the trade 
or business assets and activities of Partnership. Accordingly, X is 
engaged in the active conduct of the business of manufacturing power 
equipment. See paragraph (b)(2) of this section. In determining 
whether Y is engaged in the business of manufacturing power 
equipment, the management functions performed by X for Partnership 
are not taken into account. See paragraph (b)(2)(v)(A) of this 
section. Therefore, although Y is attributed Partnership's trade or 
business assets and activities under paragraph (b)(2)(v)(B) of this 
section because Y owns a significant interest in Partnership, Y is 
not engaged in the business of manufacturing power equipment because 
neither Y nor Partnership perform any management functions for the 
business. See paragraph (b)(2)(iii) of this section.
    Example 23. Partnership--significant but not meaningful. The 
facts are the same as Example 22 except that all the management 
functions related to the business of Partnership are performed by 
employees of Partnership. Because employees of Partnership perform 
all of the management functions related to the trade or business 
assets and activities of manufacturing power equipment, Partnership 
itself satisfies all the requirements of paragraph (b)(2)(i) of this 
section. X neither owns a significant interest in Partnership nor 
performs active and substantial management functions with respect to 
the trade or business assets and activities of Partnership. 
Accordingly, X does not satisfy the requirements of paragraph 
(b)(2)(v)(B) or (b)(2)(v)(C) of this section, X is not attributed 
the trade or business assets and activities of Partnership's 
business of manufacturing power equipment, and X is not engaged in 
the active conduct of the business of manufacturing power equipment. 
On the other hand, because Y owns a significant interest in 
Partnership, Y satisfies the requirements of paragraph (b)(2)(v)(B) 
of this section. Therefore, Y is attributed the trade or business 
assets and activities of Partnership's business. Accordingly, Y 
satisfies the requirements of paragraph (b)(2)(i) of this section 
and is engaged in the active conduct of the business of 
manufacturing power equipment.
    Example 24. Partnership--significant by many. The facts are the 
same as Example 23 except that X, Y, and Z each own a 33 1/3-percent 
interest in Partnership. Because X, Y, and Z each own a significant 
interest in Partnership, each of X, Y, and Z satisfy the 
requirements of paragraph (b)(2)(v)(B) of this section. Accordingly, 
each of X, Y, and Z are attributed the trade or business assets and 
activities of Partnership, satisfy the requirements of paragraph 
(b)(2)(i) of this section, and are engaged in the active conduct of 
the business of manufacturing power equipment.
    Example 25. Non-SAG affiliates--(i) Facts. For more than five 
years, X has owned 10 percent of the stock of D2, D2 has owned all 
the stock of D and S, and D has owned all the stock of C. Throughout 
this period, D has manufactured furniture that it sells to furniture 
stores and has been the principal owner of the goodwill and 
significant assets associated with that business and C has owned and 
operated a laundry business and has been the principal owner of the 
goodwill and significant assets associated with that business. 
Throughout this period, however, employees of S have performed all 
the active and substantial management and operational functions of 
the furniture business for D and the laundry business for C. D 
distributes the C stock to D2 (first distribution) and D2 
distributes the C stock to X in exchange for all of X's D2 stock 
(second distribution). After the distributions, employees of X 
perform all the active and substantial management and operational 
functions of the laundry business for C that the employees of S 
performed before the distributions and the employees of S continue 
to perform the same activities for D as they did before the 
distributions.
    (ii) Analysis--first distribution. In determining whether the 
furniture manufacturing business and laundry business have been 
actively conducted throughout the pre-distribution period and 
immediately after the first distribution, the activities performed 
for those businesses include activities performed by employees of 
affiliates of D and C (even if they are not DSAG or CSAG members). 
Accordingly, such activities include the activities performed by the 
employees of S for D and C. See paragraph (b)(2)(iii) of this 
section. D and C own the goodwill and significant assets associated 
with their respective businesses both throughout the pre-
distribution period and immediately after the first distribution, 
and are treated as performing active and substantial management and 
operational functions for their respective businesses both 
throughout the pre-distribution period and immediately after the 
first distribution. Therefore, D and C both satisfy the requirements 
of section 355(b) with respect to the first distribution.
    (iii) Analysis--second distribution. Because D2 owns section 
1504(a)(2) stock of D, C, and S (and D owned section 1504(a)(2) 
stock of C before the first distribution), D2, D, C, and S are D2 
SAG members throughout the pre-distribution period with respect to 
the second distribution. See paragraph (b)(1)(iii) of this section. 
Accordingly, D2, D, C, and S are treated as one corporation for 
purposes of determining whether D2 is engaged in an active trade or 
business with respect to the second distribution. See paragraph 
(b)(1)(ii) of this section. Accordingly, for purposes of the second 
distribution, D2 has been engaged in the furniture manufacturing 
business and the laundry business throughout the pre-distribution 
period. Further, for purposes of the second distribution D's 
distribution of the C stock to D2 is disregarded because it is 
between D2 SAG members. See paragraph (b)(1)(ii) of this section. D 
and S continue to be D2 SAG members immediately after the second 
distribution. See paragraph (b)(1)(iii) of this section. 
Accordingly, D2 is engaged in the furniture manufacturing business 
immediately after the second distribution. In determining whether C 
is engaged in the active conduct of a trade or business immediately 
after the second distribution, the activities performed for the 
laundry business include activities performed by employees of 
affiliates of C (even if they are not CSAG members). Accordingly, 
immediately after the second distribution, such activities include 
the activities performed for C by the employees of X. See paragraph 
(b)(2)(iii) of this section. C owns the goodwill and significant 
assets associated with the laundry business both throughout the pre-
distribution period and immediately after the second distribution, 
and is treated as performing active and substantial management and 
operational functions both throughout the pre-distribution period 
and immediately after the second distribution. Therefore, D2 and C 
both satisfy the requirements of section 355(b) with respect to the 
second distribution.
    Example 26. Purchased ATB and SAG member. For more than five 
years, P has owned all of the stock of D and S1, and D and S1 have 
owned all of the stock of S2 and S3, respectively. Throughout this 
period, S1 and S3 have engaged in the active conduct of ATB1 and 
ATB2, respectively. In year 6, S2 purchases ATB1 and all of the S3 
stock from S1 on the same day. In year 6, the DSAG acquired ATB1 and 
ATB2 (as a result of S3 becoming a DSAG member) in a transaction in 
which gain or loss was recognized. Accordingly, if D were to make a 
distribution, it could not rely on ATB1 or ATB2 to satisfy the 
requirements of section 355(b) unless the DSAG's year 6 acquisition 
of ATB1 and ATB2 is not in the pre-distribution period. See 
paragraph (b)(4)(i)(A) of this section. The fact that S2 acquired 
ATB1 and the S3 stock from an affiliate is not relevant.
    Example 27. Purchased ATB prior to entering. For more than five 
years, T has engaged in the active conduct of ATB1. In year 6, S 
purchased ATB1 from T. In year 7, D acquired all of the S stock from 
the S shareholders solely in exchange for D stock

[[Page 26034]]

in a transaction to which section 351 applied and in which no gain 
or loss was recognized. As a result, S became a DSAG member. 
Although S became a DSAG member in a transaction in which no gain or 
loss was recognized, S, a corporation that later became a DSAG 
member, acquired ATB1 in a transaction in which gain or loss was 
recognized. Accordingly, if the D were to make a distribution, it 
could not rely on ATB1 to satisfy the requirements of section 355(b) 
unless S's year 6 acquisition of ATB1 is not in the pre-distribution 
period. See paragraph (b)(4)(i)(A) of this section.
    Example 28. ATB (or new SAG member) for stock of distributing or 
a corporation in control of distributing in a reorganization--
transfer of ATB to controlled. For more than five years, unrelated T 
and Z have owned all of the stock of X and Y, respectively, and X 
and Y have engaged in the active conduct of ATB1 and ATB2, 
respectively. Unrelated P owns all of the stock of D. In year 6, D 
acquires all of X's assets (including ATB1) from X solely in 
exchange for D stock in a reorganization described in section 
368(a)(1)(A), and all of Y's assets (including ATB2) from Y solely 
in exchange for P stock in a reorganization described in section 
368(a)(1)(A) by reason of section 368(a)(2)(D). No gain or loss is 
recognized on either acquisition. In a separate transaction, D 
transfers ATB2 to new subsidiary C in exchange for all of the C 
stock in a transaction that satisfies the requirements of section 
351 and in which no gain or loss is recognized. If D were to 
distribute the C stock in a separate transaction, D and C can rely 
on ATB1 and ATB2, respectively, to satisfy the requirements of 
section 355(b). ATB1 and ATB2 were acquired in transactions in which 
no gain or loss was recognized, and were not acquired in exchange 
for assets of the DSAG. See paragraph (b)(4)(ii) of this section. 
The result would be the same if D acquired all of the assets of T 
(including the X stock) and Z (including the Y stock) in the 
reorganizations instead of acquiring the assets of X and Y, and then 
transferred the Y stock to C. See paragraphs (b)(1)(ii) and 
(b)(4)(ii) of this section.
    Example 29. Taxable transfer of ATB by distributing to 
controlled. The facts are the same as the original facts in Example 
28 except that before and after the transfer to C, D owned section 
368(c) stock but not section 1504(a)(2) stock of C, and recognized 
gain under section 357(c) gain on the transfer of ATB2 to C. D and C 
can rely on ATB1 and ATB2, respectively, to satisfy the requirements 
of section 355(b). See paragraph (b)(4)(iii)(A) of this section. The 
result would be the same if C purchased ATB2 from D. The result 
would also be the same if D acquired all of the assets of T 
(including the X stock) and Z (including the Y stock) in the 
reorganizations instead of acquiring the assets of X and Y, and then 
C purchased the Y stock from D. See paragraphs (b)(1)(ii) and 
(b)(4)(iii)(A) of this section.
    Example 30. Assets for controlled stock in a section 351 
transaction. For more than five years, unrelated D and C have 
engaged in the active conduct of ATB1 and ATB2, respectively. In 
year 6, D transfers trucks to C to be used in ATB2 in exchange for 
section 368(c) stock of C in a transaction to which section 351 
applies and in which no gain or loss is recognized. If D were to 
distribute the C stock, C could not rely on ATB2 to satisfy the 
requirements of section 355(b) unless D's year 6 acquisition of the 
C stock is not in the pre-distribution period because D acquired 
section 368(c) stock of C, a corporation engaged in ATB2, in 
exchange for assets not constituting the trade or business. See 
paragraphs (b)(4)(i)(B) and (b)(4)(ii)(A) of this section. The 
result would be the same even if C became a DSAG member as a result 
of the year 6 transfer. See paragraphs (b)(4)(i)(A) and 
(b)(4)(ii)(A) of this section.
    Example 31. ATB for controlled stock in a reorganization. For 
more than five years, unrelated D and T have engaged in the active 
conduct of ATB1 and ATB2, respectively. Throughout this period, D 
has owned all of the sole class of C stock. In year 6, T merges into 
C solely in exchange for C stock in a reorganization described in 
section 368(a)(1)(A) and in which no gain or loss is recognized. As 
a result, the T shareholders receive 20 percent of the sole class of 
C stock. Because C acquired ATB2 in exchange for C stock, solely for 
purposes of determining whether ATB2 can be relied on to satisfy the 
requirements of section 355(b), D is treated as having acquired its 
80 percent of the C stock in year 6 in a transaction in which gain 
or loss was recognized. See paragraph (b)(4)(iv)(E) of this section. 
Accordingly, if D were to distribute the C stock, C could not rely 
on ATB2 to satisfy the requirements of section 355(b) unless C's 
year 6 acquisition of ATB2 is not in the pre-distribution period 
because ATB2 was in effect indirectly acquired in exchange for D's 
assets. See paragraphs (b)(4)(i)(A), (b)(4)(ii)(A), and 
(b)(4)(iv)(E) of this section.
    Example 32. ATB and controlled stock for distributing stock in a 
section 351 transaction. For more than five years, T and unrelated C 
have engaged in the active conduct of ATB1 and ATB2, respectively. 
Unrelated P owns all of the stock of D. In year 6, P purchases ATB1 
from T, and section 368(c) stock of C from the C shareholders. In 
year 6, P contributes the C stock and ATB1 to D solely in exchange 
for additional D stock in a transaction to which section 351 applies 
and in which no gain or loss is recognized. If D were to 
subsequently distribute the C stock in a separate transaction, D can 
rely on ATB1, and C can rely on ATB2 to satisfy the requirements of 
section 355(b) because neither ATB1 nor control of C were acquired 
in exchange for assets of the DSAG. See paragraphs (b)(4)(i)(A), 
(b)(4)(i)(B), and (b)(4)(ii) of this section. The fact that P, an 
affiliate of D, purchased ATB1 and section 368(c) stock of C in year 
6 is not relevant.
    Example 33. ATB for distributing stock in a section 351 
transaction with section 357(c) gain. The facts are the same as 
Example 32 except that D has owned section 368(c) stock of C for 
more than five years, P only purchases ATB1 from T, and P recognizes 
under section 357(c) gain on the transfer of ATB1 to D as a result 
of D assuming liabilities of P. D cannot rely on ATB1 to satisfy the 
requirements of section 355(b) until D's year 6 acquisition of ATB1 
is no longer in the pre-distribution period because D acquired ATB1 
in a transaction in which gain or loss was recognized. See paragraph 
(b)(4)(i)(A) of this section.
    Example 34. Partnership distributions. For more than five years, 
X and Y have engaged in the active conduct of ATB1 and ATB2, 
respectively. Throughout this period, unrelated D has owned a 90-
percent interest in Partnership. D is attributed any trade or 
business assets and activities of Partnership under paragraph 
(b)(2)(v) of this section. In year 6, Partnership purchases ATB1 
from X and all of the Y stock from its owner. In year 9, Partnership 
distributes ATB1 and all of the Y stock to D in a non-liquidating 
distribution. Assume that no gain or loss is recognized by 
Partnership or any partner on the distribution. As a result of the 
distribution, Y becomes a DSAG member, and D is treated as having 
acquired Y's assets (and activities). See paragraphs (b)(1)(ii) and 
(b)(1)(iii) of this section. If D were to make a distribution, ATB1 
could not be relied on to satisfy the requirements of section 355(b) 
unless Partnership's year 6 acquisition of ATB1 is not in the pre-
distribution period. See paragraphs (b)(2)(v), (b)(3)(iii), and 
(b)(4)(ii)(B) of this section. If D were to make a distribution, 
ATB2 could not be relied on to satisfy the requirements of section 
355(b) unless D's year 9 acquisition of the Y stock is not in the 
pre-distribution period. See paragraphs (b)(2)(v)(A) and 
(b)(4)(ii)(B) of this section. Alternatively, if in year 9 
Partnership only makes a pro rata distribution of all the Y stock to 
its partners such that D receives 90 percent of the Y stock, ATB2 
cannot be relied on until Partnership's year 6 acquisition of all of 
the Y stock is no longer in the pre-distribution period. See 
paragraph (b)(4)(ii)(B) of this section.
    Example 35. Partnership distribution (new SAG member). For more 
than five years, D has owned a 50-percent interest in Partnership. 
The remaining interests in Partnership are owned by unrelated 
parties. Throughout this period, Partnership has engaged in the 
active conduct of ATB1, and D has been attributed the trade or 
business assets and activities of Partnership's ATB1 under paragraph 
(b)(2)(v) of this section. In year 6, pursuant to an integrated 
plan, Partnership contributes ATB1 to new subsidiary S, and 
distributes all of the S stock to D in liquidation of D's 50-percent 
interest in Partnership. Assume that no gain or loss is recognized 
by Partnership or any partner on the distribution. As a result, S 
becomes a DSAG member, and D is treated as having acquired S's 
assets (and activities). See paragraphs (b)(1)(ii) and (b)(1)(iii) 
of this section. Because D was attributed ATB1 immediately before 
the incorporation and distribution by Partnership, and S became a 
DSAG member as a result of the distribution, Partnership's 
distribution of the S stock to D is not an acquisition of ATB1. See 
paragraphs (b)(3)(iii) and (b)(4)(ii)(B) of this section. 
Accordingly, if D were to make a distribution, it can rely on ATB1 
to satisfy the requirements of section 355(b).
    Example 36. Transfer of partnership in a reorganization and 
distributions. For more than five years, T has owned a 40-percent 
interest in Partnership which has engaged in the active conduct of 
ATB1. Throughout this

[[Page 26035]]

period, T has been attributed the trade or business assets and 
activities of Partnership's ATB1 under paragraph (b)(2)(v) of this 
section. In year 6, T merges into S, a wholly owned subsidiary of 
unrelated D, solely in exchange for D stock in a reorganization 
described in section 368(a)(1)(A) by reason of section 368(a)(2)(D). 
No gain or loss is recognized. If D were to make a distribution, D 
can rely on ATB1 because ATB1 has been actively conducted throughout 
the pre-distribution period, and the interest in Partnership was 
acquired in a transaction in which no gain or loss was recognized 
and was not acquired in exchange for assets of the DSAG. See 
paragraphs (b)(2)(v), (b)(3)(i), and (b)(4)(ii) of this section. The 
results would be the same if T owned only a 20-percent interest in 
Partnership, employees of T performed active and substantial 
management functions for Partnership's trade or business assets and 
activities prior to the merger, and employees of S (or an affiliate 
of S) performed active and substantial management functions for 
Partnership's trade or business assets and activities after the 
merger. See paragraphs (b)(2)(iii), (b)(2)(v), (b)(3), and 
(b)(4)(ii) of this section.
    Example 37. Transferred ATB sold (SAG member). For more than 
five years, D and unrelated T have engaged in the active conduct of 
ATB1 and ATB2, respectively. In year 6, D contributes ATB1 to T in 
exchange for T stock in a transaction to which section 351 applies. 
No gain or loss is recognized on the contribution. Immediately after 
the contribution T is a DSAG member. In year 8, in response to 
unanticipated market changes, T sells ATB1 to an unrelated third 
party. Although T became a DSAG member as a result of D acquiring T 
stock in exchange for ATB1 in a transaction in which no gain or loss 
was recognized, ATB1 is not the trade or business to be relied upon. 
Accordingly, D cannot rely on ATB2 until the year 6 transaction is 
no longer in the pre-distribution period because D acquired ATB2 in 
exchange for D's assets not constituting the active trade or 
business to be relied on. See paragraphs (b)(4)(i)(A) and 
(b)(4)(ii)(A) of this section.
    Example 38. Transferred ATB sold (partnership). The facts are 
the same as Example 37 except that, in year 6, D and T contribute 
ATB1 and ATB2, respectively, to Partnership in a transaction to 
which section 721 applies. In the exchange, D and T each receive a 
50-percent interest in Partnership. In year 8, in response to 
unanticipated market changes, Partnership sells ATB1 to an unrelated 
third party. If D were to make a distribution, D could not rely on 
ATB2 under paragraph (b)(2)(v)(B) of this section unless the year 6 
transaction is not in the pre-distribution period because D acquired 
ATB2 in exchange for D's assets not constituting the trade or 
business to be relied on. See paragraphs (b)(4)(i)(A) and 
(b)(4)(ii)(A) of this section.
    Example 39. Indirect acquisition of control of distributing's 
ATB. For more than five years, D and T have engaged in the active 
conduct of ATB1 and ATB2, respectively. All of the T stock is owned 
by individuals. In year 6, T purchases all the stock of D in a 
transaction in which gain or loss is recognized. In a separate 
transaction, T merges downstream into D solely in exchange for D 
stock in a reorganization described in section 368(a)(1)(A) and (D). 
No gain or loss is recognized. In year 7, D transfers ATB2 formerly 
conducted by T to new subsidiary C, and then distributes the C stock 
to the D shareholders. Although D acquired ATB2 solely in exchange 
for D stock in a transaction in which no gain or loss was 
recognized, the requirements of section 355(b) are not satisfied 
because ATB1, the business of D, was indirectly acquired by T, a 
predecessor of D, during the pre-distribution period in a 
transaction in which gain or loss was recognized. See paragraphs 
(b)(4)(i)(A) and (b)(4)(iv)(A) of this section. The result would 
also be the same if prior to the year 6 acquisition D and wholly 
owned subsidiary C were engaged in the active conduct of ATB1 and 
ATB2, respectively, and T had no ATB.
    Example 40. Exception for corporate distributee. For more than 
five years, T has owned all of the stock of D which in turn owned 
all of the stock of C. Throughout this period, D and C have engaged 
in the active conduct of ATB1 and ATB2, respectively. In year 6, P 
purchases all the stock of T. In year 7, P liquidates T in a 
transaction in which no gain or loss is recognized under section 
332. Under section 334(b), P's basis in the D stock is determined in 
whole by reference to T's basis in the D stock. In year 8, D 
distributes the C stock to P. While the D stock was indirectly 
acquired in a taxable transaction, the adjusted basis that P, the 
distributee corporation, has in the D stock was determined in whole 
by reference to T's adjusted basis. Accordingly, D and C satisfy the 
requirements of section 355(b). See paragraph (b)(4)(iii)(C) of this 
section. If P were to distribute either the D stock or C stock, 
neither ATB1 nor ATB2 could be relied on unless the year 6 
acquisition of the T stock is not in the pre-distribution period. 
See paragraph (b)(4)(iii)(C) of this section. The result would be 
the same if P acquired all of T's assets in exchange for P stock and 
other property in a reorganization described in section 
368(a)(1)(A).
    Example 41. Acquisition of section 368(c) stock of controlled, 
DSAG member. For more than five years, D has owned section 
1504(a)(2) stock but not section 368(c) stock of C. Throughout this 
period, C has engaged in the active conduct of ATB1. In year 6, D 
purchased additional shares of C stock. As a result, D acquired 
section 368(c) stock of C. If D were to make a distribution of the C 
stock, C could rely on ATB1 to satisfy the requirement of section 
355(b). C was a DSAG member, so D was engaged in ATB1 prior to the 
year 6 purchase of additional C stock. Accordingly, D's acquisition 
of additional stock of a DSAG member is disregarded in applying 
paragraph (b)(4)(i)(A) of this section, and paragraph (b)(4)(i)(B) 
of this section does not apply to this acquisition of additional C 
stock. See paragraphs (b)(1)(ii) and (b)(4)(iv)(F) of this section.
    Example 42. Controlled becoming a DSAG member. For more than 
five years, D has owned section 368(c) stock but not section 
1504(a)(2) stock of C. Throughout this period, D and C have engaged 
in the active conduct of ATB1 and ATB2, respectively. In year 6, D 
purchases the remaining C stock. If D distributes all the C stock, C 
could not rely on ATB2 to satisfy the requirements of section 355(b) 
because C became a DSAG member (and thus D acquired ATB2) in a 
transaction in which gain or loss was recognized. See paragraphs 
(b)(1)(ii), (b)(4)(i)(A), and (b)(4)(iv)(F) of this section.
    Example 43. Nontaxable multi-step acquisition of control. For 
more than five years, unrelated D and C have engaged in the active 
conduct of ATB1 and ATB2, respectively. C has two classes of stock 
outstanding. X owns all 95 shares of the class A stock of C, 
representing 95 percent of the voting power and 70 percent of the 
value, and Y owns all of the class B stock of C, representing five 
percent of the voting power and 30 percent of the value. In year 6, 
D acquires 10 shares of class A C stock from X in a transaction in 
which gain or loss was recognized. In year 7, in a separate 
transaction, D acquires an additional 80 shares of class A C stock 
from X solely in exchange for D voting stock in a reorganization 
described in section 368(a)(1)(B). No gain or loss is recognized. In 
year 8, in a separate transaction, D acquires the remaining five 
shares of class A C stock from X in a transaction in which gain or 
loss was recognized. Because D only acquires 70 percent of the value 
of C stock, C does not become a DSAG member. In year 9, D 
distributes the 95 shares of class A C stock to the D shareholders. 
At the time D first acquired control of C, D owned an amount of C 
stock constituting control that was acquired in a transaction in 
which no gain or loss was recognized. Accordingly, D and C both 
satisfy the requirements of section 355(b). See paragraphs 
(b)(4)(i)(B) and (b)(4)(iv)(B) of this section.
    Example 44. Taxable multi-step acquisition of control. The facts 
are the same as Example 43 except that in year 7 D acquires 70 
shares of class A C stock solely in exchange for D voting stock in a 
reorganization described in section 368(a)(1)(B). No gain or loss is 
recognized. At the time D first acquired control of C, D did not own 
an amount of C stock constituting control that was acquired in one 
or more transactions in which no gain or loss was recognized or by 
reason of such transactions combined with acquisitions before the 
pre-distribution period. Accordingly, C cannot rely on ATB2 to 
satisfy the requirements of section 355(b) until D's year 6 
acquisition of the 10 shares of class A C stock is no longer in the 
pre-distribution period. See paragraphs (b)(4)(i)(B) and 
(b)(4)(iv)(B) of this section.
    Example 45. Taxable acquisition of control. For more than five 
years, unrelated D and C have engaged in the active conduct of ATB1 
and ATB2, respectively. In year 6, D acquires section 368(c) stock 
but not section 1504(a)(2) stock of C from unrelated T in a 
reorganization described in section 368(a)(1)(A) by reason of 
section 368(a)(2)(E) through the use of a newly created transitory 
subsidiary of D. In the reorganization, T receives consideration 95 
percent of which is D voting common stock and five percent of which 
is cash. Because D acquired control of C in a single transaction in 
which gain or loss

[[Page 26036]]

was recognized, paragraph (b)(4)(iv)(B) of this section does not 
apply. Accordingly, C cannot rely on ATB2 to satisfy the 
requirements of section 355(b) until D's year 6 acquisition of 
control of C is no longer in the pre-distribution period. See 
paragraph (b)(4)(i)(B) of this section.
    Example 46. Taxable multi-step indirect acquisition of control. 
For more than five years, C has engaged in the active conduct of 
ATB1. T owns exactly 80 percent of the total combined voting power 
of all classes of C stock entitled to vote and 80 percent of the 
total number of shares of all other classes of C stock, but T owns 
less than 80 percent of the total value of the C stock. In year 6, 
unrelated D acquires 10 percent of the sole outstanding class of 
stock of T in a transaction in which gain or loss is recognized. In 
year 8, in a separate transaction, T merges into D solely in 
exchange for D stock in a reorganization described in section 
368(a)(1)(A). No gain or loss is recognized. As a result, D owns 
section 368(c) stock of C. Because D indirectly acquired 10 percent 
of the C stock owned by T in year 6, at the time D first acquired 
control of C, D did not own stock constituting control of C that it 
acquired in one or more transactions in which no gain or loss was 
recognized or by reason of such transactions combined with 
acquisitions before the pre-distribution period. Accordingly, C 
cannot rely on ATB1 to satisfy the requirements of section 355(b) 
until D's year 6 acquisition of the T stock is no longer in the pre-
distribution period. See paragraphs (b)(4)(i)(B) and (b)(4)(iv)(B) 
of this section.
    Example 47. Nontaxable multi-step acquisition of SAG member (or 
ATB). For more than five years, S has engaged in the active conduct 
of ATB1. X owns all 100 shares of the sole outstanding class of S 
stock. In year 6, unrelated D acquires 10 shares of S stock from X 
in a transaction in which gain or loss was recognized. In year 7, in 
a separate transaction, D acquires an additional 80 shares of S 
stock from X solely in exchange for D voting stock in a 
reorganization described in section 368(a)(1)(B). No gain or loss is 
recognized. As a result, S becomes a DSAG member. In year 8, in a 
separate transaction, D acquires another 5 shares of S stock from X 
in a transaction in which gain or loss was recognized. Because at 
the time S first became a DSAG member, D owned an amount of S stock 
meeting the requirements of section 1504(a)(2) that was acquired in 
a transaction in which no gain or loss was recognized, D can rely on 
ATB1 to satisfy the requirements of section 355(b) as of the year 7 
transaction. See paragraphs (b)(4)(i)(A) and (b)(4)(iv)(C) of this 
section. The acquisition by D of other S stock in a separate 
transaction in which gain or loss was recognized during the pre-
distribution period is disregarded. See paragraph (b)(1)(ii) of this 
section. The result would be the same if, in year 7, instead of 
acquiring S stock in a reorganization described in section 
368(a)(1)(B), S merged into D in exchange for D stock in a 
reorganization described in section 368(a)(1)(A) in which no gain or 
loss was recognized. See paragraphs (b)(4)(i)(A) and (b)(4)(iv)(D) 
of this section.
    Example 48. Taxable multi-step acquisition of SAG member (or 
ATB). The facts are the same as Example 47 except that in year 6 D 
acquires 21 shares of S stock in a transaction in which gain or loss 
was recognized, and in year 7, in a separate transaction, D acquires 
an additional 79 shares of S stock solely in exchange for D voting 
stock in a reorganization described in section 368(a)(1)(B). No gain 
or loss is recognized, and S becomes a DSAG member. D cannot rely on 
ATB1 to satisfy the requirements of section 355(b) until D's year 6 
acquisition of the 21 shares of S stock is no longer in the pre-
distribution period because at the time S first became a DSAG member 
D did not own an amount of S stock meeting the requirements of 
section 1504(a)(2) that was acquired in one or more transactions in 
which no gain or loss was recognized or by reason of such 
transactions combined with acquisitions before the pre-distribution 
period. See paragraphs (b)(4)(i)(A) and (b)(4)(iv)(C) of this 
section. The result would be the same if, in year 7, in a separate 
transaction, instead of D's acquiring S stock, S merged into D in 
exchange for D stock in a reorganization described in section 
368(a)(1)(A) in which no gain or loss was recognized. See paragraphs 
(b)(4)(i)(A) and (b)(4)(iv)(D) of this section. The result would 
also be the same if in year 6 D acquired 10 shares of S stock in a 
transaction in which gain or loss was recognized and, in year 7, in 
a separate transaction, D acquired an additional 70 shares of S 
stock solely in exchange for D voting stock in a reorganization 
described in section 368(a)(1)(B). See paragraphs (b)(4)(i)(A) and 
(b)(4)(iv)(C) of this section.
    Example 49. Nontaxable multi-step indirect acquisition using 
subsidiary stock. For more than five years, X has owned all of the 
sole outstanding class of S stock. Throughout this period, S and 
unrelated T have engaged in the active conduct of ATB1 and ATB2, 
respectively. In year 6, T merges into S solely in exchange for S 
stock in a reorganization described in section 368(a)(1)(A). No gain 
or loss is recognized. Immediately after the merger, X and the 
former T shareholders own 80 percent and 20 percent of the S stock, 
respectively. In year 8, unrelated D acquires all of the S shares 
held by X solely in exchange for D voting stock in a reorganization 
described in section 368(a)(1)(B). No gain or loss is recognized. As 
a result, S becomes a DSAG member. Because D acquired ATB1 and ATB2 
in a transaction in which no gain or loss was recognized, solely in 
exchange for D stock, D can rely on both ATB1 and ATB2 to satisfy 
the requirements of section 355(b). Because X is neither a 
predecessor of D nor a DSAG member, paragraph (b)(4)(iv)(E) of this 
section is not applicable.
    Example 50. Taxable multi-step indirect acquisition using 
subsidiary stock. The facts are the same as Example 49 except that, 
for more than five years, D has owned 50 percent of the sole 
outstanding class of X stock. In year 8, instead of D acquiring the 
S stock, S merges into D solely in exchange for D stock in a 
reorganization described in section 368(a)(1)(A). No gain or loss is 
recognized. Because D indirectly owned S stock and S acquired ATB2 
in exchange for S stock, paragraph (b)(4)(iv)(E) of this section is 
applicable. Under paragraph (b)(4)(iv)(E) of this section, for 
purposes of applying paragraph (b)(4) of this section with respect 
to ATB2, D is treated as having indirectly acquired in year 6 the S 
stock it indirectly owns immediately after the merger of T into S in 
a transaction in which gain or loss was recognized. Thus, D is 
treated as having indirectly acquired 40 percent of the S stock in a 
transaction in which gain or loss is recognized at the time of the 
merger of T into S. Further, if the merger of T into S is in the 
pre-distribution period, under paragraph (b)(4)(iv)(D) of this 
section, D will be treated as having acquired ATB2 in a transaction 
in which gain or loss is recognized because, immediately before the 
merger of S into D, D indirectly owned 40 percent of the S stock 
that had been acquired in a transaction in which gain or loss was 
recognized. Accordingly, D cannot rely on ATB2 to satisfy the 
requirements of section 355(b) until the year 6 merger of T into S 
is no longer in the pre-distribution period. However, D can rely on 
ATB1 to satisfy the requirements of section 355(b). Alternatively, 
if X, instead if S, merged into D, S would become a DSAG member and 
X would be a predecessor of D. If so, for purposes of applying 
paragraph (b)(4) of this section with respect to ATB2, D is treated 
as having acquired 80 percent of the S stock in year 6 in a 
transaction in which gain or loss was recognized. Accordingly, D 
cannot rely on ATB2 to satisfy the requirements of section 355(b) 
until the year 6 merger of T into S is no longer in the pre-
distribution period. See paragraphs (b)(1)(iii), (b)(4)(i)(A), 
(b)(4)(iv)(A), and (b)(4)(iv)(E) of this section. However, D can 
rely on ATB1 to satisfy the requirements of section 355(b).
    Example 51. Taxable multi-step indirect acquisition of SAG 
member (or ATB). For more than five years, T has engaged in the 
active conduct of ATB1. Throughout this period, X owned all of the 
sole outstanding class of T stock, and D owned 50 percent of the 
sole outstanding stock of S. In year 6, S acquires 50 percent of the 
sole outstanding class of the X stock in a transaction in which gain 
or loss is recognized. In year 8, X merges into D solely in exchange 
for D stock. No gain or loss is recognized. As a result, T becomes a 
DSAG member. Because D indirectly acquired more than 20 percent of 
the T stock (D indirectly acquired 25 percent of T) in year 6, at 
the time T first became a DSAG member D did not own an amount of T 
stock meeting the requirements of section 1504(a)(2) that it 
acquired in one or more transactions in which no gain or loss was 
recognized or by reason of such transactions combined with 
acquisitions before the predistribution period. Accordingly, D 
cannot rely on ATB1 to satisfy the requirements of section 355(b) 
until D's year 6 indirect acquisition of the T stock is no longer in 
the pre-distribution period. See paragraphs (b)(4)(i)(A) and 
(b)(4)(iv)(C) of this section. The result would be the same if, 
instead of X, in year 8, T merged into D solely in exchange for D 
stock. See

[[Page 26037]]

paragraphs (b)(4)(i) and (b)(4)(iv) of this section.

Kevin M. Brown,
Deputy Commissioner for Services and Enforcement.
[FR Doc. 07-2269 Filed 5-4-07; 8:45 am]
BILLING CODE 4830-01-P