[Code of Federal Regulations]
[Title 26, Volume 4]
[Revised as of April 1, 2004]
From the U.S. Government Printing Office via GPO Access
[CITE: 26CFR1.355-2]

[Page 190-197]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.355-2  Limitations.

    (a) Property distributed. Section 355 applies to a distribution only 
if the property distributed consists solely of stock, or stock and 
securities, of a controlled corporation. If additional property 
(including an excess principal amount of securities received over 
securities surrendered) is received, see section 356.
    (b) Independent business purpose--(1) Independent business purpose 
requirement. Section 355 applies to a transaction only if it is carried 
out for one or more corporate business purposes. A transaction is 
carried out for a corporate business purpose if it is motivated, in 
whole or substantial part, by one or more corporate business purposes. 
The potential for the avoidance of Federal taxes by the distributing or 
controlled corporations (or a corporation controlled by either) is 
relevant in determining the extent to which an existing corporate 
business purpose motivated the distribution. The principal reason for 
this business purpose requirement is to provide nonrecognition treatment 
only to distributions that are incident to readjustments of corporate 
structures required by business exigencies and that effect only 
readjustments of continuing interests in property under modified 
corporate forms. This business purpose requirement is independent of the 
other requirements under section 355.
    (2) Corporate business purpose. A corporate business purpose is a 
real and substantial non Federal tax purpose germane to the business of 
the distributing corporation, the controlled corporation, or the 
affiliated group (as defined in Sec. 1.355-3(b)(4)(iv)) to which the 
distributing corporation belongs. A purpose of reducing non Federal 
taxes is not a corporate business purpose if (i) the transaction will 
effect a reduction in both Federal and non Federal taxes because of 
similarities between Federal tax law and the tax law of the other 
jurisdiction and (ii) the reduction of Federal taxes is greater than or 
substantially coextensive with the reduction of non Federal taxes. See 
Examples (7) and (8) of paragraph (b)(5) of this section. A shareholder 
purpose (for example, the personal planning purposes of a shareholder) 
is not a corporate business purpose. Depending upon the facts of a 
particular case, however, a shareholder purpose for a transaction may be 
so nearly coextensive with a corporate business purpose as to preclude 
any distinction between them. In such a case, the transaction is carried 
out for one or more corporate business purposes. See Example (2) of 
paragraph (b)(5) of this section.
    (3) Business purpose for distribution. The distribution must be 
carried out for one or more corporate business purposes. See Example (3) 
of paragraph (b)(5) of this section. If a corporate business purpose can 
be achieved through a nontaxable transaction that does not involve the 
distribution of stock of a controlled corporation and which is neither 
impractical nor unduly expensive, then, for purposes of paragraph (b)(1) 
of this section, the separation is not carried out for that corporate 
business purpose. See Examples (3) and (4) of paragraph (b)(5) of this 
section. For rules with respect to the requirement of a business purpose 
for a transfer of assets to a controlled corporation in connection with 
a reorganization described in section 368(a)(1)(D), See Sec. 1.368-
1(b).
    (4) Business purpose as evidence of nondevice. The corporate 
business purpose or purposes for a transaction are evidence that the 
transaction was not used principally as a device for the distribution of 
earnings and profits within the meaning of section 355(a)(1)(B). See 
paragraph (d)(3)(ii) of this section.
    (5) Examples. The provisions of this paragraph (b) may be 
illustrated by the following examples:

    Example (1). Corporation X is engaged in the production, 
transportation, and refining of petroleum products. In 1985, X acquires 
all of the properties of corporation Z, which is also engaged in the 
production, transportation, and refining of petroleum products. In 1991, 
as a result of antitrust litigation, X is ordered to divest itself of 
all of the properties acquired from Z. X transfers those

[[Page 191]]

properties to new corporation Y and distributes the stock of Y pro rata 
to X's shareholders. In view of the divestiture order, the distribution 
is carried out for a corporate business purpose. See paragraph (b)(1) of 
this section.
    Example (2). Corporation X is engaged in two businesses: The 
manufacture and sale of furniture and the sale of jewelry. The 
businesses are of equal value. The outstanding stock of X is owned 
equally by unrelated individuals A and B. A is more interested in the 
furniture business, while B is more interested in the jewelry business. 
A and B decide to split up the businesses and go their separate ways. A 
and B anticipate that the operations of each business will be enhanced 
by the separation because each shareholder will be able to devote his 
undivided attention to the business in which he is more interested and 
more proficient. Accordingly, X transfers the jewelry business to new 
corporation Y and distributes the stock of Y to B in exchange for all of 
B's stock in X. The distribution is carried out for a corporate business 
purpose, notwithstanding that it is also carried out in part for 
shareholder purposes. See paragraph (b)(2) of this section.
    Example (3). Corporation X is engaged in the manufacture and sale of 
toys and the manufacture and sale of candy. The shareholders of X wish 
to protect the candy business from the risks and vicissitudes of the toy 
business. Accordingly, X transfers the toy business to new corporation Y 
and distributes the stock of Y to X's shareholders. Under applicable 
law, the purpose of protecting the candy business from the risks and 
vicissitudes of the toy business is achieved as soon as X transfers the 
toy business to Y. Therefore, the distribution is not carried out for a 
corporate business purpose. See paragraph (b)(3) of this section.
    Example (4). Corporation X is engaged in a regulated business in 
State T. X owns all of the stock of corporation Y, a profitable 
corporation that is not engaged in a regulated business. Commission C 
sets the rates that X may charge its customers, based on its total 
income. C has recently adopted rules according to which the total income 
of a corporation includes the income of a business if, and only if, the 
business is operated, directly or indirectly, by the corporation. Total 
income, for this purpose, includes the income of a wholly owned 
subsidiary corporation but does not include the income of a parent or 
``brother/sister'' corporation. Under C's new rule, X's total income 
includes the income of Y, with the result that X has suffered a 
reduction of the rates that it may charge its customers. It would not be 
impractical or unduly expensive to create in a nontaxable transaction 
(such as a transaction qualifying under section 351) a holding company 
to hold the stock of X and Y. X distributes the stock of Y to X's 
shareholders. The distribution is not carried out for the purpose of 
increasing the rates that X may charge its customers because that 
purpose could be achieved through a nontaxable transaction, the creation 
of a holding company, that does not involve the distribution of stock of 
a controlled corporation and which is neither impractical nor unduly 
expensive. See paragraph (b)(3) of this section.
    Example (5). The facts are the same as in Example (4), except that C 
has recently adopted rules according to which the total income of a 
corporation includes not only the income included in Example (3), but 
also the income of any member of the affiliated group to which the 
corporation belongs. In order to avoid a reduction in the rates that it 
may charge its customers, X distributes the stock of Y to X's 
shareholders. The distribution is carried out for a corporate business 
purpose. See paragraph (b)(3) of this section.
    Example (6). (i) Corporation X owns all of the one class of stock of 
corporation Y. X distributes the stock of Y pro rata to its five 
shareholders, all of whom are individuals, for the sole purpose of 
enabling X and/or Y to elect to become an S corporation. The 
distribution does not meet the corporate business purpose requirement. 
See paragraph (b)(1) and (2) of this section.
    (ii) The facts are the same as in Example 6(i), except that the 
business of Y is operated as a division of X. X transfers this division 
to new corporation Y and distributes the stock of Y pro rata to its 
shareholders, all of whom are individuals, for the sole purpose of 
enabling X and/or Y to elect to become an S corporation. The 
distribution does not meet the corporate business purpose requirement. 
See paragraph (b)(1) and (2) of this section.
    Example (7). The facts are the same as in Example (6)(i), except 
that the distribution is made to enable X to elect to become an S 
corporation both for Federal tax purposes and for purposes of the income 
tax imposed by State M. State M has tax law provisions similar to 
subchapter S of the Internal Revenue Code of 1986. An election to be an 
S corporation for Federal tax purposes will effect a substantial 
reduction in Federal taxes that is greater than the reduction of State M 
taxes pursuant to an election to be an S corporation for State M 
purposes. The purpose of reducing State M taxes is not a corporate 
business purpose. The distribution does not meet the corporate business 
purpose requirements. See paragraph (b)(1) and (2) of this section.
    Example (8). The facts are the same as Example (7), except that the 
distribution also is made to enable A, a key employee of Y, to acquire 
stock of Y without investing in X. A is considered to be critical to the 
success of Y and he has indicated that he will seriously consider 
leaving the company if he is not

[[Page 192]]

given the opportunity to purchase a significant amount of stock of Y. As 
a matter of state law, Y could not issue stock to the employee while it 
was a subsidiary of X. As in Example (7), the purpose of reducing State 
M taxes is not a corporate business purpose. In order to determine 
whether the issuance of stock to the key employee, in fact, motivated 
the distribution of the Y stock, the potential avoidance of Federal 
taxes is a relevant factor to take into account. If the facts and 
circumstances establish that the distribution was substantially 
motivated by the need to issue stock to the employee, the distribution 
will meet the corporate business purpose requirement.

    (c) Continuity of interest requirement--(1) Requirement. Section 355 
applies to a separation that effects only a readjustment of continuing 
interests in the property of the distributing and controlled 
corporations. In this regard section 355 requires that one or more 
persons who, directly or indirectly, were the owners of the enterprise 
prior to the distribution or exchange own, in the aggregate, an amount 
of stock establishing a continuity of interest in each of the modified 
corporate forms in which the enterprise is conducted after the 
separation. This continuity of interest requirement is independent of 
the other requirements under section 355.
    (2) Examples.

    Example (1). For more than five years, corporation X has been 
engaged directly in one business, and indirectly in a different business 
through its wholly owned subsidiary, S. The businesses are equal in 
value. At all times, the outstanding stock of X has been owned equally 
by unrelated individuals A and B. For valid business reasons, A and B 
cause X to distribute all of the stock of S to B in exchange for all of 
B's stock in X. After the transaction, A owns all the stock of X and B 
owns all the stock of S. The continuity of interest requirement is met 
because one or more persons who were the owners of X prior to the 
distribution (A and B) own, in the aggregate, an amount of stock 
establishing a continuity of interest in each of X and S after the 
distribution.
    Example (2). Assume the same facts as in Example (1), except that 
pursuant to a plan to acquire a stock interest in X without acquiring, 
directly or indirectly, an interest in S, C purchased one-half of the X 
stock owned by A and immediately thereafter X distributed all of the S 
stock to B in exchange for all of B's stock in X. After the 
transactions, A owns 50 percent of X and B owns 100 percent of S. The 
distribution by X of all of the stock of S to B in exchange for all of 
B's stock in X will satisfy the continuity of interest requirement for 
section 355 because one or more persons who were the owners of X prior 
to the distribution (A and B) own, in the aggregate, an amount of stock 
establishing a continuity of interest in each of X and S after the 
distribution.
    Example (3). Assume the same facts as in Examples (1) and (2), 
except that C purchased all of the X stock owned by A. After the 
transactions, neither A nor B own any of the stock of X, and B owns all 
the stock of S. The continuity of interest requirement is not met 
because the owners of X prior to the distribution (A and B) do not, in 
the aggregate, own an amount of stock establishing a continuity of 
interest in each of X and S after the distribution, i.e., although A and 
B collectively have retained 50 percent of their equity interest in the 
former combined enterprise, they have failed to continue to own the 
minimum stock interest in the distributing corporation, X, that would be 
required in order to meet the continuity of interest requirement.
    Example (4). Assume the same facts as in Examples (1) and (2), 
except that C purchased 80 percent of the X stock owned by A. After the 
transactions, A owns 20 percent of the stock of X, B owns no X stock, 
and B owns 100 percent of the S stock. The continuity of interest 
requirement is not met because the owners of X prior to the distribution 
(A and B) do not, in the aggregate, have a continuity of interest in 
each of X and S after the distribution, i.e., although A and B 
collectively have retained 60 percent of their equity interest in the 
former combined enterprise, the 20 percent interest of A in X is less 
than the minimum equity interest in the distributing corporation, X, 
that would be required in order to meet the continuity of interest 
requirement.

    (d) Device for distribution of earnings and profits--(1) In general. 
Section 355 does not apply to a transaction used principally as a device 
for the distribution of the earnings and profits of the distributing 
corporation, the controlled corporation, or both (a ``device''). Section 
355 recognizes that a tax-free distribution of the stock of a controlled 
corporation presents a potential for tax avoidance by facilitating the 
avoidance of the dividend provisions of the Code through the subsequent 
sale or exchange of stock of one corporation and the retention of the 
stock of another corporation. A device can include a transaction that 
effects a recovery of basis. In this paragraph (d), ``exchange'' 
includes transactions, such as redemptions, treated

[[Page 193]]

as exchanges under the Code. Generally, the determination of whether a 
transaction was used principally as a device will be made from all of 
the facts and circumstances, including, but not limited to, the presence 
of the device factors specified in paragraph (d)(2) of this section 
(``evidence of device''), and the presence of the nondevice factors 
specified in paragraph (d)(3) of this section (``evidence of 
nondevice''). However, if a transaction is specified in paragraph (d)(5) 
of this section, then it is ordinarily considered not to have been used 
principally as a device.
    (2) Device factors--(i) In general. The presence of any of the 
device factors specified in this subparagraph (2) is evidence of device. 
The strength of this evidence depends on the facts and circumstances.
    (ii) Pro rata distribution. A distribution that is pro rata or 
substantially pro rata among the shareholders of the distributing 
corporation presents the greatest potential for the avoidance of the 
dividend provisions of the Code and, in contrast to other types of 
distributions, is more likely to be used principally as a device. 
Accordingly, the fact that a distribution is pro rata or substantially 
pro rata is evidence of device.
    (iii) Subsequent sale or exchange of stock--(A) In general. A sale 
or exchange of stock of the distributing or the controlled corporation 
after the distribution (a ``subsequent sale or exchange'') is evidence 
of device. Generally, the greater the percentage of the stock sold or 
exchanged after the distribution, the stronger the evidence of device. 
In addition, the shorter the period of time between the distribution and 
the sale or exchange, the stronger the evidence of device.
    (B) Sale or exchange negotiated or agreed upon before the 
distribution. A subsequent sale or exchange pursuant to an arrangement 
negotiated or agreed upon before the distribution is substantial 
evidence of device.
    (C) Sale or exchange not negotiated or agreed upon before the 
distribution. A subsequent sale or exchange not pursuant to an 
arrangement negotiated or agreed upon before the distribution is 
evidence of device.
    (D) Negotiated or agreed upon before the distribution. For purposes 
of this subparagraph (2), a sale or exchange is always pursuant to an 
arrangement negotiated or agreed upon before the distribution if 
enforceable rights to buy or sell existed before the distribution. If a 
sale or exchange was discussed by the buyer and the seller before the 
distribution and was reasonably to be anticipated by both parties, then 
the sale or exchange will ordinarily be considered to be pursuant to an 
arrangement negotiated or agreed upon before the distribution.
    (E) Exchange in pursuance of a plan of reorganization. For purposes 
of this subparagraph (2), if stock is exchanged for stock in pursuance 
of a plan of reorganization, and either no gain or loss or only an 
insubstantial amount of gain is recognized on the exchange, then the 
exchange is not treated as a subsequent sale or exchange, but the stock 
received in the exchange is treated as the stock surrendered in the 
exchange. For this purpose, gain treated as a dividend pursuant to 
sections 356(a)(2) and 316 shall be disregarded.
    (iv) Nature and use of assets--(A) In general. The determination of 
whether a transaction was used principally as a device will take into 
account the nature, kind, amount, and use of the assets of the 
distributing and the controlled corporations (and corporations 
controlled by them) immediately after the transaction.
    (B) Assets not used in a trade or business meeting the requirement 
of section 355(b). The existence of assets that are not used in a trade 
or business that satisfies the requirements of section 355(b) is 
evidence of device. For this purpose, assets that are not used in a 
trade or business that satisfies the requirements of section 355(b) 
include, but are not limited to, cash and other liquid assets that are 
not related to the reasonable needs of a business satisfying such 
section. The strength of the evidence of device depends on all the facts 
and circumstances, including, but not limited to, the ratio for each 
corporation of the value of assets not used in a trade or business that 
satisfies the requirements of section 355(b) to the value of its 
business that satisfies such requirements. A difference in the ratio

[[Page 194]]

described in the preceding sentence for the distributing and controlled 
corporation is ordinarily not evidence of device if the distribution is 
not pro rata among the shareholders of the distributing corporation and 
such difference is attributable to a need to equalize the value of the 
stock distributed and the value of the stock or securities exchanged by 
the distributees.
    (C) Related function. There is evidence of device if a business of 
either the distributing or controlled corporation (or a corporation 
controlled by it) is (1) a ``secondary business'' that continues as a 
secondary business for a significant period after the separation, and 
(2) can be sold without adversely affecting the business of the other 
corporation (or a corporation controlled by it). A secondary business is 
a business of either the distributing or controlled corporation, if its 
principal function is to serve the business of the other corporation (or 
a corporation controlled by it). A secondary business can include a 
business transferred to a newly-created subsidiary or a business which 
serves a business transferred to a newly-created subsidiary. The 
activities of the secondary business may consist of providing property 
or performing services. Thus, in Example (11) of Sec. 1.355-3(c), 
evidence of device would be presented if the principal function of the 
coal mine (satisfying the requirements of the steel business) continued 
after the separation and the coal mine could be sold without adversely 
affecting the steel business. Similarly, in Example (10) of Sec. 1.355-
3(c), evidence of device would be presented if the principal function of 
the sales operation after the separation is to sell the output from the 
manufacturing operation and the sales operation could be sold without 
adversely affecting the manufacturing operation.
    (3) Nondevice factors--(i) In general. The presence of any of the 
nondevice factors specified in this subparagraph (3) is evidence of 
nondevice. The strength of this evidence depends on all of the facts and 
circumstances.
    (ii) Corporate business purpose. The corporate business purpose for 
the transaction is evidence of nondevice. The stronger the evidence of 
device (such as the presence of the device factors specified in 
paragraph (d)(2) of this section), the stronger the corporate business 
purpose required to prevent the determination that the transaction was 
used principally as a device. Evidence of device presented by the 
transfer or retention of assets not used in a trade or business that 
satisfies the requirements of section 355(b) can be outweighed by the 
existence of a corporate business purpose for those transfers or 
retentions. The assessment of the strength of a corporate business 
purpose will be based on all of the facts and circumstances, including, 
but not limited to, the following factors:
    (A) The importance of achieving the purpose to the success of the 
business;
    (B) The extent to which the transaction is prompted by a person not 
having a proprietary interest in either corporation, or by other outside 
factors beyond the control of the distributing corporation; and
    (C) The immediacy of the conditions prompting the transaction.
    (iii) Distributing corporation publicly traded and widely held. The 
fact that the distributing corporation is publicly traded and has no 
shareholder who is directly or indirectly the beneficial owner of more 
than five percent of any class of stock is evidence of nondevice.
    (iv) Distribution to domestic corporate shareholders. The fact that 
the stock of the controlled corporation is distributed to one or more 
domestic corporations that, if section 355 did not apply, would be 
entitled to a deduction under section 243(a)(1) available to 
corporations meeting the stock ownership requirements of section 243(c), 
or a deduction under section 243(a)(2) or (3) or 245(b) is evidence of 
nondevice.
    (4) Examples. The provisions of paragraph (d)(1) through (3) of this 
section may be illustrated by the following examples:

    Example (1). Individual A owns all of the stock of corporation X, 
which is engaged in the warehousing business. X owns all of the stock of 
corporation Y, which is engaged in the transportation business. X 
employs individual B, who is extremely knowledgeable of the warehousing 
business in general and the operations of X in particular. B has 
informed A that he will seriously consider leaving the company if he is 
not given the opportunity to purchase a significant amount of stock of 
X. Because of his knowledge and experience, the loss of B would 
seriously damage the

[[Page 195]]

business of X. B cannot afford to purchase any significant amount of 
stock of X as long as X owns Y. Accordingly, X distributes the stock of 
Y to A and A subsequently sells a portion of his X stock to B. However, 
X could have issued additional shares to B sufficient to give B an 
equivalent ownership interest in X. There is no other evidence of device 
or evidence of nondevice. In light of the fact that X could have issued 
additional shares to B, the sale of X stock by A is substantial evidence 
of device. The transaction is considered to have been used principally 
as a device. See paragraph (d)(1), (2)(ii), (iii)(A), (B) and (D), and 
(3)(i) and (ii) of this section.
    Example (2). Corporation X owns and operates a fast food restaurant 
in State M and owns all of the stock of corporation Y, which owns and 
operates a fast food restaurant in State N. X and Y operate their 
businesses under franchises granted by D and E, respectively. X owns 
cash and marketable securities that exceed the reasonable needs of its 
business but whose value is small relative to the value of its business. 
E has recently changed its franchise policy and will no longer grant or 
renew franchises to subsidiaries (or other members of the same 
affiliated group) of corporations operating businesses under franchises 
granted by its competitors. Thus, Y will lose its franchise if it 
remains a subsidiary of X. The franchise is about to expire. 
Accordingly, X distributes the stock of Y pro rata among X's 
shareholders. X retains its business and transfers cash and marketable 
securities to Y in an amount proportional to the value of Y's business. 
There is no other evidence of device or evidence of nondevice. The 
transfer by X to Y and the retention by X of cash and marketable 
securities is relatively weak evidence of device because after the 
transfer X and Y hold cash and marketable securities in amounts 
proportional to the values of their businesses. The fact that the 
distribution is pro rata is evidence of device. A strong corporate 
business purpose is relatively strong evidence of nondevice. 
Accordingly, the transaction is considered not to have been used 
principally as a device. See paragraph (d)(1), (2)(ii), (iv)(A), and (B) 
and (3)(i) and (ii)(A), (B) and (C) of this section.
    Example (3). Corporation X is engaged in a regulated business in 
State M and owns all of the stock of corporation Y, which is not engaged 
in a regulated business in State M. State M has recently amended its 
laws to provide that affiliated corporations operating in M may not 
conduct both regulated and unregulated businesses. X transfers cash not 
related to the reasonable needs of the business of X or Y to Y and then 
distributes the stock of Y pro rata among X's shareholders. As a result 
of the transfer of cash, the ratio of the value of its assets not used 
in a trade or business that satisfies the requirements of section 355(b) 
to the value of its business is substantially greater for Y than for X. 
There is no other evidence of device or evidence of nondevice. The 
transfer of cash by X to Y is relatively strong evidence of device 
because after the transfer Y holds disproportionately many assets that 
are not used in a trade or business that satisfies the requirements of 
section 355(b). The fact that the distribution is pro rata is evidence 
of device. The strong business purpose is relatively strong evidence of 
nondevice, but it does not pertain to the transfer. Accordingly, the 
transaction is considered to have been used principally as a device. See 
paragraph (d)(1), (2)(ii), (iv)(A) and (B), and (3) and (i) and (ii) of 
this section.
    Example (4). The facts are the same as in Example (3), except that, 
instead of transferring cash to Y, X purchases operating assets 
unrelated to the business of Y and transfers them to Y prior to the 
distribution. There is no other evidence of device or evidence of 
nondevice. The transaction is considered to have been used principally 
as a device. See paragraph (d)(1), (2)(ii), (iv)(A) and (B), and (3)(i) 
and (ii) of this section.

    (5) Transactions ordinarily not considered as a device--(i) In 
general. This subparagraph (5) specifies three distributions that 
ordinarily do not present the potential for tax avoidance described in 
paragraph (d)(1) of this section. Accordingly, such distributions are 
ordinarily considered not to have been used principally as a device, 
notwithstanding the presence of any of the device factors described in 
paragraph (d)(2) of this section. A transaction described in paragraph 
(d)(5)(iii) or (iv) of this section is not protected by this 
subparagraph (5) from a determination that it was used principally as a 
device if it involves the distribution of the stock of more than one 
controlled corporation and facilitates the avoidance of the dividend 
provisions of the Code through the subsequent sale or exchange of stock 
of one corporation and the retention of the stock of another 
corporation.
    (ii) Absence of earnings and profits. A distribution is ordinarily 
considered not to have been used principally as a device if--
    (A) The distributing and controlled corporations have no accumulated 
earnings and profits at the beginning of their respective taxable years,
    (B) The distributing and controlled corporations have no current 
earnings and profits as of the date of the distribution, and

[[Page 196]]

    (C) No distribution of property by the distributing corporation 
immediately before the separation would require recognition of gain 
resulting in current earnings and profits for the taxable year of the 
distribution.
    (iii) Section 303(a) transactions. A distribution is ordinarily 
considered not to have been used principally as a device if, in the 
absence of section 355, with respect to each shareholder distributee, 
the distribution would be a redemption to which section 303(a) applied.
    (iv) Section 302(a) transactions. A distribution is ordinarily 
considered not to have been used principally as a device if, in the 
absence of section 355, with respect to each shareholder distributee, 
the distribution would be a redemption to which section 302(a) applied. 
For purposes of the preceding sentence, section 302(c)(2)(A)(ii) and 
(iii) shall not apply.
    (v) Examples. The provisions of this subparagraph (5) may be 
illustrated by the following examples:

    Example (1). The facts are the same as in Example (3) of paragraph 
(d)(4) of this section, except that X and Y had no accumulated earnings 
and profits at the beginning of its taxable year, X and Y have no 
current earnings and profits as of the date of the distribution, and no 
distribution of property by X immediately before the separation would 
require recognition of gain that would result in earnings and profits 
for the taxable year of the distribution. The transaction is considered 
not to have been used principally as a device. See paragraph (d)(5)(i) 
and (ii) of this section.
    Example (2). Corporation X is engaged in three businesses: a hotel 
business, a restaurant business, and a rental real estate business. 
Individuals A, B, and C own all of the stock of X. X transfers the 
restaurant business to new corporation Y and transfers the rental real 
estate business to new corporation Z. X then distributes the stock of Y 
and Z pro rata between B and C in exchange for all of their stock in X. 
In the absence of section 355, the distribution would be a redemption to 
which section 302(a) applied. Since this distribution involves the stock 
of more than one controlled corporation and facilitates the avoidance of 
the dividend provisions of the Code through the subsequent sale or 
exchange of stock in one corporation and the retention of the stock of 
another corporation, it is not protected by paragraph (d)(5)(i) and (iv) 
of this section from a determination that it was used principally as a 
device. Thus, the determination of whether the transaction was used 
principally as a device must be made from all the facts and 
circumstances, including the presence of the device factors and 
nondevice factors specified in paragraph (d)(2) and (3) of this section.

    (e) Stock and securities distributed--(1) In general. Section 355 
applies to a distribution only if the distributing corporation 
distributes--
    (i) All of the stock and securities of the controlled corporation 
that it owns, or
    (ii) At least an amount of the stock of the controlled corporation 
that constitutes control as defined in section 368(c). In such a case, 
all, or any part, of the securities of the controlled corporation may be 
distributed, and paragraph (e)(2) of this section shall apply.
    (2) Additional rules. Where a part of either the stock or the 
securities of the controlled corporation is retained under paragraph 
(e)(1)(ii) of this section, it must be established to the satisfaction 
of the Commissioner that the retention by the distributing corporation 
was not in pursuance of a plan having as one of its principal purposes 
the avoidance of Federal income tax. Ordinarily, the corporate business 
purpose or purposes for the distribution will require the distribution 
of all of the stock and securities of the controlled corporation. If the 
distribution of all of the stock and securities of a controlled 
corporation would be treated to any extent as a distribution of ``other 
property'' under section 356, this fact tends to establish that the 
retention of stock or securities is in pursuance of a plan having as one 
of its principal purposes the avoidance of Federal income tax.
    (f) Principal amount of securities--(1) Securities received. Section 
355 does not apply to a distribution if, with respect to any shareholder 
or security holder, the principal amount of securities received exceeds 
the principal amount of securities surrendered, or securities are 
received but no securities are surrendered. In such cases, see section 
356.
    (2) Only stock received. If only stock is received in a distribution 
to which section 355(a)(1)(A) applies, the principal amount of the 
securities surrendered, if any, and the par value or stated value of the 
stock surrendered, if any, are

[[Page 197]]

not relevant to the application of that section.
    (g) Period of ownership--(1) Other property. For purposes of section 
355(a)(1)(A), stock of a controlled corporation acquired in a 
transaction in which gain or loss was recognized in whole or in part 
(other than a transaction described in Sec. 1.355-3(b)(4)(iii)) within 
the five-year period ending on the date of the distribution shall not be 
treated as stock of the controlled corporation but shall be treated as 
``other property.'' See section 356. However, for purposes of section 
355(a)(1)(D), the stock so acquired is stock of the controlled 
corporation.
    (2) Example. Paragraph (g)(1) of this section may be illustrated by 
the following example:

    Example. Corporation X has held 85 of the 100 outstanding shares of 
the stock of corporation Y for more than five years on the date of the 
distribution. Six months before that date, X purchased ten more shares. 
If X distributes all of its 95 shares of the stock of Y, so much of 
section 356 as relates to section 355 may apply to the transaction and 
the ten newly acquired shares are treated as other property. On the 
other hand, if X retains ten of the shares of the stock of Y then the 
application of paragraph (e) of this section must take into account all 
of the stock of Y, including the ten shares newly acquired by X and the 
five shares owned by others. Similarly, if, by the use of any agency, X 
acquired any of the stock of Y within the five-year period ending on the 
date of the distribution in a transaction in which gain or loss was 
recognized in whole or in part (for example, where another subsidiary of 
X purchased stock of Y), then that stock is treated as other property. 
If X had held only 75 of the 100 outstanding shares of the stock of Y 
for more than five years on the date of the distribution and had 
purchased the remaining 25 shares six months before that date, then 
neither section 355 nor section 356 would apply to the distribution.

    (h) Active conduct of a trade or business. Section 355 applies to a 
distribution only if the requirements of Sec. 1.355-3 (relating to the 
active conduct of a trade or business) are satisfied.

[T.D. 8238, 54 FR 290, Jan. 5, 1989; 54 FR 5577, Feb. 3, 1989; 57 FR 
28463, June 25, 1992]