[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: 26CFR1.355-3]

[Page 197-201]
 
                       TITLE 26--INTERNAL REVENUE
 
    CHAPTER I--INTERNAL REVENUE SERVICE, DEPARTMENT OF THE TREASURY 
                               (CONTINUED)
 
PART 1_INCOME TAXES--Table of Contents
 
Sec. 1.355-3  Active conduct of a trade or business.

    (a) General requirements--(1) Application of section 355. Under 
section 355(b)(1), a distribution of stock, or stock and securities, of 
a controlled corporation qualifies under section 355 only if--
    (i) The distributing and the controlled corporations are each 
engaged in the active conduct of a trade or business immediately after 
the distribution (section 355(b)(1)(A)), or
    (ii) Immediately before the distribution, the distributing 
corporation had no assets other than stock or securities of the 
controlled corporations, 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 the distributing corporation shall be disregarded for purposes 
of this paragraph (a)(1)(ii).
    (2) Examples. Paragraph (a)(1) of this section may be illustrated by 
the following examples:

    Example (1). Prior to the distribution, corporation X is engaged in 
the active conduct of a trade or business and owns all of the stock of 
corporation Y, which also is engaged in the active conduct of a trade or 
business. X distributes all of the stock of Y to X's shareholders, and 
each corporation continues the active conduct of its trade or business. 
The active business requirement of section 355(b)(1)(A) is satisfied.
    Example (2). The facts are the same as in Example (1), except that X 
transfers all of its assets other than the stock of Y to a new 
corporation in exchange for all of the stock of the new corporation and 
then distributes the stock of both controlled corporations to X's 
shareholders. The active business requirement of section 355(b)(1)(B) is 
satisfied.

    (b) Active conduct of a trade or business defined--(1) In general. 
Section 355(b)(2) provides rules for determining whether a corporation 
is treated as engaged in the active conduct of a trade or business for 
purposes of section 355(b)(1). Under section 355(b)(2)(A), a corporation 
is treated as engaged in the active conduct of a trade or business if it 
is itself engaged in the active conduct of a trade or business or if 
substantially all of its assets consist of the stock, or stock and 
securities, of a corporation or corporations controlled by it 
(immediately after the distribution) each of which is engaged in the 
active conduct of a trade or business.

[[Page 198]]

    (2) Active conduct of a trade or business immediately after 
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 paragraph (b)(2)(ii), (iii), and (iv) of this section.
    (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 are 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 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. Generally, activities performed by the 
corporation itself do not include activities performed by persons 
outside the corporation, including independent contractors. A 
corporation may satisfy the requirements of this subdivision (iii) 
through the activities that it performs itself, even though some of its 
activities are performed by others. Separations of real property all or 
substantially all of which is occupied prior to the distribution by the 
distributing or the controlled corporation (or by any corporation 
controlled directly or indirectly by either of those corporations) will 
be carefully scrutinized with respect to the requirements of section 
355(b) and this Sec. 1.355-3.
    (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.
    (3) Active conduct for five-year period preceding distribution. 
Under section 355(b)(2)(B), a trade or business that is relied upon to 
meet the requirements of section 355(b) must have been actively 
conducted throughout the five-year period ending on the date of the 
distribution. For purposes of this subparagraph (3)--
    (i) Activities which constitute a trade or business under the tests 
described in paragraph (b)(2) of this section shall be treated as 
meeting the requirement of the preceding sentence if such activities 
were actively conducted throughout the 5-year period ending on the date 
of distribution, and
    (ii) The fact that a trade or business underwent change during the 
five-year period preceding the distribution (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 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.
    (4) Special rules for acquisition of a trade or business (Prior to 
the Revenue Act of 1987 and Technical and Miscellaneous Revenue Act of 
1988)--(i) In general. Under section 355(b)(2)(C), a trade or business 
relied upon to meet the requirements of section 355(b) must not have 
been acquired by the distributing corporation, the controlled 
corporation, or another member of the affiliated group during the five-
year period ending on the date of the distribution unless it was 
acquired in a transaction in which no gain or loss was recognized. 
Similarly, under section

[[Page 199]]

355(b)(2)(D), the trade or business must not have been indirectly 
acquired by any of those corporations (or a predecessor in interest of 
any of those corporations) during that five-year period in a transaction 
in which gain or loss was recognized in whole or in part and which 
consisted of the acquisition of control of the corporation directly 
engaged in the trade or business, or the indirect acquisition of control 
of that corporation through the direct or indirect acquisition of 
control of one or more other corporations. A trade or business acquired, 
directly or indirectly, within the five-year period ending on the date 
of the distribution 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 transferror.
    (ii) Example. Paragraph (b)(4)(i) of this section may be illustrated 
by the following example:

    Example. In 1985, corporation X, which operates a business and has 
cash and other liquid assets, purchases all of the stock of corporation 
Y, which is engaged in the active conduct of a trade or business. Later 
in the same year, X merges into Y in a ``downstream'' statutory merger. 
In 1986, Y transfers the business assets formerly owned by X to a new 
subsidiary, corporation Z, and then distributes the stock of Z to Y's 
shareholders. Section 355 does not apply to the distribution of the 
stock of Z because the trade or business of Y was indirectly acquired by 
X, a predecessor in interest of Y, during the five-year period preceding 
the distribution.

    (iii) Gain or loss recognized in certain transactions. The 
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 corporation of that trade of 
business in a distribution to which section 355 would otherwise apply. A 
direct or indirect acquisition of a trade or business by one member of 
an affiliated group from another member of the group is not the type of 
transaction to which section 355(b)(2)(C) and (D) is intended to apply. 
Therefore, in applying section 355(b)(2)(C) or (D), such an acquisition, 
even though taxable, shall be disregarded.
    (iv) Affiliated group. For purposes of this subparagraph (4), the 
term affiliated group means 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).
    (5) Special rules for acquisition of a trade or business (After the 
Revenue Act of 1987 and Technical and Miscellaneous Revenue Act of 
1988). [Reserved]
    (c) Examples. The following examples illustrate section 355(b)(2)(A) 
and (B) and paragraph (b)(1), (2), and (3) of this section. However, a 
transaction that satisfies these active business requirements will 
qualify under section 355 only if it satisfies the other requirements of 
section 355 (a) and (b).

    Example (1). Corporation X is engaged in the manufacture and sale of 
soap and detergents and also owns investment securities. X transfers the 
investment securities to new subsidiary Y and distributes the stocks of 
Y to X's shareholders. Y does not 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.
    Example (2). Corporation X owns, manages, and derives rental income 
from an office building and also owns vacant land. X transfers the land 
to new subsidiary Y and distributes the stock of Y to X's shareholders. 
Y will subdivide the land, install streets and utilities, and sell the 
developed lots to various homebuilders. Y does not satisfy the 
requirements of section 355(b) because no significant development 
activities were conducted with respect to the land during the five-year 
period ending on the date of the distribution. See paragraph (b)(3) of 
this section.
    Example (3). Corporation X owns land on which it conducts a 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. X has engaged in no significant activities in connection with 
its mineral rights. X transfers its mineral rights to new subsidiary Y 
and distributes the stock of Y to X's shareholders. Y will actively 
pursue the development of the oil producing potential of the property. Y 
does not satisfy the requirements of section 355(b) because X engaged in 
no significant exploitation activities with respect to the mineral 
rights during the five-

[[Page 200]]

year period ending on the date of the distribution. See paragraph (b)(3) 
of this section.
    Example (4). For more than five years, corporation X has conducted a 
single business of constructing sewage disposal plants and other 
facilities. X transfers one-half of its assets to new subsidiary Y. 
These assets include a contract for the construction of a sewage 
disposal plant in State M, construction equipment, cash, and other 
tangible assets. X retains a contract for the construction of a sewage 
disposal plant in State N, construction equipment, cash, and other 
intangible assets. X then distributes the stock of Y to one of X's 
shareholders in exchange for all of his stock of X. X and Y both satisfy 
the requirements of section 355(b). See paragraph (b)(3)(i) of this 
section.
    Example (5). For the past six years, corporation X has owned and 
operated two factories devoted to the production of edible pork skins. 
The entire output of one factory is sold to one customer, C, while the 
output of the second factory is sold to C and a number of other 
customers. To eliminate errors in packaging, X opens a new factory. 
Thereafter, orders from C are processed and packaged at the two original 
factories, while the new factory handles only orders from other 
customers. Eight months after opening the new factory, X transfers it 
and related business assets to new subsidiary Y and distributes the 
stock of Y to X's shareholders. X and Y both satisfy the requirements of 
section 355(b). See paragraph (b)(3)(i) and (ii) of this section.
    Example (6). Corporation X has owned and operated a men's retail 
clothing store in the downtown area of the City of G for nine years and 
has owned and operated another men's retail clothing store in a suburban 
area of G for seven years. X transfers the store building, fixtures, 
inventory, and other assets related to the operations of the suburban 
store to new subsidiary Y. X also transfers to Y the delivery trucks and 
delivery personnel that formerly served both stores. Henceforth, X will 
contract with a local public delivery service to make its deliveries. X 
retains the warehouses that formerly served both stores. Henceforth, Y 
will lease warehouse space from an unrelated public warehouse company. X 
then distributes the stock of Y to X's shareholders. X and Y both 
satisfy the requirements of section 355(b). See paragraph (b)(3)(i) of 
this section.
    Example (7). For the past nine years, corporation X has owned and 
operated a department store in the downtown area of the City of G. Three 
years ago, X acquired a parcel of land in a suburban area of G and 
constructed a new department store on it. X transfers the suburban store 
and related business assets to new subsidiary Y and distributes the 
stock of Y to X's shareholders. After the distribution, each store has 
its own manager and is operated independently of the other store. X and 
Y both satisfy the requirements of section 355(b). See paragraph 
(b)(3)(i) and (ii) of this section.
    Example (8). For the past six years, corporation X has owned and 
operated hardware stores in several states. Two years ago, X purchased 
all of the assets of a hardware store in State M, where X had not 
previously conducted business. X transfers the State M store and related 
business assets to new subsidiary Y and distributes the stock of Y to 
X's shareholders. After the distribution, the State M store has its own 
manager and is operated independently of the other stores. X and Y both 
satisfy the requirements of section 355(b). See paragraph (b)(3)(i) and 
(ii) of this section.
    Example (9). For the past eight years, corporation X has engaged in 
the manufacture and sale of household products. Throughout this period, 
X 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. X transfers the 
research department to new subsidiary Y and distributes the stock of Y 
to X's shareholders. After the distribution, Y continues its research 
operations on a contractual basis with several corporations, including 
X. X and Y both satisfy the requirements of section 355(b). See 
paragraph (b)(3)(i) of this section. The result in this example is the 
same if, after the distribution, Y continues its research operations but 
furnishes its services only to X. See paragraph (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 (10). For the past six years, corporation X has processed 
and sold meat products. X derives income from no other source. X 
separates the sales function from the processing function by 
transferring the business assets related to the sales function and cash 
for working capital to new subsidiary Y. X then distributes the stock of 
Y to X's shareholders. After the distribution, Y purchases for resale 
the meat products processed by X. X and Y both satisfy the requirements 
of section 355(b). See paragraph (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 (11). For the past eight years, corporation X has been 
engaged in the manufacture and sale of steel and steel products. X owns 
all of the stock of corporation Y, which, for the past six years, has 
owned and operated a coal mine for the sole purpose of supplying X's 
coal requirements in the manufacture of steel. X distributes the stock 
of Y to X's shareholders. X and Y both satisfy the requirements of 
section 355 (b). See paragraph (b)(3)(i) of this section. However, see

[[Page 201]]

Sec. 1.355-2 (d)(2)(iv)(C) (related function device factor) for 
possible evidence of device.
    Example (12). For the past seven years, corporation X, a bank, has 
owned an eleven-story office building, the ground floor of which X has 
occupied in the conduct of its banking business. The remaining ten 
floors are rented to various tenants. Throughout this seven-year period, 
the building has been managed and maintained by employees of the bank. X 
transfers the building to new subsidiary Y and distributes the stock of 
Y to X's shareholders. Henceforth, Y will manage the building, negotiate 
leases, seek new tenants, and repair and maintain the building. X and Y 
both satisfy the requirements of section 355 (b). See paragraph (b)(3) 
of this section.
    Example (13). For the past nine years, corporation X, a bank, has 
owned a two-story building, the ground floor and one half of the second 
floor of which X has occupied in the conduct of its banking business. 
The other half of the second floor has been rented as storage space to a 
neighboring retail merchant. X transfers the building to new subsidiary 
Y and distributes the stock of Y to X's shareholders. After the 
distribution, X leases from Y the space in the building that it formerly 
occupied. Under the lease, X will repair and maintain its portion of the 
building and pay property taxes and insurance. Y 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 X with respect to the building 
prior to the separation would constitute the active conduct of a trade 
or business.

[T.D. 8238, 54 FR 294, Jan. 5, 1989]