TRA '97 and Sec. 355.

The Taxpayer Relief Act of 1997 (TRA '97) made significant changes to Sec. 355. In spite of all the brouhaha about the repeal of Morris Trust transactions, not all of the changes were anti-taxpayer. The TRA '97 gives added flexibility for post-distribution transactions involving the stock of a newly formed controlled corporation.

If all of the requirements of Sec. 355 are satisfied, a distributing corporation (D) can distribute stock of a controlled corporation (C) to its shareholders without D or its shareholders recognizing gain or other income on the distribution and receipt, respectively, of the C corporation stock. For a distribution to qualify under Sec. 355, (1) D must control C before the distribution, (2) the distribution must not be a device for the distribution of earnings and profits of either corporation, (3) there must be a continuity of interest on the part of the D shareholders after the distribution and (4) there must be a valid business purpose for the distribution of the C stock.

C can be either a preexisting or newly created corporation. In relevant part, Secs. 351 and 368(a)(1)(D) permit D to contribute assets tax-free to a corporation whose stock it will distribute to D shareholders in a Sec. 355 distribution. Both Secs. 351 and 368(a)(1)(D) require D or its shareholders to control C immediately after the contribution of assets. Before the TRA '97, control was defined as 80% of a corporation's voting stock and 80% of the number of shares of all other classes of stock.

Also, before the TRA '97, a distribution of the stock of newly created or preexisting C, followed by a tax-free merger of D into another corporation, could qualify under Sec. 355, notwithstanding the post-distribution merger (this is a Morris Trust transaction; in fact, facilitating the merger could be a good business purpose for the distribution). Similarly, persons could contribute assets to C for additional C stock after the distribution of its shares. In cases involving newly formed controlled corporations, however, the "control immediately after" requirement of Secs. 351 and 368(a)(1)(D) limited the amount of stock received for such an investment to less than 20% of outstanding C stock if D had transferred assets to C before the distribution. For example, if an investor received 20% or more of the stock of C in a post-distribution investment, under prior law, the transfer of assets by D to C likely would have been a taxable transfer; see Rev. Rul. 70-225.

With the TRA '97, Congress sought to prevent the use of Sec. 355 to facilitate the effective disposition of a business, while also treating post-distribution transactions involving C in the same manner as transactions involving D. Generally, the TRA '97 changes to Sec. 355 implement these policies by (1) taxing D on its distribution of C stock if there is a 50% or greater shift in the ownership of either D or C, when such owner shift is pursuant to the same plan as the distribution of the C stock and (2) lowering the Secs. 351 and 368(a)(1)(D) "control immediately after" requirement from 80% to 50% for transfers of assets from D to C in anticipation of a distribution of C stock.

These changes bring both bad news and good news. The bad news is that D can no longer distribute C stock and then merge into an unrelated corporation without risking a corporate-level tax on its distribution. The good news is that post-distribution transfers to C in exchange for more than 20% of its stock will not jeopardize the tax-free status of transfers of assets from D to C, provided D shareholders own at least 50% of the C stock following the distribution. This second change can be helpful, for example, if a newly formed C plans to undertake a post-distribution initial public offering of more than 20% of its stock.