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MEMORANDUM
TO: Senior Partner
FROM: Team Number 5
DATE: November 12, 2003
SUBJECT: 2003 Law Student Tax Challenge Problem
You asked us to analyze the facts of the proposed deal involving LandCo, Inc.
(“LandCo”) and discuss the following questions:
QUESTIONS PRESENTED
1) Whether LandCo is engaged in an active trade or business within the meaning of Section 355
of the Internal Revenue Code of 1986, as amended (“Code”);
2) Whether the proposed transaction would satisfy the business purpose test;
3) Whether the proposed transaction would constitute a “reportable transaction” under the
appropriate Treasury Regulations (“Regulations”).
SHORT ANSWERS
1) No, LandCo is not engaged in an active trade or business under § 355;
2) Yes, the proposed transaction will satisfy the business purpose test;
3) No, the proposed transaction will not constitute a “reportable transaction.”
SUMMARY OF THE ARGUMENT
LandCo is not engaged in an active trade or business because it leases real estate solely
for investment purposes, and the LandCo shareholders operate the business as would any prudent
real estate investor. However, the mutual desire of Fermier and Colona to part ways and devote
substantially more time to their respective businesses, as well as Colona’s desire to sell stock in
LandCo to her key employees, constitute a cognizable business purpose that will be respected
under § 355. Lastly, based on the requirements of Regulation § 1.6011-4(b) the completion of
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the proposed transaction will not be a reportable transaction.
LEGAL ARGUMENT
Fermier1 and Colona Smith desire to divide their interests in LandCo’s land to pursue
their individual economic goals for their respective portions of the land. To achieve these goals
they propose to distribute one-half of the land to a newly formed wholly owned subsidiary of
LandCo (“Newco”) in an I.R.C. § 368(a)(1)(D) reorganization, followed by a § 355 split-off
where Fermier and Mimi shall, immediately after the distribution, transfer all of their LandCo
stock for all outstanding stock of the Newco (the “Transaction”). In order to qualify for a § 355
split-off the following statutory requirements must be met:
1) The distribution must consist of solely controlled corporation stock;
2) The distribution must not be principally a device to distribute the earnings and profits
of either corporation;
3) Both corporations must conduct an active trade or business as defined in § 355(b);
4) All of the stock of the controlled corporation held by the distributing corporation must
be distributed in the transaction.
In addition to these statutory requirements, the Transaction must have a business purpose.
This memorandum will discuss whether the Transaction satisfies the active trade or business
requirements of § 355(b) and the business purpose requirements.2 Further, this memorandum
will also discuss whether the Transaction would qualify as a reportable transaction under
Regulations § 1.6011-4.
1
All proposed transactions assume that Mimi, Fermier’s wife, will act in accordance with the goals of Fermier and
exchange her LandCo stock in the same manner as Fermier. Indeed under § 355(d)(7) such would be necessary to
complete a valid split-off because Mimi’s stock is attributable to Fermier.
2
Research on additional pertinent statutory or judicial requirements for such a transaction will be conducted per
your request.
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I. The Active Trade or Business and Business Purpose Requirements.
A. Active Trade or Business.
Section 355(b) as amplified by the Regulations establishes the requirements for what
constitutes an active trade or business. The statute merely states that a corporation, or its
controlled corporation, must be actively engaged in a trade or business for “the 5-year period
ending on the date of the distribution.” Further, neither the trade or business nor control of a
corporation which conducts the trade or business may be acquired in a transaction where gain or
loss is recognized within the proceeding five year period. § 355(b)(2). Since LandCo has
conducted its real estate leasing business for more than five years, we must look to the
Regulations, the case-law, and revenue rulings to determine whether the leasing business meets
the definition of an active trade or business.
Regulation § 1.355-3(b)(2)(iii) provides that an active trade or business must include
“active and substantial management and operational functions. … Separations of real property
all or substantially all of which is occupied prior to the distribution by the distributing or the
controlled corporation . . . will be carefully scrutinized with respect to the requirements of
section 355(b) and this § 1.355-3.” Specifically excluded as not constituting an active trade or
business are: “(A) [t]he holding for investment purposes of stock, securities, land, or other
property, or (B) [t]he 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.” § 1.355-3(b)(iv)(A), (B) (emphasis added).
The case-law on active trade or business in the real estate leasing context also requires a
high level of management and administrative activity. In Rafferty v. Commissioner, 452 F.2d
767, 772 (1st Cir. 1971), the court found that “in order to be an active trade or business under §
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355 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.” In Rafferty the
activities of the corporation in question included holding real estate and leasing it back to its
parent corporation through a net lease, purchasing vacant land on which it built a plant, leasing
that land to its parent corporation, and keeping separate books. Id. at 768-69. The corporation in
Rafferty had no employees, but conducted all of its operations through its sole stockholder and
officer. Id. The court in Rafferty found the corporation in question indistinguishable from a
mere investment, and that its activities did not constitute an active trade or business. Id. at 773.3
Revenue Ruling 86-126, 1986-2 C.B. 58, holds that a corporation is not engaged in an
active trade or business when it leases a large tract of land to two tenant farmers and the only
activities performed by the corporation were occasional inspections of the property and decisions
regarding crop rotations. Revenue Ruling 86-126 expressly distinguished Rev. Rul. 73-234,
1973-1 C.B. 180, where a controlled corporation leased its land to tenant farmers and actively
participated in the management of day to day operations on the farms. In Rev. Rul. 73-234 the
controlled corporation actively engaged in negotiations with the tenant farmers, employed a
handyman to maintain farm equipment, obtained and supplied financing to the tenant farmers,
purchased and bred livestock, planned all crop rotations and harvesting, and sold and accounted
for all crops harvested by the tenant farmers. The IRS held such activities constituted an active
trade or business. Rev. Rul. 73-234, 1973-1 C.B. 180.
LandCo appears not to be engaged in an active trade or business. The only activities
3
See also Bonsall v. Comm’r, 317 F.2d 61 (2nd Cir. 1963) (real estate businesses will be given special scrutiny
because of potential for abuse; holding small amounts of real estate and not actively placing them on the market
does not constitute an active real estate rental business); Appleby v. Comm’r, 35 T.C. 755 (1961) (rental of excess
portions of owner-occupied real estate not considered an active trade or business); Elliot v. Comm’r, 32 T.C. 283
(1959) (same); But see King v. Comm’r, 458 F.2d 245 (6th Cir. 1972) (corporations that acquired land, negotiated
with contractors, obtained financing for construction projects, built extensively on land, and leased it back to parent
corporation through a net lease were engaged in active trade or business in part because net leases were common in
that industry and were the most efficient way to operate).
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performed by LandCo are through its officers and one part-time employee and consist solely of
collecting rent, maintaining a road on the land, spraying for weeds on the edge of the land, and
keeping the books of the corporation. These activities seem to fall squarely within the
Regulations that state that the leasing of real estate is not an active trade or business “unless the
owner performs significant services with respect to the operation and management of the
property.” § 1.355-3(b)(iv)(B). The collecting of rent, spraying for weeds, and maintaining a
road are not significant management and operational activities. Further, the activities performed
by LandCo are even of a lesser quality and quantity than those engaged in by the taxpayer in
Rafferty who was found to not be actively engaged in a trade or business. Additionally,
LandCo’s activities closely parallel those in Rev. Rul. 86-126 (finding no active trade or
business) and are markedly different from the active leasing business described in Rev. Rul. 73-
234. LandCo is essentially a dormant real estate holding company for the shareholders’
investment purposes. Therefore, LandCo will not qualify as conducting an active trade or
business under § 355(b).4
B. Business Purpose.
In Gregory v. Helvering, 293 U.S. 465 (1935) the Court imported the business purpose
requirement into § 355. The Regulations define a business purpose as “a real and substantial non
Federal tax purpose germane to the business of the distributing corporation, the controlled
corporation, or the affiliated group . . . .” § 1.355-2(b)(2). A corporate business purpose is not
synonymous with a shareholder purpose; however, a shareholder purpose that is co-extensive
4
However, the following alternate transaction would allow LandCo to conduct an active trade or business. First,
both Tenant Farm Company, LLC (“TFC”) owned by Colona and Grain & Seed, LLC (“G&S”) owned by Fermier
shall be incorporated in Section 351 transactions. Second, TFC and G&S shall merge into LandCo in Section
368(a)(1)(A) reorganizations. Then, LandCo will be deemed to have acquired two active trades or businesses within
five years in transactions in which no gain or loss was recognized pursuant to Section 355(b)(2)(C). Such a
transaction could supply the active business that LandCo currently lacks.
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with an otherwise valid business purpose “germane to the continuance of the corporate business”
will not preclude the finding of a valid business purpose. Rafferty, 452 F.2d at 770.
Revenue Procedure 96-30, 1996-1 C.B. 696 lists, inter alia, the following motives which
constitute a valid business purpose for a § 355 distribution:
1) when the distribution would enable either a distributing or a controlled corporation to
issue a significant equity share to key employees to retain their services, and such goal
cannot realistically be accomplished by another non-taxable transaction; or
2) when the distribution would eliminate stress and friction between shareholders who
desire to pursue different goals.
Revenue Ruling 85-127, 1985-2 C.B. 119 held a valid business purpose for a § 355 split-
off existed where a key employee of a unified business received, pursuant to a distribution, an
equity stake in the portion of the business where the employee worked, and the unified business
stock was too expensive for the employee to purchase.5 Revenue Ruling 69-460, 1969-2 C.B.
51, situation 1, held a valid business purpose existed when two co-owners of a company had
serious disputes as to the future of their business such that the operation of the business was
seriously affected. The Ruling allowed a split-off half the assets in a § 355 transaction to one of
the shareholders so that they could each pursue their individual plans and desires.6
Revenue Ruling 2003-52, 2003-22 I.R.B. 960 describes a family owned farming business
operated by two siblings who desired to develop the business in two different directions. Their
disagreements had not caused any inability to operate the current business per se, but prevented
each from focusing on their individual desires. A § 355 split-off of half the farm was proposed
5
See also § 1.355-2(b)(5) example 8; Rev. Rul. 69-460, 1969-2 C.B. 51, situation 2.
6
See also § 1.355-2(b)(5) example 2; P.L.R. 8712019 (Dec. 18, 1986) (satisfying key employees with equity interest
where they do not wish to own any interest in other business owned by the same corporation); P.L.R. 9326011 (July
2, 1993) (same).
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so that each sibling could use his and her respective half as desired with a consistent business
approach appropriate to the respective businesses. The purposes of the transaction also included
the promotion of family harmony and family estate planning goals. The IRS ruled that the
proposed transaction had a valid business purpose. Id.
The Transaction contains many of the elements required by Rev. Proc. 96-30, 1996-1
C.B. 696 and found in Rev. Rul.’s 85-127, 2003-52, and 69-460. Fermier and Colona have
differing ideas on how to best make use of LandCo’s asset to satisfy their respective expectations
of the profitability of that asset. Fermier wishes to be able to sell portions of the land to raise the
cash he needs to retire and fund his children’s education. Colona wishes to retain her half of the
land longer than Fermier in order to continue her composting business, sell stock to key
employees, and does not wish LandCo to be saddled with the tax expenses involved with
Fermier’s plans. Furthermore, Colona desires that her son inherit what she views as her portion
of the land without any entanglement with Fermier’s half.
Fermier’s and Colona’s motives closely resemble those described in Rev. Rul. 2003-52.
The Transaction will give both Fermier and Colona the freedom to develop and liquidate their
respective businesses when they choose without affecting or requiring the approval of the other.
While not the primary purpose, the Transaction will also further Colona’s estate planning goals
in a way similar to the goals of the taxpayers in Rev. Rul. 2003-52. However, Rev. Rul. 2003-52
may be distinguishable because those facts describe two businesses within the corporation to be
divided, while in the Transaction the businesses are not part of LandCo, but owned separately by
Colona and Fermier. Further, the ownership of the land by LandCo does not prevent them from
focusing all their attention on their respective businesses, just as they have been doing since
1997. Colona’s estate planning desires are not a valid business purpose but are more of a
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shareholder purpose which is not co-extensive with any LandCo business purpose.
However, a strong business purpose can be found in Colona’s desire to sell stock in
LandCo to several of her key employees who cannot otherwise afford to purchase the stock. Her
desire has existed for some time and is specifically sanctioned in both Rev. Proc. 96-30 and Rev.
Rul.’s 85-127 and 69-460. While the facts in the Transaction are not quite the same as those in
Rev. Rul.’s 85-127 and 69-460, in that Colona’s employees are not employees of LandCo, if
LandCo views TFC as a valuable tenant, maintaining the health of TFC is well within the
business interests of LandCo. Even though Colona could easily incorporate TFC and issue stock
in the TFC corporation to her employees, the equity in TFC would probably not be a sufficiently
valuable enticement to her key employees to have the desired effect without the value of the land
TFC uses as part of the assets of TFC.
Therefore the facts seem to establish a sufficient business purpose for the Transaction.
II. The Reportable Transaction Requirements.7
A “reportable transaction” is defined in 26 CFR § 1.6011-4(b), and includes the
following kinds of transactions: (1) listed transactions, (2) confidential transactions, (3)
transactions with contractual protections, (4) loss transactions, (5) transactions with a significant
book-tax difference, and (6) transactions involving a brief asset holding period.8
A “transaction with a significant book-tax difference” only applies to taxpayers that (1)
are reporting companies under the Securities and Exchange Act of 1934 and related businesses;
or (2) business entities that have $250,000,000 or more in gross assets for book purposes. §
7
In regards to your concern about our firm having to comply with the list-keeping requirements, as you know these
requirements are extremely detailed and we would be happy to present to you our analysis of them in a separate
memorandum.
8
The Transaction is not : (3) a transaction with contractual provisions because the fee arrangement is neither
contingent or reimbursement in nature, § 1.6011-4(b)(4); (4) a loss transaction because LandCo only has built in
gain assets, § 1.6011-4(b)(5); nor (6) a transaction involving a brief asset holding period because both Fermier and
Colona intend to hold the assets of LandCo for more than 45 days, § 1.6011-4(b)(7).
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1.6011-4(b)(6)(ii). LandCo is not characterized by either of these requirements.
A “listed transaction” is a transaction equal or substantially similar to any transaction
identified by the IRS as a tax avoidance transaction in some form of published guidance. §
1.6011-4(b)(2). The Transaction does not contain any substantially similar characteristics to any
transaction identified by the IRS as a tax avoidance transaction.9
“A confidential transaction is a transaction that is offered to a taxpayer under conditions
of confidentiality.” § 1.6011-4(b)(3)(i). Included are transactions where the taxpayer may not
disclose the structure or nature of the transaction pursuant to an agreement that is “for the benefit
of any person who makes or provides a statement, oral or written, to the taxpayer . . . .” Id. The
Preamble to the Regulation states that “[a] confidential transaction is a transaction that is offered
under conditions of confidentiality.” 68 Fed. Reg. 10161 (to be codified in 26 C.F.R. pt. 1, 20,
25, 31, 53, 54, 56, 301, and 602); Treas. Dec. Int. Rev. 9046 (2003) (emphasis added). In the
House Report to I.R.C. § 6111, which requires disclosure of a tax shelter offered pursuant to a
confidential agreement, Congress used the word “promoter” to describe the party that in the §
1.6011-4 context would be making the tax statement. H.R. Rep. No. 105-148, at 469-70 (1997),
reprinted in 1997 U.S.C.C.A.N. 678, 863-64.10 Thus, the Congressional intent behind the
disclosure of confidential agreements seems to be to alert the IRS to a possibly abusive tax
shelter where a law or accounting firm is marketing the shelter and does not want the shelter
disclosed to others so that the firm can continue exploiting the shelter as a means of income. The
Transaction is not a highly lucrative or secretive shelter that our firm is marketing and
promoting. Furthermore, our firm did not approach or offer the transaction to Fermier or
9
See Steven M. Rosenthal & Jeanne K. Falstrom, Me, A Material Advisor? What Now?, 98 Tax Notes 1749, 1761-
62, March 17, 2003.
10
The confidentiality standard in Code § 6111 and Reg. § 1.6011-4 are substantially the same, and thus it is
appropriate to view the legislative history of § 6111 in interpreting § 1.6011-4.
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LandCo. Rather, Fermier came to our firm having already signed a confidentiality agreement to
which our firm is not a party. Additionally, from what Fermier has told us it is not clear what he
intended to accomplish with the confidentiality agreement. He stated that it was in order to not
deter potential buyers by tax planning. The only thing that may deter potential buyers is hiding
from them crucial facts like the tax basis of the land, which is the only aspect of this Transaction
that would affect a potential buyer.
Therefore, while the Transaction, along with the confidentiality agreement, may fit into a
certain interpretation of the definition of confidential transaction, the intent of Congress and the
drafters of the Regulations appears not to encompass our current situation. For additional
assurance, Fermier and our firm should sign waivers stating any counsel we render regarding the
Transaction is not confidential.
Therefore, LandCo should not have to report the Transaction to the IRS because it does
not fall under any of the Regulations as a reportable transaction.
CONCLUSION
Absent modifications to the Transaction, LandCo lacks the necessary level of
management and operational activities to constitute an active trade or business. However,
LandCo’s motives in executing the Transaction should be sufficient to establish a valid business
purpose to qualify the Transaction as a § 355 split-off. Additionally, even as proposed, LandCo
will not be required to report the Transaction to the IRS; however, a waiver may be desired to
achieve a certain level of assurance. Lastly, as indicated in Footnote 4 on p. 5, we feel there is a
relatively easy way to restructure the Transaction so that LandCo could establish an active trade
or business and qualify the Transaction for § 355 treatment. We will be happy to present you
with our research on this matter.
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LAW OFFICES OF TEAM NUMBER 5
Tax Town, ABA State, 10000
Mr. Fermier Smith,
Tax Town, ABA State, 10000
November 12, 2003
Re: 2003 Law Student Tax Challenge Problem
Dear Mr. Smith,
You asked us to give an opinion as to whether LandCo could divide and transfer half of
its land to a new corporation, after which you and your wife would exchange your stock in
LandCo for all of the stock in the new corporation, all in a tax free transaction. We have also
considered whether you will need to report the transaction to the IRS. We have relied on the
following facts in rendering our opinion.
LandCo is a corporation that owns one asset consisting of a 320-acre piece of farmland.
LandCo has 400 shares outstanding of its sole class of voting stock of which you own 100
shares, your wife, Mimi, owns 100 shares, and your sister, Colona, owns 200 shares. LandCo
leases half the land to Tenant Farm Company, LLC (“TFC”) which is wholly owned by Colona
and manufactures and sells compost. LandCo leases the other half of the land to Grain & Seed,
LLC (“G&S”) which you own and operate as a traditional farm. Both of the leases are triple net
leases, which is to say that TFC and G&S are responsible for the taxes, insurance, and
maintenance for their respective leased portions of the land, and LandCo is not responsible for
those activities pursuant to the leases.
The only actions performed by LandCo are through you and Colona as officers, and
Mimi as an officer and a part-time employee. Those actions consist solely of collecting rent,
keeping the books, maintenance of a road on the land, and spraying for weeds on the edge of the
land.
The disagreements between you and Colona as to the future of the land owned by
LandCo have prompted the need for the proposed transaction. Colona wishes to continue her
composting business on her leased portion of the LandCo land for approximately 12 more years,
and have her son inherit that half of the land. She also wishes to sell stock to some of her key
employees, but currently LandCo stock would be too expensive for them; she believes the
proposed transaction will solve that problem.
You, however, wish to continue your G&S farming business for only about 6 more years,
and then sell portions of the land that G&S leases as necessary to fund your children’s education.
In pursuance of this transaction you, your wife, and Colona have signed a confidentiality
agreement not to disclose the terms of the transaction to any third parties.
The proposed transaction will be tax free if it qualifies under section 355 of the Internal
Revenue Code (“§ 355”). Section 355 has several requirements, most of which the proposed
transaction clearly satisfies. However, there are two requirements that may be difficult to
establish in the proposed transaction as currently contemplated: (1) LandCo and the new
corporation to be formed must both be actively engaged in a trade or business as defined in §
355; and (2) there must be a valid corporate business purpose for the proposed transaction.
LandCo’s current business is the leasing of real estate in that LandCo has only one asset,
a large tract of real estate, and its sole significant activity is leasing that land to TFC and G&S.
To be actively engaged in the business of leasing real estate a corporation must, through its own
employees or officers, perform significant activities with respect to the management and
operation of the property. Examples of such significant activities when the tenants engage in
2
farming include the planning of crop rotation and harvesting, obtaining financing for tenants,
providing maintenance of farm equipment, and actively seeking out and negotiating with
multiple tenant farmers. Conversely, the IRS has decided that when a corporation leasing
farmland merely keeps separate books, makes occasional inspections of the land, and helps make
decisions about crop rotations, then those activities do not rise to the level of an active business.
Currently the only activities performed by LandCo are collecting rent, keeping separate
books, the maintenance of a road, and spraying weeds along the edges of the property. These
activities involve neither the management nor operation of the property, nor do these activities
seem significant as described to us. Therefore, LandCo does not currently appear to be engaged
in an active trade or business as required by § 355.
Another area of concern in this transaction is whether, from the perspective of LandCo or
the new corporation, a valid business purpose exists. Business purposes recognized by the IRS
include the desire for shareholders of a single corporation to part ways in order to develop
separate lines of business, and where the transaction would enable one of the corporations to
distribute stock to key employees who cannot otherwise obtain stock in a tax free manner. The
business purpose must not be solely the avoidance of federal income taxes.
Several business purposes motivate the proposed transaction other than the avoidance of
federal income tax. A valid disagreement exists with respect to the future of LandCo and the
continuing use of its asset. A separation of the land into two separate corporations would
facilitate a resolution satisfactory to both you and Colona. Colona also wishes to sell some of
her key employees stock in LandCo and the proposed transaction would make that possible.
Therefore, even as currently structured, a sufficient business purpose exists for the proposed
transaction to qualify under § 355.
3
Lastly, we have examined whether you will need to report the proposed transaction to the
IRS. The only aspect of the proposed transaction that would potentially require disclosure to the
IRS is the confidentiality agreement you signed. The tax regulations require that a transaction be
reported where a confidential agreement benefits a firm giving tax advice to certain taxpayers,
including those in your position. The agreement you signed could potentially benefit our firm by
preventing you from disclosing tax related aspects of the transaction that you learn from us, even
though you signed the agreement before you retained us as counsel. However, the proposed
transaction is neither complex nor novel, and thus we have no proprietary interest in keeping the
tax aspects of the transaction a secret.
To insure that the proposed transaction will not be characterized by the IRS as a
reportable transaction we should both execute waivers to the confidentiality agreement. Those
waivers would specify that the advice and counsel we give you is not confidential, and that your
confidentiality agreement does not cover any advice that we render. Additionally, you would be
well advised to obtain such a waiver from your accountant.
The federal income tax laws are complex, and their impact depends on a close and careful
analysis of the facts. Our conclusions are based on the facts and assumptions stated in this letter.
If the actual facts differ or if our assumptions prove incorrect, our conclusions may change.
If you have any questions, please contact us.
Sincerely,
TEAM NUMBER 5
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