Rev. Rul. 79-49: Shareholder Disputes as a Business Purpose

Revenue Ruling 79-49, from the Internal Revenue Service (IRS), provides guidance on the “business purpose” requirement for a corporate separation to qualify for tax-free treatment. It specifically addresses whether a significant dispute between shareholders can serve as a valid reason for a “split-off,” a type of corporate division where some shareholders exchange their stock in the parent corporation for stock in a new, separate corporation. This ruling is a reference point for businesses structuring corporate separations under Section 355 of the Internal Revenue Code.

The guidance clarifies that not just any disagreement qualifies; the conflict must be substantial enough to negatively affect the corporation’s operations. Understanding this distinction helps in navigating the requirements for a tax-free reorganization and avoiding unintended tax liabilities.

The Factual Background of the Ruling

Revenue Ruling 79-49 was based on a corporation with two main lines of business and two shareholders who owned the company equally. One shareholder managed the corporation’s automobile dealership, while the other managed a separate automobile leasing and rental business. Both businesses had been actively conducted for more than five years.

The conflict between the two shareholders stemmed from irreconcilable disagreements over business policies, including how to expand the business, appropriate inventory levels for the dealership, and the amount of financing for the leasing operations. This ongoing friction created a significant operational problem for the corporation. The inability of the shareholders to agree on major decisions led to a management deadlock, hindering the day-to-day functioning and strategic growth of both businesses.

To resolve this impasse, the shareholders separated the corporation into two distinct entities, with the leasing manager exchanging their stock in the original company for all the stock of a new corporation holding the leasing assets.

The Ruling’s Core Principle

The ruling’s core principle is the distinction between a corporate business purpose and a shareholder business purpose. For a corporate separation to qualify for tax-free treatment under Section 355, the transaction must be motivated by a non-federal tax purpose germane to the business of the corporation. A purpose that primarily benefits the shareholders personally, such as for estate planning, is not sufficient on its own.

The IRS determined that the shareholder dispute rose to the level of a legitimate corporate business purpose. The conflict was not merely a personal disagreement but had a direct and detrimental impact on the corporation’s ability to conduct its business. The lack of consensus on operational issues was harming the company’s performance and growth.

By separating the two businesses, the corporation could resolve the management deadlock, allowing each business to be managed independently. The IRS concluded that because the dispute was so severe that its resolution served a corporate need, the business purpose requirement was satisfied.

Requirements for Citing Shareholder Dispute as a Business Purpose

Citing a shareholder dispute as the business purpose for a tax-free separation requires showing the conflict is genuine, severe, and directly impacts the corporation’s operations. A primary requirement is demonstrating that the dispute is irreconcilable, meaning the shareholders have reached a deadlock where they cannot jointly manage the company effectively.

Evidence of this negative impact is paramount. Taxpayers must show how the disagreement is harming the business, such as by causing a standstill in decision-making, preventing the company from pursuing profitable opportunities, or negatively affecting relationships with suppliers, lenders, or customers. The dispute must be a corporate-level problem, not just a personal one.

Furthermore, the separation must be the only practical solution to resolve the issue. If less drastic, non-taxable alternatives exist that are not impractical or unduly expensive, the IRS may not accept the dispute as a valid business purpose. Proper documentation, such as board meeting minutes and emails detailing the conflict and its effect on the business, can provide crucial support.

Tax Treatment of the Transaction

The tax implications of a corporate split-off depend on whether the transaction meets the requirements of Section 355, including the business purpose test. If the separation qualifies, it is a tax-free event for all parties involved. The distributing corporation does not recognize any gain or loss on the assets of the subsidiary it distributes to the departing shareholder.

For the shareholder receiving the stock, the exchange is also tax-free. The shareholder who surrenders their stock in the original corporation in exchange for stock in the newly formed corporation does not recognize any gain or income. The shareholder’s tax basis in the new stock is the same as their basis in the stock they surrendered.

Conversely, if the transaction fails to qualify, the tax consequences are significant. The distributing corporation would be treated as if it sold the distributed assets at their fair market value, recognizing any built-in gain. For the shareholder, the fair market value of the stock they receive would be treated as a taxable distribution, which could be taxed as a dividend or as a capital gain.