                         115 T.C. No. 18



                     UNITED STATES TAX COURT



         DOUGLAS P. MCLAULIN, JR., ET AL.,1 Petitioners v.
           COMMISSIONER OF INTERNAL REVENUE, Respondent



     Docket Nos. 7832-98, 7833-98,   Filed September 20, 2000.
                 7834-98.



          Ps’ "S corporation", A, owned 50 percent of the
     stock of corporation B, a "C corporation". B redeemed
     individual H’s 50-percent stock interest in B for cash
     and real property. On the previous day, B had borrowed
     from A an amount exceeding the cash consideration and
     representing over 96 percent of the total consideration
     paid to H for his stock. On the same day as the
     redemption, A distributed its then 100-percent stock
     interest in B to Ps in a transaction intended to
     qualify as a tax-free spinoff under sec. 355(a)(1) and
     (c)(1), I.R.C.


          Held: Because A’s distribution of the stock of B
     occurred less than 5 years after A acquired control of

     1
          Cases of the following petitioners are consolidated
herewith: Augustus H. King III, docket No. 7833-98, and
Alfred E. and Lynn B. Holland, docket No. 7834-98.
                               - 2 -

     B in a transaction in which gain or loss was
     recognized, the distribution failed to satisfy the
     active business requirement of sec. 355(a)(1)(C) and
     (b)(2)(D)(ii), I.R.C. The distribution resulted in
     gain to A under sec. 311(b), I.R.C., taxable to P’s
     under sec. 1366(a), I.R.C.



     Robert J. Beckham, Donald W. Wallis, and Suzanne M. Judas,

for petitioners.

     William R. McCants, for respondent.



     HALPERN, Judge:   These consolidated cases involve the

following determinations by respondent of deficiencies in

petitioners’ Federal income taxes for 1993:

                Petitioner                 Deficiency

          Douglas P. McLaulin, Jr.          $97,244
          Augustus H. King III               97,124
          Alfred E. & Lynn B. Holland        97,244

     Unless otherwise indicated, all section references are to

the Internal Revenue Code in effect for the year in issue, and

all Rule references are to the Tax Court Rules of Practice and

Procedure.   Petitioners bear the burden of proof.      See Rule

142(a).

     After concessions, the only issue for decision is whether

the January 15, 1993, distribution by Ridge Pallets, Inc., a

Florida corporation (Ridge), of all of the outstanding stock of

Sunbelt Forest Products, Inc., also a Florida corporation

(Sunbelt), qualifies as a tax-free "spinoff" of Sunbelt to
                                - 3 -

petitioners, the sole shareholders of Ridge, pursuant to section

355.    We hold that it does not.   Our reasons follow.

                          FINDINGS OF FACT

Introduction

       Some facts have been stipulated and are so found.   The

stipulation of facts filed by the parties, with attached

exhibits, is incorporated by reference.

       At the time the petitions were filed, petitioner Douglas P.

McLaulin, Jr. (McLaulin) resided in Mulberry, Florida, petitioner

Augustus H. King III (King) resided in Lakeland, Florida, and

petitioners Alfred E. and Lynn B. Holland (Holland, when

referring to Alfred) resided in Bartow, Florida.

Ridge and Sunbelt

       Ridge was incorporated in 1959 by Richard B. Craney

(Craney).    From 1977 until July 25, 1993, the sole, equal

shareholders of Ridge were McLaulin, King (Craney’s stepson), and

Holland.    Ridge was engaged in the forest products business.

Ridge was profitable, with more than $13 million in retained

earnings as of July 25, 1993.

       On December 31, 1986, Ridge elected to become an

S corporation as that term is defined by section 1361(a)(1)

(S corporation), effective for its taxable year ended July 25,

1988.    Ridge qualified as an S corporation for each taxable year

thereafter, through and including its taxable year ended July 25,

1994.
                                - 4 -

     Sunbelt was incorporated in 1981.2     Initially, its sole,

equal shareholders were Craney, Ridge, and an otherwise unrelated

individual, John L. Hutto (Hutto).      In 1986, Craney’s shares of

stock were redeemed by Sunbelt, and, from then until January 15,

1993, Ridge and Hutto were the sole, equal shareholders of

Sunbelt.    Hutto was president of Sunbelt and chairman of its

board of directors.    He was responsible for all executive

functions of Sunbelt.    Sunbelt produced and sold pressure-treated

lumber.    That business was profitable.   In February 1989, based

on Hutto’s experience in the millwork business (manufacturing

doors and window frames), Sunbelt entered the millwork business

(the millwork division).    The millwork division lost money from

its inception to its shutdown in mid-1990.     Because of Sunbelt’s

management’s focus on the millwork division, Sunbelt’s core

business (pressure-treating lumber) also suffered.     Nonetheless,

Sunbelt had over $1.8 million in retained earnings as of the

close of its fiscal taxable year ended June 26, 1993.

Events Leading to Ridge’s Distribution of the Sunbelt Stock to
Ridge’s Shareholders

     In 1982, Sunbelt began to borrow money from Citrus and

Chemical Bank, in Bartow, Florida (the Bank), pursuant to a

     2
          There is a conflict between Stipulation of Facts 15,
which recites that Sunbelt was incorporated in 1983, and Exhibit
43-J, Form 1120, U.S. Corporation Income Tax Return, 1992, for
Sunbelt, which states that Sunbelt’s date of incorporation is
Oct. 16, 1981. We may disregard a stipulation where it is
clearly contrary to the evidence in the record, and we do so
here. See Jasionowski v. Commissioner, 66 T.C. 312, 318 (1976).
                               - 5 -

series of renewable notes (the notes).   Beginning in 1984, and

until 1989, Ridge stood as a guarantor of the notes.      Borrowings

pursuant to the notes reached $2 million by 1989.    On

February 26, 1990, the board of directors of Ridge (the Ridge

board) authorized the withdrawal of Ridge’s guaranty of Sunbelt’s

debt to the bank (the Ridge guaranty) if there was not "a prompt

cessation and controlled liquidation of the millwork division."

Ridge could not force a shutdown of the millwork division because

it was unable to outvote Hutto, who, like Ridge, was a 50-percent

shareholder in Sunbelt.   The Ridge board reasoned that, without

the Ridge guaranty, Sunbelt would be unable to obtain new funds

to cover future losses, and, as a result, Hutto would be forced

to shut down the millwork division.

     On May 18, 1990, Ridge withdrew the Ridge guaranty and,

shortly thereafter, the millwork division was liquidated.     On

September 17, 1990, Ridge purchased Sunbelt’s 1989 note (the 1989

note) from the Bank for $630,000, the balance due.    Thereafter,

Ridge financed Sunbelt directly by extending and modifying the

1989 note on numerous occasions.   In that way, Ridge was able to

exercise control over the management of Sunbelt.

     In mid-1992, Hutto decided to sell his shares in Sunbelt and

leave the company.   Hutto’s decision culminated several months of

negotiations between Ridge and Hutto, in which Ridge sought

either to purchase Hutto’s interest in Sunbelt or sell its

interest to Hutto.   Ridge instigated those negotiations because
                               - 6 -

of its dissatisfaction with Hutto’s management of Sunbelt.

Earlier in 1992, Ridge and Hutto had tentatively agreed to a

price of $825,000 for a 50-percent stock interest in Sunbelt,

applicable whether Hutto was the buyer or the seller.   Ridge and

Hutto finally agreed that Ridge and Hutto would cause Sunbelt to

redeem Hutto’s shares in Sunbelt (the redemption) in exchange for

$828,943.75 in cash and real estate valued at $101,000.   The

redemption was accomplished on January 15, 1993.   Immediately

thereafter, Ridge owned the only outstanding shares of Sunbelt.

     Also on January 15, 1993, subsequent to the redemption,

Ridge made a distribution with respect to its stock of all of its

shares in Sunbelt (the distribution and the Sunbelt shares,

respectively).   The distribution was to petitioners, the sole

shareholders of Ridge, pro rata.   The Ridge board set forth its

reasons for the distribution as follows:

          WHEREAS, Sunbelt’s activities are regulated by the
     Environmental Protection Agency and the Florida
     Department of Environmental Regulation and are subject
     to certain provisions of state and federal
     environmental protection laws, including the
     Comprehensive Environmental Response, Compensation, and
     Liability Act of 1980 (CERCLA). Any violation of such
     laws in the past or in the future by Sunbelt may
     subject Corporation [Ridge] to liability as a
     shareholder of Sunbelt for damages, fines or penalties;
     and

          WHEREAS, Sunbelt anticipates offering certain of
     its securities in a public offering in the future and
     the Corporation does not want to be involved in a
     public offering or to have the securities law
     obligations of a control shareholder of a public
     corporation; and
                                 - 7 -

           WHEREAS, if corporation continues to wholly own
      Sunbelt subsequent to the redemption, Sunbelt and
      Corporation will be prohibited from electing or
      maintaining their respective Subchapter S status for
      Federal tax purposes and for purposes of the income tax
      imposed by the State of Florida * * *

Funding the Redemption

      Sunbelt needed cash in the amount of $828,243.74 to fund the

redemption.   Although Sunbelt had assets and accumulated earnings

in excess of that amount, it did not have the necessary cash.        On

January 14, 1993, the amount available to Sunbelt pursuant to the

1989 note was increased from $2 million to $3 million, and, on

that same date, Sunbelt took advantage of its increased borrowing

power under the 1989 note and borrowed $900,000 from Ridge,

which, in part, it used to make the redemption.

                                OPINION

I.   Introduction

      The fundamental question we must answer is whether gain

is to be recognized to Ridge on account of the distribution.

If so, then, since, for Ridge’s taxable year ending July 25,

1993, it was an S corporation, petitioners must take into account

their pro rata shares of such gain.       See sec. 1366(a).   No gain

will be recognized to Ridge on account of the distribution if

that transaction qualifies for nonrecognition treatment pursuant

to section 355.     The pertinent provisions of section 355(a) and
                               - 8 -

(c) are set forth in the margin.3   If the distribution does not

     3
          SEC. 355.   DISTRIBUTION OF STOCK AND SECURITIES
                      OF A CONTROLLED CORPORATION.

          (a) Effect on Distributees.--

             (1) General Rule.--If--

               (A) a corporation (referred to in this
               section as the "distributing corporation")

                 (i) distributes to a shareholder, with
               respect to its stock, * * *

               *      *   *    *       *   *   *

          solely stock or securities of a corporation
          (referred to in this section as "controlled
          corporation") which it controls immediately before
          the distribution,

               (B) the transaction was not used principally
               as a device for the distribution of the
               earnings and profits of the distributing
               corporation or the controlled corporation or
               both * * *

               (C) the requirements of subsection (b)
               (relating to active businesses) are
               satisfied, and

               (D) as part of the distribution, the
               distributing corporation distributes--

                 (i) all of the stock and securities in the
               controlled corporation held by it immediately
               before the distribution, * * *


               *      *   *    *       *   *   *

          then no gain or loss shall be recognized to (and
          no amount shall be includible in the income of)
          such shareholder or security holder on the receipt
          of such stock or securities.

                                                    (continued...)
                                   - 9 -

qualify for section 355 nonrecognition treatment, then gain will

be recognized to Ridge pursuant to section 311(b).4    Moreover,

the parties have stipulated that, if the distribution does not

qualify for section 355 nonrecognition treatment, the

deficiencies determined by respondent with respect to petitioners

are correct.   Respondent argues that the distribution does not

     3
      (...continued)
                       *   *   *    *      *   *   *

          (c) Taxability of Corporation on Distribution.--

               (1) In general.--* * * no gain or loss shall
          be recognized to a corporation on any distribution
          to which this section * * * applies and which is
          not in pursuance of a plan of reorganization.

     4
          Sec. 311(b) generally provides for a distributing
corporation’s recognition of gain on its distribution of
appreciated property "as if such property were sold to the
distributee at its fair market value." Sec. 311(b) only applies
to a corporate distribution of appreciated property to which
subpart A (secs. 301-307) applies. Sec. 355(a)(1), if applicable
to this case, would provide an exception to dividend treatment
under sec. 301 and, therefore, an exception to the application of
sec. 311(b). See sec. 355(c)(3).

     We note, in passing, that, because Ridge’s S corporation
election was made on, not after, Dec. 31, 1986, sec. 1374, as
amended by the Tax Reform Act of 1986 (TRA of 1986), Pub. L.
99-514, 100 Stat. 2085, does not apply to tax the alleged sec.
311(b) gain to Ridge. See TRA of 1986 sec. 633(b); Rev. Rul. 86-
141, 1986-2 C.B. 151, 152. Sec. 1374 requires that "built-in
gain" be taxed directly to an S corporation. The pre-TRA of 1986
version of sec. 1374 applied only during the first 3 years (not
the first 10 years as under the amended provision) for which an
S corporation election was in effect. See former sec.
1374(c)(1). For Ridge, the applicable years were its 1988-90
taxable years. Therefore, any taxable gain to Ridge arising out
of the Jan. 15, 1993, distribution of the Sunbelt stock would not
be subject to former sec. 1374. Such gain would be directly
taxable to the petitioner-shareholders pursuant to sec. 1366(a).
                                - 10 -

qualify for section 355 nonrecognition treatment on two separate

and independent grounds:

     (1)     The contemporaneous redemption and distribution fail to

satisfy the requirements of section 355(b) as to active trade or

business.5    Specifically, respondent argues that, although

     5
             SEC. 355(b) provides:

     (b) Requirements as to Active Business.--

        (1) In general.--Subsection (a) shall apply only if
     either-

               (A) the distributing corporation, and the
             controlled corporation (or, if stock of more than
             one controlled corporation is distributed, each of
             such corporations), is engaged immediately after
             the distribution in the active conduct of a trade
             or business, or

               (B) immediately before the distribution, the
             distributing corporation had no assets other than
             stock or securities in the controlled corporations
             and each of the controlled corporations is engaged
             immediately after the distribution in the active
             conduct of a trade or business.

        (2) Definition.--For purposes of paragraph(1), a
     corporation shall be treated as engaged in the active
     conduct of a trade or business if and only if--


               (A) it is engaged in the active conduct of a
             trade or business, or substantially all of its
             assets consist of stock and securities of a
             corporation controlled by it (immediately after
             the distribution) which is so engaged,

               (B) such trade or business has been actively
             conducted throughout the 5-year period ending on
             the date of the distribution,

               (C) such trade or business was not acquired
                                                      (continued...)
                              - 11 -

Sunbelt had been engaged in an active trade or business for more

than 5 years on the date of the distribution, control of Sunbelt

was acquired by the distributing corporation (Ridge), within such

5-year period, in a transaction (the redemption) in which gain

was recognized, thereby violating the requirements of section

355(b)(2)(D)(ii).

     (2)   Petitioners have failed to prove that the distribution

was designed to achieve a corporate business purpose, as required

by section 1.355-2(b), Income Tax Regs.




     5
      (...continued)
          within the period described in subparagraph (B) in
          a transaction in which gain or loss was recognized
          in whole or in part, and

             (D) control of a corporation which (at the time
           of acquisition of control) was conducting such
           trade or business--

                (i) was not acquired by any distributee
              corporation directly (or through 1 or more
              corporations, whether through the distributing
              corporation or otherwise) within the period
              described in subparagraph (B) and was not
              acquired by the distributing corporation
              directly (or through 1 or more corporations)
              within such period, or

                (ii) was so acquired by any such corporation
              within such period, but, in each case in which
              such control was so acquired, it was so
              acquired, only by reason of transactions in
              which gain or loss was not recognized in whole
              or in part, or only by reason of such
              transactions combined with acquisitions before
              the beginning of such period.
                               - 12 -

      Because we agree with respondent’s first ground, we do not

address respondent’s second ground.

II.   Active Business Requirement

      A.   Pertinent Provisions of the Internal Revenue Code

      One of the specific requirements for section 355

nonrecognition treatment on the pro rata distribution of the

shares of a controlled corporation (a so-called spinoff) is that

"the requirements of subsection (b) [of section 355] (relating to

active businesses) are satisfied".      Sec. 355(a)(1)(C).   Section

355(b)(1)(A) provides that both the distributing and the

controlled corporation must be "engaged immediately after the

distribution in the active conduct of a trade or business".

Section 355(b)(2) defines the circumstances under which "a

corporation shall be treated as engaged in the active conduct of

a trade or business".    Section 355(b)(2)(B) provides that the

trade or business must have been "actively conducted throughout

the 5-year period ending on the date of the distribution" (the

5-year period).   Section 355(b)(2)(D) provides, in pertinent

part, that control6 of the corporation engaged in the active

conduct of a trade or business on the date of acquisition of

control must not have been acquired within the 5-year period or,

if acquired within such period, it must have been acquired "only


      6
          For purposes of sec. 355, control is defined in terms
of 80 percent of both voting control and share ownership. See
sec. 368(c).
                              - 13 -

by reason of transactions in which gain or loss was not

recognized in whole or in part, or only by reason of such

transactions combined with acquisitions before the beginning of

such period."   Sec. 355(b)(2)(D)(ii).

     B.   Arguments of the Parties

     Respondent does not dispute that both Ridge and Sunbelt were

engaged in the active conduct of a trade or business immediately

after the distribution.   Nor does he dispute that both businesses

had been actively conducted throughout the 5-year period.

Respondent argues, however, that Ridge violated the conditions of

section 355(b)(2)(D)(ii) because it acquired control of Sunbelt

within the 5-year period in a transaction (the redemption) in

which gain or loss was recognized.7    In reaching that conclusion,

respondent relies upon the statutory language and upon Rev. Rul.

57-144, 1957-1 C.B. 123, in which respondent determined that a

personal holding company’s distribution to its shareholders of

the stock of one of its two controlled operating subsidiaries

does not qualify as a tax-free spinoff where control of the


     7
          It appears from the record that Hutto’s basis in his
Sunbelt stock was his initial investment of $66,667 (one-third of
the total initial shareholder investment of approximately
$200,000). Thus, Hutto’s gain on the redemption was
approximately $863,276.75 ($929,943.75 redemption price less
$66,667 stock basis). Petitioners have not assigned error to
respondent’s finding that petitioners together realized and had
recognized to them the same amount of gain on Ridge’s same-day
distribution to them of the same number of Sunbelt shares as were
redeemed from Hutto, assuming sec. 355 is inapplicable to such
distribution.
                              - 14 -

parent’s other operating subsidiary (which was merged into the

parent after the distribution) was obtained during the 5-year

period as a result of that subsidiary’s redemption of a portion

of a more than 20-percent minority interest.

     Petitioners respond that this case simply does not involve

tax avoidance of a kind that the active business requirement of

section 355(b) and, in particular, section 355(b)(2)(D) is

designed to combat.   In that regard, petitioners argue that

(1) Ridge’s accumulated adjustment account under section

1368(e)(1) (in this case, Ridge’s undistributed, previously taxed

earnings) exceeded the value of the distributed Sunbelt stock so

that the distribution could not have constituted a taxable

dividend to petitioners even if it had taken the form of a cash

distribution (see sec. 1368(c)(1)), and (2) the redemption was

not an acquisition of control by Ridge for purposes of section

355(b)(2)(D).   Alternatively, petitioners argue that, even if the

combined redemption-distribution is deemed to have violated the

literal terms of the statute (since gain was, in fact, recognized

to Hutto), respondent has allowed tax-free treatment for other

transactions that failed to meet the literal statutory

requirements for nonrecognition of gain.   Petitioners claim that

nonrecognition of gain is equally justified in this case.

Petitioners also argue that the facts of Rev. Rul. 57-144, supra,

are distinguishable from the facts of this case, and, therefore,

it is not germane.
                               - 15 -

     C.   Discussion

           1.   Acquisition of Control

     We generally treat a revenue ruling as merely the

Commissioner’s litigating position not entitled to any judicial

deference or precedential weight.   See, e.g., Norfolk S.S. Corp.

v. Commissioner, 104 T.C. 13, 45-46 (1995), supplemented by 104

T.C. 417 (1995), affd. 140 F.3d 240 (4th Cir. 1998); Simon v.

Commissioner, 103 T.C. 247, 263 n.14 (1994), affd. 68 F.3d 41 (2d

Cir. 1995); Pasqualini v. Commissioner, 103 T.C. 1, 8 n.8 (1994);

and Exxon Corp. v. Commissioner, 102 T.C. 721, 726 n.8 (1994).

We may, however, take a revenue ruling into account where we

judge the underlying rationale to be sound.   See Spiegelman v.

Commissioner, 102 T.C. 394, 405 (1994) (citing Newberry v.

Commissioner, 76 T.C. 441, 445 (1981)).   The degree to which we

must respect the Respondent’s longstanding position in Rev. Rul.

57-144, supra, is of no concern, however, because, in the

circumstances of this case, we reach the same result.

     First of all, we do not agree with petitioners that the

facts in Rev. Rul. 57-144, supra, are distinguishable from the

facts in this case in any significant way.    While it is true that

the ruling involves (1) a parent holding company and two

operating subsidiaries rather than, as in this case, a parent

operating company and a single operating subsidiary, and (2) a

taxable stock redemption by the retained rather than by the

distributed subsidiary, those are distinctions of no legal
                              - 16 -

significance.   The key determination by respondent in Rev. Rul.

57-144, supra, which is relevant to this case, is the

determination that a parent corporation is considered to acquire

control of its subsidiary by virtue of the subsidiary’s

redemption of the stock of another shareholder whose interest in

the subsidiary before the redemption exceeded 20 percent.

     In opposition to that determination by respondent,

petitioners argue that, where control of the subsidiary is the

result of the subsidiary’s redemption of its own stock, there is

no “acquisition” of control by the parent distributing

corporation as contemplated by section 355(b)(2)(D).    Again, we

disagree with that blanket assertion.   As one commentator has

noted:

           The literal statutory language supports the
     redemption rule of Rev. Rul. 57-144, since P acquired
     control of S as a result of a taxable transaction.
     Although the purpose of §355(b)(2)(D) to prevent
     Distributing from using its liquid assets to buy a
     corporation conducting an active business would not at
     first blush seem to be violated by a redemption of S
     stock before a spin-off (because P is not using any of
     its own assets in a way contrary to the purpose of
     §355(b)(2)(D)), the fungibility of cash makes such a
     redemption problematic. It may be difficult to
     determine whether, in true economic effect, the cash
     used in the redemption could be attributed to P--as,
     for instance, if S used all of its cash normally used
     for its working capital requirements for the
     redemption, which P made up to S after the redemption.
     * * *

Ridgway, 776-2d Tax Mgmt. (BNA), Corporate Separations at A-42,

A-43 (2000) (fn. refs. & citations omitted; emphasis added).
                              - 17 -

     In this case, all of the cash needed to accomplish the

redemption came directly from Ridge, the parent distributing

corporation.   On January 14, 1993, Sunbelt borrowed $900,000 from

Ridge.   On the following day, Sunbelt redeemed all of Hutto’s

stock for $828,943.75, in cash, plus real estate with a value of

$101,000.   Petitioners specifically acknowledge that Sunbelt

lacked sufficient liquidity to fund the redemption and,

therefore, needed to borrow the necessary funds.   Although, as

petitioners point out, Sunbelt might have borrowed the funds from

a third-party lender, it did not.   Moreover, the negotiations

between Hutto and Ridge prior to the redemption, whereby the two

parties sought to terminate their joint ownership of Sunbelt by

having one buy the stock of the other, clearly indicate that

Ridge was the motivating force for the buyout of Hutto’s interest

in Sunbelt and that Sunbelt was, in effect, serving Ridge’s

purpose in accomplishing this goal.    Any distinction between that

series of transactions and an outright purchase of the stock by

Ridge, the distributing corporation, is illusory for purposes of

section 355(b)(2)(D)(ii).8



     8
          See Waterman S.S. Corp. v. Commissioner, 430 F.2d 1185
(5th Cir. 1970), revg. 50 T.C. 650 (1968), in which the court
held that, where a subsidiary-payor distributed a promissory note
to its shareholder-payee in the form of an intercompany dividend,
the payor’s discharge of the note with funds borrowed from the
purchaser of the payor’s stock from the payee was, in substance,
the purchaser’s payment of additional purchase price for the
stock.
                                - 18 -

     Under Rev. Rul. 57-144, 1957-1 C.B. 123, section

355(b)(2)(D) applies to any taxable redemption during the 5-year

period that results in control of the subsidiary by the

distributing corporation.    We need not and do not decide whether

we would reach the same result as Rev. Rul. 57-144, supra, in all

such cases.    We decide only that we reach the same result under

the circumstances of this case.

          2.    Additional Arguments

     In reaching our decision, we find none of petitioners’

additional arguments persuasive.

          a.    Active Business Test

     Petitioners argue that the fundamental goal of the active

business test is to prevent shareholder withdrawal of accumulated

earnings at capital gain rates, and that, because Ridge’s

accumulated adjustment account under section 1368(e)(1) exceeded

the value of the distributed Sunbelt stock, an otherwise taxable

distribution (including a cash dividend) would not have been

taxable to petitioners.     Therefore, petitioners continue, there

could not have been any conversion of ordinary income into

capital gain.   Additionally, petitioners argue that the issue in

this case, the taxation of corporate level gain, is not addressed

by section 355(b)(2)(D).

     Petitioners’ first argument ignores the fact that, pursuant

to sections 1367(a)(2)(A) and 1368(e)(1)(A), the accumulated

adjustment account is reduced by the amount of the distribution
                                - 19 -

(the value of the distributed Sunbelt stock) thereby reducing the

interval before additional distributions by Ridge would become

taxable to petitioners.   Moreover, petitioners’ argument proves

too much, as it would also apply to Ridge’s purchase of Hutto’s

Sunbelt stock directly from Hutto during the 5-year period.

     Petitioners’ additional argument (section 355(b)(2)(D) does

not deal with corporate level gain) ignores the post-1986

evolution of section 355 (including amendments to section

355(b)(2)(D)) into a weapon against avoidance of the repeal of

the General Utilities9 doctrine, which, prior to its repeal by

the Tax Reform Act of 1986, Pub. L. 99-514, sec. 631(c), 100

Stat. 2085, 2272, generally provided for the nonrecognition of

gain realized by a corporation on the distribution of appreciated

property to its shareholders.    As noted by one commentator:

          It should not be surprising that more attention
     has been directed toward Section 355 today than was
     ever the case in the past. From a tax perspective, its
     attraction is grounded on the fact that it is one of
     the few (some might say the only) viable opportunity to
     escape the repeal of the General Utilities doctrine.
     * * *

Gould, "Spinoffs:   Divesting in a Post-General Utilities World,

with Emphasis on Practical Problems", 69 TAXES 889 (Dec. 1991);

(fn. refs. omitted).   Indeed, petitioners themselves place

obvious reliance upon section 355 to avoid taxation pursuant to

section 311(b).

     9
          See General Utils. & Operating Co. v. Helvering,
296 U.S. 200 (1935).
                              - 20 -

          b.   Literal Compliance With Section 355 Not Always
               Required

     Petitioners also argue that nonrecognition treatment is

justified herein on the basis of case law and respondent’s

pronouncements in which nonrecognition of gain was afforded to a

transaction despite a failure to satisfy the literal terms of the

governing statute.   In general, the authorities cited by

petitioners involve either (1) cash payments that are disregarded

in determining the applicability of a nonrecognition provision,

see Rev. Rul. 55-440, 1955-2 C.B. 226, Chief Counsel’s

Memorandum, formerly General Counsel’s memorandum (G.C.M.), 33712

(Dec. 21, 1967), and G.C.M. 32868 (June 26, 1964) or (2) gain

recognition transfers of assets or stock between affiliated

corporations within the 5-year period that are held not to negate

the tax-free treatment of a subsequent spinoff pursuant to

section 355(b)(2)(C) or (D); see Commissioner v. Gordon, 382 F.2d

499 (2d Cir. 1967), revd. on other grounds 391 U.S. 83 (1968);

Rev. Rul. 78-442, 1978-2 C.B. 143; Rev. Rul. 69-461, 1969-2 C.B.

52; G.C.M. 35633 (Jan. 23, 1974).

     Both Rev. Rul. 55-440, supra, and G.C.M. 33712, supra,

determine that the “solely for voting stock” requirement of a

tax-free reorganization under section 368(a)(1)(B) is satisfied

where, in connection with the reorganization, the acquired

corporation purchases (redeems) some of its stock for cash.

G.C.M. 32868, supra, determines that the cash redemption of
                              - 21 -

preferred stock from shareholders of both common and preferred,

in connection with the acquisition of all of the common stock in

a tax-free reorganization under section 368(a)(1)(C), is taxable

to the shareholders under section 302 as a transaction separate

from the reorganization.   The cash is not “boot” taxable to the

shareholders under section 356.   In both of the G.C.M.’s, Counsel

explicitly bases his determination on the fact that the acquired

corporation used its own funds for the redemption.   Although the

issue of which corporation provided the funds for the redemption

was not specifically addressed in Rev. Rul. 55-440, supra, it

appears that such funds were, in fact, provided by the acquired

corporation.   We find that that feature, among others, of all

three of the pronouncements distinguishes their facts from the

facts of this case.

     The other authorities relied upon by petitioners are also

distinguishable because, in each, either the taxable acquisition

(or incorporation) of the subsidiary to be spun off within the

5-year period or the spinoff itself less than 5 years after a

taxable purchase of the subsidiary occurred within the context of

an affiliated group of corporations.   Thus, Commissioner v.

Gordon, supra, involves a subsidiary spun off within 5 years of

its incorporation in a transaction involving the receipt of

“boot” (a demand note) taxable to the transferor parent.   The

Court of Appeals for the Second Circuit held that the section

355(b)(2)(C) and (D) prohibition against acquiring a business or
                              - 22 -

a corporation in a taxable transaction within the 5-year period

must be restricted to acquisitions from outside the affiliated

group in order to carry out the legislative intent of section

355(b), which, it concluded, was to prevent “the temporary

investment of liquid assets in a new business in preparation for

a 355(a) division.”   Id. at 506 (emphasis added).10   Respondent

adopted that reasoning in Rev. Rul. 78-442, supra, and Counsel

did so in G.C.M. 35633, supra, both of which involve the

incorporation of an operating division preparatory to a spinoff

of the newly formed subsidiary in a transaction intended to

qualify as a tax-free reorganization under section 368(a)(1)(D).

In both pronouncements, the incorporation of the more-than-

5-year-old division involves the assumption of liabilities in

excess of the transferor’s basis, resulting in gain recognized to

the transferor under section 357(c).   Respondent and Counsel,

like the Court of Appeals for the Second Circuit in Commissioner

v. Gordon, supra, determined that section 355(b)(2)(C) is

intended to prevent the acquisition of a new business from

outside the affiliated group within the 5-year period.

Therefore, they found no violation of that provision by virtue of


     10
          In Baan v. Commissioner, 45 T.C. 71 (1965), revd. and
remanded 382 F.2d 485 (9th Cir. 1967), we reached the same result
as the Court of Appeals for the Second Circuit, but on the ground
(rejected by the Court of Appeals) that the incorporation of the
subsidiary was, in fact, a nonrecognition transaction because the
gain attributable to the receipt of boot was eliminated in
consolidation.
                              - 23 -

the section 357(c) gain on the distributing corporation’s

incorporation of an existing business.11

     In Rev. Rul. 69-461, supra, respondent determined that a

distribution by a subsidiary to its parent of the stock of the

former’s subsidiary, within 5 years of the first-tier

subsidiary’s purchase of such stock, does not violate section

355(b)(2)(D).   Respondent reasoned that section 355(b)(2)(D) is

not intended to apply to a distribution “that merely has the

effect of converting indirect control into direct control”, but,

rather, “applies to a transaction in which stock is acquired from

outside a direct chain of ownership.”   Rev. Rul 69-461, 1969-2

C.B. at 53.   Similarly, in Rev. Rul. 74-5, 1974-1 C.B. 82

(discussed by both parties), the parent distributee (P) purchases

the stock of the subsidiary distributor less than 5 years prior

to the latter’s distribution of an operating subsidiary that it

had owned for more than 5 years.   Respondent determined that that

conversion of P’s indirect control into direct control of the

distributed subsidiary within the 5-year period did not violate

section 355(b)(2)(D) because there is no passthrough of P’s




     11
          Sec. 1.355-3(b)(4)(iii), Income Tax Regs., applicable
to acquisitions prior to the Revenue Act of 1987, Pub. L. 100-
203, 101 Stat. 1330, and the Technical and Miscellaneous Revenue
Act of 1988, Pub. L. 100-647, 102 Stat. 3342, also provides that
sec. 355(b)(2)(C) and (D) does not apply to an acquisition of
assets or stock by one member of an affiliated group from another
member of the same group, even if the acquisition is taxable.
                               - 24 -

“accumulated excess funds through another corporation to P

shareholders”.12

       In this case, the redemption accomplished more than merely

the conversion of indirect to direct control of Sunbelt.    It

accomplished the acquisition of control where none had existed

previously.    For that reason, it represents, in the language of

the Court of Appeals for the Second Circuit in Commissioner v.

Gordon, 382 F.2d at 506, “the temporary investment of liquid

assets in a new business in preparation for * * * [a spinoff]”.

We hold that, in contrast to the circumstances involved in the

pronouncements cited by petitioners, the distribution within

5 years of the redemption is precisely the type of transaction

section 355(b)(2)(D) is designed to eliminate from nonrecognition

treatment under section 355(a).

III.    Conclusion

       Respondent’s deficiencies against petitioners are sustained.


                                          Decisions will be entered

                                     for respondent.


       12
          In Rev. Rul. 74-5, 1974-1 C.B. 82, respondent further
determined that parent distributee’s (P’s) subsequent
distribution of the subsidiary stock to its shareholders, within
the 5-year period, does violate the requirements of sec.
355(b)(2)(D). The prior distribution to P also violates sec.
355(b)(2)(D) as amended by the Revenue Act of 1987, sec.
10223(b), 101 Stat. 1330, supra, and sec. 2004(h)(1) of TAMRA,
supra. As a result, Rev. Rul. 89-37, 1989 C.B. 107, obsoletes
the holding of Rev. Rul. 74-5, supra, with respect to the
distribution to P.
