*223 Decision will be entered under Rule 50.
The petitioner, Theodore F. Appleby, and his father, prior to 1922, operated an insurance and real estate brokerage business at a certain location. In 1922 they acquired the property and erected the present 2-story building, renting to five tenants that portion of the building they did not use. In 1932 the business was incorporated under the name of T. Frank Appleby Agency, Inc., and petitioners have since been its only shareholders. In 1947, the agency acquired title to the property and occupied space on both floors of the building and rented the other floorspace to tenants. By 1954 it was using approximately 50 percent of the total floorspace and renting the balance to four tenants. In January 1955, the agency caused the Appleby Building Corporation to be organized, transferred to it its property for the building corporation's no-par-value capital stock, and distributed all the shares to petitioners. Held, that under the facts, the distribution of the stock did not qualify as a tax-free distribution under section 355 of the Internal Revenue Code of 1954.
*755 The respondent has determined a deficiency in income tax against the petitioners for the calendar year 1955 in the amount of $ 43,099.11. The question to be decided is whether the distribution of the stock of the Appleby Building Corporation by the T. Frank Appleby Agency, Inc., to the petitioners in January 1955, was a dividend includible in their gross income or, whether it qualified under section 355 of the Internal Revenue*225 Code of 1954 as a distribution on which no gain or loss is recognized.
FINDINGS OF FACT.
Some of the evidence and some of the facts have been stipulated and the facts stipulated are found as stipulated.
*756 Petitioners are husband and wife and are residents of West Allenhurst, New Jersey. They filed a joint income tax return for the taxable year 1955 with the district director of internal revenue at Camden, New Jersey.
T. Frank Appleby Agency, Inc., hereafter sometimes referred to as the agency, is a New Jersey corporation and since 1932 has been engaged in the business of real estate brokerage and insurance brokerage. All of its stock is owned by petitioners.
Since 1932 the agency has occupied a portion of a building located at the intersection of Main Street and Mattison Avenue, Asbury Park, New Jersey, usually known as 230 Main Street. Sometimes the property is referred to as 730 Mattison Avenue. Hereafter it will sometimes be referred to as the 230 Main Street property.
The father of petitioner Theodore F. Appleby had rented a frame building at the same location from 1885 until 1922 when the Applebys acquired the property from an estate and erected the present building, *226 a 2-story hollow-tile building. A small portion of the ground floor was used by the Applebys in the operation of their business and the balance of the building was rented to five tenants. The main part of the ground floor was rented to a restaurant. Two small stores were rented to a tailor and a barber, and a dentist and a credit bureau rented space on the second floor. The agency acquired title to the property in 1947. During the years 1950 through 1954, the agency occupied approximately 50 percent of the floorspace of the building, consisting of space on both ground floor and the second floor. During 1950 through 1954 one of the tenants was a tailor by the name of Stefanile. During 1950, 1951, and 1952, another tenant was one "Major," unidentified but probably a barber, as Gentile, a barber, was a tenant during 1953 and 1954. Ripley Stores, "cleaners, launderers, tailors," rented ground floorspace, facing on Main Street during the period of 1950 through 1954. The credit bureau and Samuel Bennett, a dentist, rented space on the second floor during that 5-year period.
The agency executed the leases to the tenants, had repairs made to the building, looked after the tax ratals*227 and appeals, and watched the occupancy and use of the property so that insurance rates would not be affected.
At a meeting of the board of directors on November 22, 1954, a proposed plan of reorganization of the agency was approved. A purpose of the reorganization was to segregate the ownership of real estate from the real estate brokerage and insurance brokerage activities carried on by the agency and to expand this ownership operation in the new corporation by the purchase or construction by it of additional rental real estate.
At a special meeting of the agency's stockholders on December 20, 1954, the plan of reorganization was approved.
*757 In January 1955, the Appleby Building Corporation, sometimes hereafter referred to as the building corporation, was incorporated under the laws of the State of New Jersey.
In January 1955, the agency transferred its 230 Main Street property to the building corporation in exchange for 750 shares of the latter's no-par-value capital stock and immediately distributed such stock to petitioners in proportion to their stockholdings in the agency. The 750 shares of the building corporation represented 100 percent of the outstanding stock of*228 that corporation, and their fair market value at the time of distribution was $ 50,400 and not $ 75,000, as determined by respondent in the notice of deficiency. At the date of distribution the building corporation's sole asset was the 230 Main Street property. In December 1955, it acquired the land and building at 500 Grand Avenue, Asbury Park, subject to a lease to the New Jersey Bell Telephone Company and it subsequently continued to lease the building to the telephone company.
On January 2, 1955, the building corporation and the agency executed a lease which provided in part as follows:
This Indenture, Made The 2nd day of January A.D. Nineteen Hundred and Fifty-five.
Between APPLEBY BUILDING CORPORATION of the City of Asbury Park State of New Jersey of the first part and T. FRANK APPLEBY AGENCY, Inc. of the City of Asbury Park State of New Jersey of the second part
Witnesseth, That the said party of the first part, (by T. Frank Appleby Agency, Inc., Main Street and Mattison Avenue, Asbury Park, N.J.) have let and by these presents do grant, demise and let unto the said party of the second part, and the said [party] of the second part [has] hereby hired and taken from the said*229 [party] of the first part
ALL THAT ENTIRE BUILDING KNOWN AS No. 230 MAIN STREET, ASBURY PARK, N.J. and No. 730 MATTISON AVENUE, ASBURY PARK, N.J.
from JANUARY 1, 1955 to JANUARY 1, 1965 at the rent or sum of ONE HUNDRED TWENTY THOUSAND DOLLARS ($ 120,000.00) to be paid as follows: $ 12,000.00 Annually -- payable $ 1,000.00 on the first day of February and every month thereafter, to expiration.Provided, that if any portion of the said premises not occupied by the party of the second part for use in its insurance and real estate business is leased to another person or persons by the party of the first part, then the party of the second part has the right to collect the rents due from the said other person or persons and apply same as a reduction of its annual rental of $ 12,000.00
The agency further agreed "to pay the said rent in the proportions and upon the conditions aforesaid"; that "at the expiration of said term, to yield up and surrender the possession thereof, with the appurtenances, in as good state and condition as the same now are; or may be put into by the said [party] of the first part, reasonable wear and tear and accidents happening by fire or other casualties*230 excepted"; and that the agency "shall pay for all gas and electric current consumed, and telephone bills, repair or replace all articles that may be lost, broken or damaged."
*758 The lease was signed by Theodore F. Appleby, as president, of each corporate party.
The fair rental value of the property in its entirety is approximately $ 12,000 per annum.
After the reorganization in January 1955, the building corporation owned and operated the 230 Main Street property. The agency continued its real estate and insurance business and continued to occupy approximately 50 percent of the floorspace of the building, using space on both floors. Besides the agency, there were four other tenants or space available to four tenants. The building corporation set up its bank account, its system of bookkeeping, took complaints, drew up leases, checked records, and looked after insurance rates. It had two employees, petitioner Theodore F. Appleby, its president, who was paid $ 1,500 a year, and one of the agency's employees who was assigned to "that building" and was paid $ 62.50 a week. The agency's office was used by the building corporation.
Prior to conveying the property in January 1955, *231 the agency had received gross income from the portions rented to tenants for the years 1950, 1951, 1952, 1953, and 1954 as follows:
| 1950 | 1951 | 1952 | 1953 | 1954 | Total | |
| Stefanile | $ 725.00 | $ 630 | $ 890.00 | $ 330 | $ 2,575.00 | |
| Ripley stores | 1,800.00 | 1,800 | 1,800.00 | 1,800 | $ 1,650 | 8,850.00 |
| Retail credit | 512.50 | 540 | 690.00 | 660 | 720 | 3,122.50 |
| Bennett | 422.50 | 551 | 552.50 | 510 | 425 | 2,461.00 |
| Major | 240.00 | 240 | 130.00 | 610.00 | ||
| Gentile | 300 | 720 | 1,020.00 | |||
| 3,700.00 | 3,761 | 4,062.50 | 3,600 | 3,515 | 18,638.50 |
During the same period of time the agency's gross rental income, gross income from all sources, and net income were as follows:
| Year | Gross rental | Gross income | Net income |
| income | all sources | ||
| 1950 | $ 3,700.00 | $ 88,507.95 | $ 5,114.72 |
| 1951 | 3,761.00 | 108,322.03 | 12,140.30 |
| 1952 | 4,062.50 | 103,301.23 | 6,007.92 |
| 1953 | 3,600.00 | 115,686.84 | 8,224.30 |
| 1954 | 3,515.00 | 163,264.17 | 38,046.53 |
Petitioners received salaries from the agency during the same period of time, as follows:
| Year | Theodore F. | Marie W. |
| Appleby | Appleby | |
| 1950 | $ 15,600 | $ 3,600 |
| 1951 | 19,000 | 3,600 |
| 1952 | 19,000 | 3,600 |
| 1953 | 23,250 | 3,600 |
| 1954 | 30,000 | 5,200 |
*759 *232 During the same years the agency incurred expenses with the 230 Main Street property as follows:
| 1950 | 1951 | 1952 | 1953 | 1954 | |
| Property taxes | $ 1,532.85 | $ 1,609.09 | $ 1,790.48 | $ 1,848.92 | $ 2,028.00 |
| Insurance | 1,026.66 | 1,045.85 | 1,114.98 | 1,304.30 | 1,086.70 |
| Maintenance and | |||||
| supplies | 1,611.68 | 3,286.05 | 1,051.70 | 614.81 | 1,654.97 |
| Janitor service | 954.00 | 1,056.00 | 1,112.50 | 1,112.50 | 1,132.50 |
| Depreciation | 1,128.66 | 1,128.66 | 1,128.66 | 1,128.66 | 1,128.66 |
| Interest on | |||||
| mortgage | 1,039.29 | 970.66 | 775.15 | 707.79 | 531.62 |
| Heating oil and | |||||
| repairs | 432.27 | 362.91 | 402.51 | 387.12 | 553.01 |
| Total | 7,725.41 | 9,459.22 | 7,375.98 | 7,104.10 | 8,115.46 |
The undistributed earnings and profits of the agency as of December 31, 1955, were $ 72,315.74.
Prior to 1948, in addition to the 230 Main Street property, the agency owned and occupied a frame building at Main Street, Allenhurst, New Jersey. The building was destroyed by fire in 1948 and the lots were sold in 1948 and 1949 at a profit. In April 1944, the agency purchased a small hotel property in Asbury Park which it leased to a tenant. This property was sold in 1945 at a profit.
The agency's management of its 230 Main *233 Street property prior to conveying it in January 1955 to its building corporation was incidental to the operation of its real estate and insurance brokerage business.
OPINION.
The only issue is whether the distribution by the agency of all the stock of its wholly owned subsidiary, the building corporation, to its stockholders, the petitioners, qualifies as a nontaxable distribution under section 355 of the Internal Revenue Code of 1954. 1
*234 *760 Section 355(a), insofar as applicable here, provides that (1) if a corporation distributes to its shareholders with respect to their stock, solely stock of a corporation which it controlled immediately before the distribution, (2) the transaction was not used principally as a device for distributing the earnings or profits of either corporation, (3) the requirements of subsection (b) with reference to active conduct of businesses are satisfied, and (4) all of the stock of the controlled corporation held by the distributing corporation is distributed, then no gain or loss shall be recognized to the shareholders on receipt of the stock.
Petitioners contend that all the above requirements have been met and respondent contends that neither corporation was actively engaged in the conduct of the business of property management or the renting of real estate throughout the 5-year period ending on the date of distribution within the meaning of section 355.
The evidence shows that the father of Theodore F. Appleby established the real estate brokerage and the insurance brokerage business in 1885 at the site that now is 230 Main Street in Asbury Park; that at some undetermined date*235 Theodore became engaged in the business with his father; that together they acquired the 230 Main Street property in 1922; that they erected the present building, a small part of which they used for their business and the remaining space was rented to various tenants; that in 1932 the business was incorporated under the name of T. Frank Appleby Agency, Inc., with petitioners owning all the stock; that the business of the agency was carried on in the building until January 1955; that it acquired title to the property in 1947; that its business grew and expanded to where it needed and occupied more space; that at some undetermined time it occupied space on both floors of the building to the extent of 50 percent of the *761 total floor area; that the agency continued to rent space to tenants, there being five during the years 1950 through 1953 and four in 1954 and 1955; that the gross rental received by the agency during the 5-year period, 1950 through 1954, was $ 3,700 in 1950, $ 3,761 in 1951, $ 4,062.50 in 1952, $ 3,600 in 1953, and $ 3,515 in 1954; that its gross income from all sources was $ 88,507.95 in 1950, $ 108,322.03 in 1951, $ 103,301.23 in 1952, $ 115,686.84 in 1953, *236 and $ 163,264.17 in 1954; that the agency incurred expenses in connection with the property, covering property taxes, insurance, maintenance and supplies, janitor service, heating oil and repairs, depreciation, and interest on mortgage, amounting to $ 7,725.41 in 1950, $ 9,459.22 in 1951, $ 7,375.98 in 1952, $ 7,104.10 in 1953, and $ 8,115.46 in 1954.
The evidence also shows that no records were maintained as to the net income of the rentals; that the net income of the agency for the 5-year period was $ 5,114.72 in 1950, $ 12,140.30 in 1951, $ 6,007.92 in 1952, $ 8,224.30 in 1953, and $ 38,046.53 in 1954; that during the same period Theodore and Marie received salaries in the respective amounts of $ 15,600 and $ 3,600 in 1950, $ 19,000 and $ 3,600 in 1951, $ 19,000 and $ 3,600 in 1952, $ 23,250 and $ 3,600 in 1953, and $ 30,000 and $ 5,200 in 1954.
It is further shown that in January 1955 the agency caused the building corporation to be incorporated; that it transferred its only asset, the 230 Main Street property, to the new corporation in exchange for all the 750 shares of no-par-value capital stock and immediately distributed the stock to the petitioners; that thereupon the building*237 corporation owned and operated the property; that at the same time the agency and the building corporation executed a lease under which the entire building was rented to the agency for the annual rental of $ 12,000, with a provision that any other rentals received would be applied on the agency's rental; that the fair market value of the 750 shares of stock distributed was $ 50,400 and that as of December 31, 1955, the agency had undistributed earnings and profits in the amount of $ 72,315.74.
Patently, the building corporation in January 1955, when it was created, when it received the 230 Main Street property, and when its stock was distributed to petitioners, had not been engaged in the active conduct of a business for 5 years prior to the distribution of its stock. On the other hand, it is obvious that at the time of the transaction the agency, the controlling and distributing corporation, had been engaged during the 5-year period in the conduct of an active trade or business, but was it engaged in the active business of property management or the rental of real estate for which business its subsidiary, the building corporation, was created?
*762 Under the original regulation*238 (sec. 1.355-1(a)), section 355 was made applicable to divisions of only those corporations which had conducted two or more separate and distinct businesses for a 5-year period and that "Section 355 does not apply to the division of a single business." However, a majority of this Court held that that part of the regulation was invalid and that there was nothing in the statute that prevented the section from applying to the division of a single business into two separate businesses, where such business had been actively conducted over the required 5-year period of time. Edmund P. Coady, 33 T.C. 771">33 T.C. 771.
However, we are not confronted with the question of a single business being divided into two businesses. To the contrary, petitioners contend that the agency was engaged in the active conduct of the business of renting real estate or property management as well as conducting the real estate brokerage and insurance brokerage business; and that the building corporation was organized for the purpose of operating the rental of its real estate.
Subsection (c) of the above-mentioned regulation (sec. 1.355-1) describes "Active business" as follows:
Section 355 is*239 not applicable unless the controlled corporation and the distributing corporation are each engaged in the active conduct of a trade or business. For specific rules in this connection see section 355(b) (1) and (2). Without regard to such rules, for purposes of section 355, a trade or business consists of a specific existing group of activities being carried on for the purpose of earning income or profit from only such group of activities, and the activities included in such group must include every operation which forms a part of, or a step in, the process of earning income or profit from such group. Such group of activities ordinarily must include the collection of income and the payment of expenses. It does not include --
(1) The holding for investment purposes of stock, securities, land or other property, including casual sales thereof (whether or not the proceeds of such sales are reinvested).
(2) The ownership and operation of land or buildings all or substantially all of which are used and occupied by the owners in the operation of a trade or business, or
(3) A group of activities which, while a part of a business operated for profit, are not themselves independently *240 producing income even though such activities would produce income with the addition of other activities or with large increases in activities previously incidental or insubstantial.
Several examples are set forth in the regulation that illustrate the application of the above-described rules, two of which are as follows:
Example (3). Corporation C, a bank, owns an eleven-story downtown office building, the ground floor of which is occupied by it in the conduct of its banking business and the remaining ten floors of which it rents to various tenants. The ten floors are rented, managed and maintained by the real estate department of the bank. It is proposed to transfer the building to a new corporation and distribute the stock of such new corporation to the bank's shareholders. *763 The activities in connection with banking constitute a trade or business as do also the activities in connection with the rental of the building.
Example (4). Corporation D, a bank, owns a two-story building in a suburban area, the ground floor and approximately one-half of the second floor of which is occupied by it in the conduct of its banking business. The remainder of the second floor is rented*241 as storage space to a neighboring retail merchant. It is proposed to transfer the building to a new corporation and distribute the stock of such new corporation to the bank's shareholders. With respect to the rental of part of the second floor of its building, the bank is not engaged in the active conduct of a trade or business, such activity being only incidental to its banking business.
While the facts in the instant case do not fall exactly within either example, example No. 4 is more applicable than example No. 3.
Example No. 4 was followed and upheld by this Court in Isabel A. Elliott, 32 T.C. 283">32 T.C. 283. There Centrifix Corporation bought an old house in 1946, occupying about half of it in its business and renting the remainder of it to others until it was sold in 1950, at which time it bought a larger building. Title to the new building was immediately transferred to a newly formed corporation, Centrifix Management Corporation, in April 1950. Management rented about half the space in the new building to Centrifix and held the rest for rental to others. On December 15, 1954, Centrifix distributed all the stock of Management to Elliott, its principal*242 stockholder, in exchange for all of Centrifix's issued preferred stock. The Court held that the distribution of stock to Elliott did not qualify as a tax-free distribution under section 355 since Centrifix was not actively conducting a real estate rental business prior to April of 1950.
In the instant case we have a similar situation. Prior to distribution of the stock the building in principal part was utilized by the agency for the conduct of its business. On a square footage basis the space occupied was approximately 50 percent of the floorspace of the building but was 70 percent of the rental value. The renting of the space the agency did not use in the conduct of its other business was incidental and that is shown by the small activity exerted, the small amount collected in rentals as compared to the total income received from all sources and the lack of records maintained to show profits or losses from the operation of a rental business. As stated in the opinion of the Elliott case, supra, "we do not think a mere passive receipt of income from the use of property which is used in the principal trade or business and which is only incidental to, or an incidental use*243 of a part of property used primarily in, the principal business would constitute the active conduct of a trade or business within the meaning of section 355(b) of the Code, whether or not such use of property might constitute a trade or business within the meaning of other sections of the Code."
*764 Petitioner's references to such cases as John D. Fackler, 45 B.T.A. 708">45 B.T.A. 708, affd. 135 F.2d 509">135 F. 2d 509, and Leland Hazard, 7 T.C. 372">7 T.C. 372, are not appropriate in the application of section 355.
Respondent is sustained.
Decision will be entered under Rule 50.
Footnotes
1. 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.
* * * *
(b) Requirements as to Active Business. --
(1) In general. -- Subsection (a) shall apply only if either --
(A) the distributing corporation, and the controlled corporation * * * 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, * * *
(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 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 directly (or through one or more corporations) by another corporation within the period described in subparagraph (B), or
(ii) was so acquired by another corporation within such period, but such control 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.↩