Rev. Rul. 56-220

Advice has been requested with respect to the tax effect of cash distributed in connection with a statutory merger (reorganization) under section 368(a)(1)(A) of the Internal Revenue Code of 1954 involving two banks.

Pursuant to a plan of reorganization, Y bank merged into Z bank. In consideration for the net assets of the absorbed bank, the acquiring bank made available to the stockholders of the former shares of its capital stock plus cash. The stockholders of Y bank surrendered the stock of their corporation in exchange for stock of Z bank and cash.

The case was paid by Z bank from a special trust set up by it for that purpose in its trust department. Such money was paid directly to the individual stockholders of Y bank and did not pass through the Y corporation. It was not part of the assets which were transferred to Z bank.

When the negotiations for the merger first began, it was the intention of the officers of both banks that the assets of Y be acquired by Z solely in exchange for stock of the latter bank. However, after determining the relative values of the stock of the two banks, it was found that the exchange of stock of the Y bank for stock of the Z bank on the basis of the values agreed upon would result in odd fractional shares of stock which would not be practicable to issue. The Z bank would not consent to issue fractional shares on any basis, but insisted on whole shares, plus cash. Moreover, Z bank did not desire to give the stockholders of Y such a large common stock ownership in the surviving corporation. Finally, the officers of both banks agreed to the exchange of stock of the Y bank for stock of the Z bank on a whole share basis, plus cash.

Section 354 of the Internal Revenue Code of 1954 provides in part:

(a) GENERAL RULE.-

(1) IN GENERAL.-No gain or loss shall be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of the plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.

Also, section 356 of such Code states in part:

(a) GAIN ON EXCHANGES.-

(1) RECOGNITION OF GAIN.-If-

(A) section 354 * * * would apply to an exchange but for the fact that

(B) the property received in the exchange consists not only of property permitted by section 354 * * * to be received without the recognition of gain but also of other property or money, then the gain, if any, to the recipient shall be recognized, but in an amount not in excess of the sum of such money and the fair market value of such other property.

(2) TREATMENT AS DIVIDEND.-If an exchange is described in paragraph (1) but has the effect of the distribution of a dividend, then there shall be treated as a dividend to each distributee such an amount of the gain recognized under paragraph (1) as is not in excess of his ratable share of the undistributed earnings and profits of the corporation accumulated after February 28, 1913. The remainder, if any, of the gain recognized under paragraph (1) shall be treated as gain from the exchange of property.

The question at issue is whether the distribution of cash had the effect of the distribution of a dividend within the meaning of section 356(a)(2) of the Code. In Commissioner v. Edward T. Bedford Estates, et al. , 325 U.S. 283, Ct. D. 1641, C.B. 1945, 357, the Supreme Court of the United States took the position that where preferred stock is exchanged for new preferred stock, common stock and cash, the cash received was taxable as an ordinary dividend under the provisions of section 112(c)(2) of the Revenue Act of 1936. That provision corresponds to section 356(a)(2) of the 1954 Code. It is stated in the Bedford opinion that under section 115(a) (section 301 of the 1954 Code) a distribution out of accumulated earnings and profits is a `dividend,' thus confirming the conclusion that a distribution of earnings and profits has the `effect of the distribution of a taxable dividend' under section 112(c)(2). It is specifically stated in the opinion that:

It has been ruled in a series of cases that where the stock of one corporation was exchanged for the stock of another and cash then distributed, such distributions out of earnings and profits had the effect of a distribution of a taxable dividend under section 112(c)(2). ( Commissioner v. Owens , 69 Fed.(2d) 597; Commissioner v. Forhan Realty Corporation , 75 Fed .(2d) 268; Rose v. Little Investment Company , 86 Fed.(2d) 50; Love v. Commissioner , 113 Fed.(2d) 236; Campbell v. United States , 144 Fed.(2d) 177).

To the same effect is the United States Board of Tax Appeals decision in the case of George Woodward v. Commissioner , 23 B.T.A. 1259.

Accordingly, it is held that the cash received in the exchange had the effect of the distribution of a dividend under the provisions of section 356(a)(2) of the Code. Therefore, the portion of the gain recognized which was not in excess of each distributee's ratable share of the undistributed earnings and profits of the Y bank accumulated after February 28, 1913, is treated as a dividend to Y's stockholders. The remainder, if any, of the gain recognized is treated as gain from the exchange of property.