Rev. Rul. 56-223

The Internal Revenue Service has been requested to state its position with respect to the tax effect of a proposed sale of preferred stock received in a nontaxable exchange in pursuance of a plan of reorganization of a corporation.

Prior to the reorganization described below, the outstanding capital stock of M corporation consisted of shares of no-par common stock. Such stock was owned by approximately 100 stockholders, approximately 80 percent being owned by employees of the corporation. An employees' trust created by M corporation as a qualified profit sharing trust under the provisions of the Internal Revenue Code was also a stockholder.

In order that the employees of the corporation might continue in the future to own substantially all of M's voting stock, it was desired to recapitalize the corporation in such a way as to reduce the value of the voting stock to a price at which the employees would be able to purchase it. Accordingly, a plan of recapitalization was adopted under which M corporation issued shares of new preferred and common stock to its stockholders in exchange for their old common shares on the basis of one share of preferred stock and three shares of common stock for each share of old common stock exchanged. The transaction qualified as a reorganization under the provisions of section 368(a)(1)(E) of the Internal Revenue code of 1954, and the exchanges of stock made pursuant to the plan were nontaxable to the stockholders under section 354(a)(1). The preferred stock received by the stockholders under the plan constituted section 306 stock within the meaning of section 306(c)(1)(B).

Prior to the reorganization, a certain corporation had expressed a desire to purchase the common stock of M corporation at a price not less than its book value. Certain older employees who were to be retired over the following six years, with a view to liquidating their holdings of common stock of M corporation upon being no longer connected with the corporation, indicated a desire to sell their stock to such other corporation. These employees owned almost half of M's outstanding shares. If the sales were carried out, M corporation would lose its identity, and the employees' trust would likely be terminated or the corporation's contribution thereto greatly reduced. To meet this threat, the trust entered into an agreement with the retiring employees under which it agreed to purchase all of the stock of M corporation owned by the retiring employees over a six-year period. Pursuant to the terms of the agreement, one-sixth of the shares of each retiring employee was to be purchased by the trust in each year. Under the agreement, all stock of the retiring employees was placed in escrow.

The agreement was formulated on the basis of a single class of capital stock but contained a provision that, in the event M corporation changed its capital structure by issuing new shares in exchange for the shares then outstanding, the new shares would be subject to the agreement. Accordingly, the new preferred shares and the new common shares received by the retiring employees in the reorganization will be substituted for the old shares and held in escrow. Thereafter, in carrying out each sale to the trust called for by the agreement, the escrow agent, on behalf of each retiring employee, will transfer to the trust shares of both classes of new stock in the same ratio in which they were issued in the reorganization.

A ruling has been requested to the effect that the sale of preferred shares of M corporation to the trust by the retiring employees under the terms of the agreement is not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax within the meaning of section 306(b)(4) of the Internal Revenue Code of 1954.

As to dispositions of section 306 stock, section 306 provides in part as follows:

(a) GENERAL RULE.-If a shareholder sells or otherwise disposes of section 306 stock (as defined in subsection(c))-

(1) DISPOSITIONS OTHER THAN REDEMPTIONS.-If such disposition is not a redemption * * *-

(A) The amount realized shall be treated as gain from the sale of property which is not a capital asset. * * *

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(b) EXCEPTIONS.-Subsection (a) shall not apply-

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(4) TRANSACTIONS NOT IN AVOIDANCE.-If it is established to the satisfaction of the Secretary or his delegate-

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(B) in the case of a prior or simultaneous disposition * * * of the stock with respect to which the section 306 stock disposed of * * * was issued, that the disposition * * * of the section 306 stock, was not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax.

In the instant case, the disposition of section 306 stock is not in pursuance of a plan having as one of its principal purposes the avoidance of Federal income tax. Inasmuch as the retiring employees, pursuant to the terms of the agreement, are selling all of their stock, both preferred and common, of M corporation, the result of the sale to them will be exactly the same as it would have been if the reorganization had never taken place and their old common stock had been sold under the agreement. By virtue of the provisions of section 306(b)(4), section 306(a) will not apply to the sale of their preferred shares to the trust.

Accordingly, under the facts in this case, the gain or loss realized by each of the retiring employees upon each sale of shares of his preferred stock and common stock to the trust will constitute capital gain or loss, subject to the provisions of Subchapter P of Chapter 1 of the 1954 Code. Under section 1223(1) of the Code, in determining the period for which a retiring employee has held the new preferred and common shares, there will be included the period for which he held the old common shares exchanged therefor.