Rev. Rul. 56-117

Advice has been requested whether the distribution by a corporation of its shares of the common stock and preferred stock of another corporation to a group of its stockholders in exchange for their stock of the distributing corporation constituted a nontaxable transaction.

Corporation M , a domestic corporation engaged in the hardware business, owned all of the common stock and 12 percent of the preferred stock of corporation N , a domestic corporation engaged in the appliance business at a different location. Both corporations had been engaged in the active conduct of their respective business for more than five years, and all of the stock of corporation N owned by corporation M had been owned by it for more than five years. The preferred stock of corporation N had no voting power, sole voting rights being vested in the common stock. The outstanding stock of corporation M consisted solely of common stock.

Differences of opinion had arisen among the stockholders and directors of corporation M as to the basic policies of management and operation of the corporations. The differences became so pronounced that the stockholders concluded they could not continue the united ownership and management of the two corporations. A group of dissatisfied stockholders, who owned approximately one-half of the stock of corporation M and who were primarily concerned with the business of corporation N , offered to surrender all of their M stock to corporation M in exchange for the common stock and preferred stock of corporation N owned by corporation M . The proposal was accepted by the other stockholders, and, in order to equalize the value of the stocks being exchanged, corporation M transferred an amount of cash to corporation N as a capital contribution.

Prior to the separation, in pursuance of a plan of recapitalization, corporation N issued additional shares of its common stock in exchange for the outstanding shares of its preferred stock owned by stockholders other than corporation M , the exchange ratio being based upon the respective values of the preferred and common shares. The additional common shares so issued constituted seven percent of the common shares then outstanding. As a result, the shares of corporation N owned by corporation M after the recapitalization constituted 93 percent of the outstanding common stock and 100 percent of the outstanding preferred stock.

Corporation M distributed all of the common stock and preferred stock of corporation N owned by it to the group of dissatisfied stockholders in exchange for all of their stock of corporation M . Such group thereby acquired control of corporation N and continued the operation of its business under their management. Corporation M continued the active conduct of its business under the separate ownership and management of its remaining shareholders.

Section 355(a) of the Internal Revenue Code of 1954 provides, in part, that if a corporation distributes to its shareholders, with respect to its stock, solely the stock of a corporation which it controlled immediately before the distribution, and the transaction is not used principally as a device for the distribution of earnings and profits and the requirements of subsection (b) (relating to active business) are satisfied, then no gain or loss shall be recognized to such shareholder. Subsection (b) provides that the controlled corporation and the distributing corporation must be actively engaged in a trade or business for a five-year period ending on the date of distribution. It is further provided therein that the trade or business cannot have been acquired within the five-year period and that the control of the corporation which conducts the trade or business cannot have been acquired within the five-year period unless the provisions of subparagraph (D) of subsection 355(b) are complied with.

Section 355(b)(2)(D) provides as follows:

(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-

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(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.

For purposes of section 355, the term `control,' as defined in section 368(c), `means the ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.'

Although corporation M owned over 80 percent of the voting common stock of corporation N throughout the entire 5-year period ending on the date of the distribution of the N stock, it owned only 12 percent of the nonvoting preferred stock of corporation N from the beginning of such period until the consummation of the recapitalization of corporation N , when the preferred shares owned by it became the only nonvoting shares of corporation N outstanding. Thus, corporation M acquired control of corporation N during the said 5-year period, but only by reason of such recapitalization, combined with acquisitions of N stock before the beginning of the 5-year period. However, since the recapitalization of corporation N constituted a reorganization within the meaning of section 368(a)(i)(E) of the Code, and the exchanges made by the preferred stockholders in pursuance of such reorganization were nontaxable exchanges under the provisions of section 354(a)(1), control of corporation N was acquired by corporation M in a manner permitted by section 355(b)(2)(D)(ii).

Accordingly, it is held that, by reason of the provisions of section 355(a)(1) of the Code, no gain or loss is recognized to those stockholders, who received the common stock and preferred stock of corporation N , as a result of the distribution of such stock to them in exchange for their stock of corporation M . The basis of the common stock and preferred stock of corporation N received by such stockholders is the same in their hands as their adjusted basis for the stock of corporation M exchanged therefor (section 358(a)(1) of the Code). No gain or loss is recognized to the stockholders of corporation M who continued to hold their stock of that corporation, or to either corporation M or corporation N as a result of the distribution.