Rev. Rul. 69-34

The Internal Revenue Service has been asked to state its position concerning the tax treatment of cash received by shareholders in lieu of fractional shares of stock in a reorganization defined in section 368(a)(1)(E) of the Internal Revenue Code of 1954.

Revenue Ruling 66-365, C.B. 1966-2, 116, holds that the "solely for voting stock" requirement contained in sections 368(a)(1)(B) and (C) of the Code will not be violated where a cash payment made by the acquiring corporation to the shareholders of the acquired corporation is in lieu of fractional interests and represents a mere mechanical rounding off of the fractions in the exchange rather than separately bargained-for consideration. That Revenue Ruling also holds that in a transaction qualifying under section 368(a)(1)(A), (C) (by reason of section 368(a)(2)(B)), or (D) of the Code, if the cash paid by the acquiring corporation represents separately bargained-for consideration it will be treated as the receipt of "boot" under sections 356(a) and 361(b) of the Code.

In addition Revenue Ruling 66-365 holds that where such a cash payment is in lieu of fractional interests and is not in the nature of bargained-for consideration, it will be treated as a distribution in full payment in exchange for the fractional share under section 302(a) of the Code provided the payment is not essentially equivalent to a dividend.

The tests set forth in Revenue Ruling 66-365 (namely, where the cash paid represents "merely a mechanical rounding off of the fractions in the exchange, and is not a separately bargained-for consideration") will also be applied to cash payments accompanying a reorganization qualifying under section 368(a)(1)(E) of the Code relating to recapitalizations. If these criteria are satisfied, the cash payments will be tested under section 302 of the Code relating to distributions in redemption of stock. However, if these criteria are not satisfied, the cash payments will be treated either as the receipt of "boot" under section 356(a) of the Code or as distributions to which section 301 of the Code applies, depending upon all the facts and circumstances involved. See section 1.301-1(1) of the Income Tax Regulations.

The following is an example of a transaction where the criteria are satisfied:

A corporation has outstanding 100,000 shares of common stock which are owned by over 700 shareholders. The stock is traded in the over the counter market at $40 per share. The corporation has outstanding 500 shares of $100 par value preferred stock that were issued for cash to seven individuals. No dividends are in arrears on the preferred shares. The owners of the preferred own no common stock of the corporation.

Pursuant to a plan of reorganization under section 368(a)(1)(E) of the Code, the corporation will change its capital structure for valid business reasons by issuing shares of common stock in exchange for the outstanding preferred stock. The preferred shareholders will receive 2.5 shares of common stock in exchange for each share of preferred stock presently held. No fractional shares of common stock will be issued. Cash will be paid to any shareholder in lieu of a fractional share interest to which he is entitled. Under the exchange ratio, only two of the seven shareholders will receive cash in lieu of one-half share of common stock ($20 per one-half share).

In this case the cash payments are deemed to be in lieu of fractional interests and not separately bargained-for consideration because the two shareholders will receive only a relatively small sum of cash and the transaction will not result in a substantially proportionate distribution to the shareholders of the corporation. Accordingly, such payments will be tested under section 302 of the Code. The payments will be treated under section 302 as redemptions that are "not essentially equivalent to a dividend" under section 302(b)(1) of the Code inasmuch as they are non-pro rata distributions the purpose of which is the mere mechanical rounding off of fractional interests. Under the provisions of section 302(a) of the Code, such redemptions will be treated as distributions in full payment in exchange for the one-half share of stock.