Rev. Rul. 69-407

Advice has been requested whether section 355 of the Internal Revenue Code of 1954 applies to the distribution of stock of a controlled corporation in the circumstances described below.

All of the outstanding stock of corporation Y was represented by 1,000 shares of $100 par value common stock. Corporation X owned 70 percent of the stock of Y and the balance was owned by A and B who did not own directly or indirectly any stock of X. Both corporations had been engaged in the active conduct of their respective businesses for more than five years, and all of the stock of Y owned by X had been held by it for more than five years.

Pursuant to a plan of recapitalization, Y issued 200 shares of $150 par value Class A voting common stock to A and B in exchange for the 300 shares of $100 par value common stock held by them. Y issued 800 shares of $87.50 par value Class B voting common stock to X in exchange for the 700 shares of $100 par value common stock held by it. The value of the stock received was equal to the value of the stock surrendered. The Class A and Class B common stocks had one vote each and were entitled to share in dividends paid by Y and in the assets of Y in the event of liquidation in proportion to the relative par values of the stocks. Thus the recapitalization did not change the proportionate interests of A, B and X in corporation Y but only altered the proportionate voting rights of the parties. After the recapitalization, the Class B stock owned by X represented 80 percent of the total combined voting power of all classes of common stock of Y entitled to vote. The purpose for the recapitalization of Y was to create a class of stock that will be available to key employees of Y and to facilitate the transaction described below.

After the recapitalization and for valid business reasons X distributed all of the Class B common stock of Y owned by it to its shareholders on a pro rata basis. Both X and Y continued the active conduct of their respective businesses.

Section 355(a) of the Code provides that if, (1) a corporation distributes to its shareholders, with respect to its stock, solely the stock of a corporation that it controlled immediately before the distribution, (2) the transaction is not used principally as a device for the distribution of earnings and profits, and (3) the requirements of section 355(b) of the Code are satisfied, no gain or loss will be recognized to the shareholders.

Section 355(b) of the Code requires that both the distributing corporation and the controlled corporation be engaged immediately after the distribution in the active conduct of a trade or business that has been actively conducted throughout the five-year period ending on the date of distribution and that was not acquired within the five-year period in a transaction in which gain or loss was recognized in whole or in part. The distributing corporation cannot have acquired the stock of the controlled corporation within the five-year period ending on the date of the distribution in a transaction in which gain or loss was recognized.

The term "control" for purposes of section 355 of the Code 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 each class of nonvoting stock of the corporation, as defined in section 368(c) of the Code.

The transaction in which Y issued to its shareholders shares of new Class A voting common stock and new Class B voting common stock in exchange for all of its outstanding stock constituted a recapitalization and therefore a reorganization within the meaning of section 368(a)(1)(E) of the Code. No gain or loss was recognized to the shareholders of Y as a result of the exchange of their stock for new Class A voting common stock or new Class B voting common stock under the provisions of section 354 of the Code.

Although X owned only 70 percent of the outstanding voting stock of Y for the greater part of the five-year period prior to the distribution, it acquired sufficient (80 percent) voting stock of Y immediately prior to the transaction to give it control of Y within the meaning of section 368(c) of the Code. Since the stock was acquired in a transaction in which no gain or loss was recognized by reason of section 354 of the Code, the requirements of section 355(b)(2)(C) of the Code were met and Y is treated as engaged in an active trade or business for purposes of section 355 of the Code.

Accordingly, no gain or loss will be recognized to (and no amount will be includible in the income of) the shareholders of X on the distribution to them of the stock of Y as provided in section 355 of the Code. See Revenue Ruling 56-117, C.B. 1956-1, 180, in which a similar transaction was held to constitute a recapitalization qualifying under section 368(a)(1)(E) of the Code followed by a distribution pursuant to section 355 of the Code.

This case is distinguishable from the situation covered in Revenue Ruling 63-260, C.B. 1963-2, 147, which holds that where A owned all of the stock of which X owned 70 percent of the stock of Y (A owned the other 30 percent), a transfer of ten percent of the shares of Y stock by A to X prior to a distribution by X of 80 percent of the shares of Y stock to A does not qualify as a nontaxable distribution under the provisions of section 355 of the Code since X did not have "control" of Y within the meaning of section 368(c) of the Code immediately before the distribution except in a transitory and illusory sense. Here the recapitalization that preceded the distribution of Y stock to the shareholders of X resulted in a permanent realignment of voting control.