Rev. Rul. 74-516

Advice has been requested concerning the treatment under section 356 of the Internal Revenue Code of 1954 of cash received in an exchange, otherwise qualifying under section 355 of the Code, under the circumstances described below.

Corporation X and corporation Y have been actively engaged in separate businesses for more than five years. X corporation acquired all the stock of Y corporation upon the formation of the latter. Prior to the exchange described below, X corporation had 1,000 shares of stock outstanding and Y corporation had 100 shares of stock outstanding. A, one of five individual shareholders of X, held 400 shares of its stock. For valid business reasons, X desired to dispose of all of the stock of Y. X distributed all the stock of Y plus cash to A in exchange for his 400 shares of X stock of equal value. The amount of cash distributed was equal to the value of 200 shares of A's stock in X. Thereafter, both corporations continued the active conduct of their respective businesses. The gain realized by A on the exchange of X stock for Y stock plus cash exceeded the amount of cash received. A's ratable share of X's undistributed earnings and profits exceeded the amount of cash received on the exchange.

Both reorganizations and distributions qualifying under section 355 of the Code are accorded nonrecognition treatment because they represent a reshuffling of corporate structures. Such transactions effect only a readjustment of continuing interests in property under modified corporate forms. See sections 1.368-1(b) and 1.355-2(c) of the Income Tax Regulations. Section 1.355-2(c) provides in part:

* * * Section 355 contemplates a continuity of the entire business enterprise under modified corporate forms and a continuity of interest in all or part of such business enterprise on the part of those persons who, directly or indirectly, were the owners of the enterprise prior to the distribution or exchange . . .

The transaction described above qualifies under section 355 of the Code but for the fact that cash was distributed in the exchange. Section 355(a)(4) contains a cross reference to section 356 prescribing the treatment of the distribution where property other than stock or securities is received.

Section 356 of the Code provides, in part, as follows:

(a) Gain on Exchanges.--

(1) Recognition of Gain.--If--

(A) section 354 or 355 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 or 355 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.

In this case, except for the cash distribution, no gain or loss will be recognized to A upon receipt of the stock of Y because the requirements of section 355 of the Code are met. In the context of a "split-off" transaction qualifying under section 355 of the Code, the determination as to whether a distribution to A has the effect of a dividend requires an analysis of the overall transaction. Although A has terminated his investment in the distributing corporation, he has retained an equity investment in a continuing enterprise. He has continued to maintain a direct stock interest in a portion of the assets in which he formerly held an indirect interest, as required by section 1.355-2(c) of the regulations.

Therefore, for purposes of determining whether the distribution of cash had the effect of the distribution of a dividend, the transaction is viewed as if A had remained as shareholder in the distributing corporation, but recognition should be given to the fact that the distribution to him was non pro rata and that his proportionate equity interest in the total enterprise was altered by the distribution of cash with respect to a portion of his interest in the corporation.

When applied to a transaction qualifying under section 355 of the Code which describes a corporate separation, the effect of the distribution to the former shareholder is to be measured by comparing his interest in the distributing corporation prior to the exchange with the interest he would have retained had he not received the stock of the subsidiary (that is, the interest he would have retained had he only surrendered the shares represented by the cash distribution). See Ross v. United States, 173 F. Supp. 793 (Ct. Cl. 1959), cert. denied, 361 U.S. 875 (1959), involving the determination of whether a pro rata distribution of cash to shareholders of a combining corporation in a statutory consolidation had the effect of a dividend under section 356(a)(2). Also see United States v. Davis, 397 U.S. 301 (1970), 1970-1 C.B. 62, holding that a distribution in redemption of stock must result in a "meaningful reduction" in the shareholder's proportionate interest in the corporation.

In the instant case, A owned 400 shares of the 1,000 shares of X stock outstanding before the transaction, or 40 percent. By considering A to have surrendered only the 200 shares represented by the cash distribution, A owned 200 shares of the 800 shares of X stock outstanding after the transaction, or 25 percent. After the transaction, A's 25-percent stock interest represented 62.5 percent of his stock interest of 40 percent before the transaction. Therefore, the cash distribution to A resulted in a percentage reduction of his proportionate stock interest of 37.5 percent.

Section 302(b)(2) of the Code provides that a distribution is substantially disproportionate with respect to the shareholder-distributee if there is a percentage reduction greater than 20 percent in his proportionate stock interest. Although section 302 does not literally apply in determining whether a distribution has the effect of a dividend under section 356(a)(2), in appropriate cases the tests contained in that section may serve as useful guidelines for purposes of applying section 356(a)(2). See Rev. Rul. 74-515, page 118, this Bulletin.

Accordingly, under the facts and circumstances involved in the instant case, the exchange on which gain is recognized to A under section 356(a)(1) of the Code does not have the effect of a dividend under section 356(a)(2), and is treated as gain from the exchange of property.