Rev. Rul. 74-515

Advice has been requested as to the Federal income tax consequences to the shareholders of the acquired corporation on the exchange of their stock pursuant to the plan of reorganization described below.

Corporation X had outstanding 2,000,000 shares of common stock and 200,000 shares of preferred stock. The preferred stock had been issued for cash and represented less than 10 percent of the combined value of the total outstanding common and preferred stock of X. Shareholders of X who owned both common and preferred stock of X held an aggregate of nine percent of the outstanding common stock and eight percent of the outstanding preferred stock. However, there was no proportional relationship between the holdings of common stock and preferred stock by such shareholders and none of such shareholders owned more than one percent of either class of stock within the meaning of section 318(a) of the Internal Revenue Code of 1954. Both the common and preferred stock of X were widely held and traded in the over-the-counter market. The simultaneous ownership of both common and preferred stock by shareholders of X was the result of unrelated transactions and such shareholders did not have any form of control of X. The preferred stock and common stock of X were by their terms distinct classes of stock with dissimilar characteristics.

For good business reasons, X merged into Y corporation in a reorganization which met the requirements of section 368(a)(1)(A) of the Code. Pursuant to the terms of the merger agreement, which specifically set forth separate exchanges that were separately bargained for, common stock of X was exchanged for common stock of Y and preferred stock of X was exchanged for cash. The shareholders of X did not own any stock in Y prior to the merger.

Section 354(a)(1) of the Code provides that no gain or loss will be recognized if stock in a corporation a party to a reorganization is, in pursuance of the plan of reorganization, exchanged solely for stock in such corporation or in another corporation a party to the reorganization.

Section 356(a)(1) of the Code provides, in part, that if money or other property is received in an exchange to which section 354 would otherwise apply, then gain, if any, to the recipient will be recognized to the extent of the sum of the money and fair market value of the other property received. Section 356(a)(2) provides that if such exchange has the effect of the distribution of a dividend, then there will be treated as a dividend to each distributee such an amount of the gain recognized under section 356(a)(1) as is not in excess of his ratable share of the undistributed earnings and profits of the corporation accumulated after February 28, 1913, and the remainder, if any, of the recognized gain will be treated as gain from the exchange of property. Section 356(c) provides that no loss from the exchange will be recognized.

Section 302 of the Code provides, in part, that a redemption will be treated as a distribution in part or full payment in exchange for stock if it is not essentially equivalent to a dividend to the shareholder.

Those X shareholders who owned only common stock made an exchange under section 354(a)(1) of the Code because they exchanged their X common stock solely for Y common stock.

Section 356(a)(1) of the Code is not applicable to those X shareholders who owned only preferred stock since these shareholders did not receive any stock of Y to which section 354 would apply but for the fact that other property or cash was received. Those X shareholders who directly owned only X preferred stock, but who, under the attribution rules of section 318(a), would be considered as owning X common stock, are not considered as having made an exchange described in sections 354 or 356 because section 318(a) is not applicable to exchanges under sections 354 and 356 for determining ownership of stock. The X shareholders who owned only preferred stock are treated as having had their stock redeemed under section 302. Under the facts of this case, the cash received by those X shareholders who owned only X preferred stock was not essentially equivalent to a dividend.

Those X shareholders who owned both common stock and preferred stock are treated as having made an exchange described in section 356(a)(1) of the Code because the property they received in the exchange for their former X stock interest consisted not only of Y stock which is permitted by section 354, but also of cash. In determining the tax consequences to the X shareholders who owned both common and preferred stock, under the facts of this case, each class of stock is considered separately. See section 1.358-2(a)(4) of the Income Tax Regulations. The X common stock is treated as being transferred for Y common stock, and the X preferred stock is treated as being transferred for cash. Since the X common stock was transferred solely for Y common stock, no gain or loss is recognized on this part of the exchange to these X shareholders. However, gain is recognized under section 356(a)(1) to these shareholders to the extent that the cash received on the transfer of the preferred stock exceeds the cost or other basis of the preferred stock.

A determination must be made whether the gain recognized to those X shareholders who owned both common stock and preferred stock of X should be treated as having had the effect of the distribution of a dividend under section 356(a)(2) of the Code. Whether or not a reorganization distribution has the effect of a dividend must be determined by examining the facts and circumstances surrounding the distribution and looking to the principles for determining dividend equivalency developed under section 356(a)(2) and other provisions of the Code. See Ross v. United States, 173 F. Supp. 793 (Ct. Cl. 1959), cert. denied, 361 U.S. 875 (1959). Also see Davis v. United States, 397 U.S. 301 (1970), 1970-1 C.B. 62, wherein the Supreme Court of the United States held that a redemption must result in a meaningful reduction of the shareholder's proportionate interest in the corporation in order not to be essentially equivalent to a dividend under section 302(b)(1).

Under the facts of the instant case, the cash received by those X shareholders who owned both X common stock and preferred stock did not have the effect of a dividend. The few shareholders of X who owned both common and preferred stock had no form of control over X. The cash distribution was disproportionate and bore no relationship to the common stockholdings of the X shareholders. Compare Rev. Rul. 56-220, 1956-1 C.B. 191, which holds, in effect, that cash received on a pro rata basis from the acquiring corporation by all the shareholders of the acquired corporation, as the result of a reorganization, had the effect of the distribution of a dividend.

Accordingly, the tax effects of the transactions to the X shareholders in the instant case are summarized as follows:

(1) No gain or loss is recognized under section 354(a)(1) of the Code to those shareholders of X who owned only common stock and exchanged their common stock solely for Y common stock.

(2) The receipt of cash by the X shareholders who owned only preferred stock is a distribution in exchange for the stock pursuant to section 302(a). Gain or loss is recognized to these shareholders measured by the difference between the amount received in the redemption and the cost or other basis of the stock.

(3) Under section 356 of the Code, gain is recognized to those shareholders of X who exchanged both common and preferred stock for Y common stock and cash. No gain is recognized on the portion of the exchange involving the transfer of X common stock for Y common stock. Gain, if any, is recognized under section 356(a)(1) on the transfer of the X preferred stock for cash. The gain recognized on this transfer is measured by the excess of the cash received for the preferred stock over the cost or other basis of that stock. Such gain is not treated as having the effect of the distribution of a dividend under section 356(a)(2). No loss is recognized as provided in section 356(c).

Rev. Rul. 56-220 is clarified to remove any implication that cash paid by an acquiring corporation always has the effect of the distribution of a dividend within the meaning of section 356(a)(2) of the Code.