Rev. Rul. 78-294

Advice has been requested regarding the effect of a sale of stock by an underwriter to the general public on the control requirement of section 351 of the Internal Revenue Code of 1954 in the situations described below.

A is a person who conducted business in a noncorporate form. The business needed additional capital. A decided to incorporate the business to increase its capital through a public offering of stock. Therefore, A sought the assistance of U, an underwriter of corporate stock, in order to engage in the transactions described below. In accordance with the plan, A organized a new corporation, Z. Z had capital stock of 1,000 authorized but unissued shares upon its formation.

Situation 1

Pursuant to an agreement among A, U, and Z, A transferred all of A's business property to Z in exchange for 500 shares of Z stock. U agreed to use its best efforts as Z's agent to sell the 500 unissued shares of Z stock to the general public at $200 per share. U succeeded in selling the 500 shares within two weeks of the initial offering with no change in the terms of the offering. This transaction is considered to fall within the general definition of a "best efforts" underwriting.

Situation 2

Pursuant to an agreement among A, U, and Z, A transferred all of A's business property to Z in exchange for 500 shares of Z stock, and U transferred $100,000 in cash to Z in exchange for the remaining 500 shares. At the time of U's purchase of 500 Z shares U had not entered into a binding contract to dispose of the Z shares. However, U intended to sell its 500 shares of Z stock, but, if unsuccessful, was required to retain them. Following the A-Z and U-Z exchanges, U sold its 500 shares of Z stock to the general public within two weeks of the initial offering. A retained A's 500 shares of Z stock. This transaction is considered to fall within the general definition of a "firm commitment" underwriting.

Section 351(a) of the Code provides, in part, that no gain or loss will be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation and, immediately after the exchange, the transferors are in control (as defined in section 368(c)) of the corporation.

Section 368(c) of the Code provides that the term "control" 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.

Section 1.351-1(a)(1) of the Income Tax Regulations states that the phrase "immediately after the exchange" does not necessarily require simultaneous exchanges by two or more persons, but comprehends a situation where the rights of the parties have been previously defined and the execution of the agreement proceeds with an expedition consistent with orderly procedure. Thus, in each case an analysis must be made of all the facts and circumstances of the transaction.

In a public offering of stock, the function of a best-efforts underwriter is solely to bring the parties together as agent of the corporation. See Spence v. Balogh & Co., 216 F. Supp. 492, 494 (D.D.C. 1962), aff'd 317 F.2d 909 (D.C. Cir. 1963). The best-efforts underwriter transfers no property to the corporation and should not be considered a transferor for purposes of section 351 of the Code under these circumstances. On the other hand, in a best-efforts underwriting the movement of property from the public investors to the corporation is direct and uninterrupted so that in appropriate cases the public investors should be deemed to be transferors in testing whether the requirements of section 351 have been met.

Situation 1--Analysis and Holding

In Situation 1 the business needed additional capital so that the public stock offering was integral to A's plan to incorporate the going business. In such circumstances it is appropriate to treat the incorporation and subsequent public offering as elements in a single transaction that may be tested for qualification under section 351 of the Code. See Bassick v. Commissioner, 85 F.2d 8 (2d Cir. 1936), cert. denied, 299 U.S. 592 (1936).

Furthermore, the charter and by-laws of the issuing corporation as well as various public documents required to be filed with governmental agencies in connection with a public offering of stock set forth the rights of the parties to the offering. Thus, the rights of the parties in Situation 1 are previously defined as required by section 1.351-1(a)(1) of the regulations.

Finally, the sale of stock to the public in Situation 1 took place in a short period of time with no change in the terms of the offering. These facts indicate that the transfers in Situation 1 occurred with an expedition consistent with orderly procedure within the meaning of section 1.351-1(a)(1) of the regulations.

Therefore, the public investors in Situation 1 should be treated, along with A, as transferors for purposes of section 351 of the Code.

Accordingly, in Situation 1 the transferors are in control of Z immediately after the exchange within the meaning of section 1.351-1(a)(1) of the regulations. The overall transaction qualifies under section 351 of the Code since the other requirements of that section are also met in Situation 1. The determination of whether other public stock offerings involving best-efforts underwriters qualify under section 351 must be made on the basis of an analysis of all the facts and circumstances of those transactions.

Situation 2--Analysis and Holding

In a firm-commitment underwriting, the underwriter transfers its own property to the issuing corporation in exchange for stock of that corporation. Therefore, such underwriter should be considered a transferor for purposes of section 351 of the Code. Hartman Tobacco Company v. Commissioner, 45 B.T.A. 311, 314 (1941), acq. in another issue, 1943 C.B. 11. Furthermore, the firm-commitment underwriter in the instant case assumes the risk of reselling the acquired stock to the general public and in so doing recognizes that it may be forced to retain a portion of that stock for an extended period. Consequently, since the transaction is completed for section 351 purposes with the underwriter's exchange of property for the stock, its subsequent resale of that stock will not violate the control "immediately after" requirement of that Code section. See American Bantam Car Co. v. Commissioner, 11 T.C. 397 (1942), aff'd per curiam, 177 F.2d 513 (3rd Cir. 1949), cert. denied, 339 U.S. 920 (1950).

Accordingly, under Situation 2, since A and the firm-commitment underwriter hold 100 percent of the Z stock at culmination of the incorporation transaction, the transferor group is in control of Z immediately after the exchange. Furthermore, as the other requirements of section 351 of the Code are also satisfied, the transaction is entitled to treatment thereunder.