Rev. Rul. 78-251

Advice has been requested whether the receipt of cash by shareholders of the distributing corporation who dissent to the acquisition of all of the distributing corporation's stock by an unrelated corporation subsequent to the pro rata distribution of all of a controlled corporation's stock to the shareholders of the distributing corporation will cause the corporate "spin-off" to be viewed as used principally as a device for the distribution of earnings and profits under section 355(a)(1)(B) of the Internal Revenue Code of 1954.

Corporation P, all of the stock of which was publicly held, owned all of the stock of corporation S for over 5 years. Both P and S had been engaged in the active conduct of a trade or business for a period in excess of 5 years, with substantially all of their assets used in their respective business. Corporation X, an unrelated corporation, desired to acquire all of the stock of P but did not want to acquire S. Pursuant to a plan of reorganization, P made a pro rata distribution of all of the S stock to its shareholders in a transaction intended to meet the requirements of section 355(a) of the Code. Immediately thereafter, with the exception of shares held by shareholders of P who dissented to the acquisition of P's stock, X acquired all of the outstanding stock of P in exchange solely for voting common stock of X in a transaction that qualified as a reorganization within the meaning of section 368(a)(1)(B). The dissenting shareholders of P, who had no form of control over the business of P or X, owned 5 percent of the outstanding stock of P and received cash from P in an amount equal to the fair value of their P stock. Under the provisions of the applicable state law, a shareholder of P who elected not to participate in the exchange had to completely terminate stock ownership in P. As a result of the transaction, the dissenting shareholders of P received their pro rata portion of the S stock and cash. P remained in existence as a wholly-owned subsidiary of X.

Section 355(a) of the Code provides, in part, that if: (i) a corporation distributes to its shareholders in exchange for its stock, solely the stock of a corporation that it controls (within the meaning of section 368(c)) immediately before the distribution; (ii) the transaction is not used principally as a device for the distribution of earnings and profits; and (iii) the requirements of section 355(b) (relating to the active conduct of a trade or business) are satisfied, no gain or loss will be recognized to the shareholders upon the distribution.

Section 355(a)(1)(B) of the Code provides that the mere fact that after the distribution stock or securities in one or more of the corporations is sold or exchanged by all or some of the distributees, other than pursuant to an arrangement negotiated or agreed upon before the distribution, will not be construed to mean that the transaction was used principally as a device for the distribution of earnings and profits.

In Commissioner v. Morris Trust, 367 F.2d 794 (4th Cir. 1966), the court concluded that a parent corporation's distribution of the stock of a newly-created subsidiary corporation's stock qualified as a non-taxable spin-off within the meaning of section 355(a) of the Code in spite of the subsequent merger of the distributing corporation, saying at pages 798-799:

"If the corporation proceeds to withdraw assets from the conduct of the active business and to abandon it, the Commissioner has recourse to the back-up provisions of section 355(a)(1)(B) and to the limitations of the underlying principles. At the same time, the limitation, so construed, will not inhibit continued stockholder conduct of the active business through altered corporate form and with further changes in corporate structure, the very thing the reorganization sections were intended to facilitate."

The premise of Morris Trust that a corporate separation may be a preliminary step to a subsequent reorganization involving the distributing corporation was accepted by the Internal Revenue Service in Rev. Rul. 72-530, 1972-2 C.B. 212, Rev. Rul. 70-434, 1970-2 C.B. 83, and Rev. Rul. 68-603, 1968-2 C.B. 148.

In Rev. Rul. 55-103, 1955-1 C.B. 31, corporation Z desired to purchase all of the outstanding stock of X corporation but did not want to pay for the value of Y, an 80 percent-owned subsidiary of X. Therefore, X proposed to distribute the Y stock to its shareholders prior to the completion of the sale negotiations. The revenue ruling established that a purpose of the requirement that a corporate separation not be used principally as a device for the distribution of earnings and profits is to limit the application of section 355 of the Code to those cases in which the distribution of stock of the controlled corporation effects only a readjustment of continuing interests in property under modified corporate forms. Concluding that the distribution of Y's stock was a device for the distribution of the earnings and profits of X, section 355 was held not to apply to the transaction because the sale of the distributing corporation's stock immediately subsequent to a distribution of the controlled corporation's stock, when negotiations for such sale are already in process, is generally considered sufficient evidence that the distribution of stock was used principally as a device, and the purpose of the corporate separation was to facilitate the sale of the stock of X, with no continuing interest in X on the part of any of its present stockholders contemplated.

Implicit in Morris Trust's acceptance of a corporate separation as a preliminary step to a subsequent reorganization involving the distributing corporation is the further acceptance that shareholders of that corporation may exercise their right of dissent as a normal adjunct to the subsequent reorganization. The exercise of the right to dissent is in the nature of an arrangement agreed upon prior to the distribution of stock of the controlled corporation. Under such circumstances, however, this would not be determinative that the transaction was used principally as a device for the distribution of earnings and profits. Therefore, in determining whether the instant transaction was used principally as a device for the distribution of earnings and profits, consideration must be given to all of the facts and circumstances of the transaction.

In the instant case, substantially all of the assets of both P and S were used in the active conduct of their respective business prior to the distribution of S's stock, and after the distribution, both P and S continued the active conduct of their respective business substantially without change in their activities or assets. Unlike the sale illustrated in Rev. Rul. 55-103, the redemption of the dissenting shareholders' P stock was an intracorporate transaction occurring only as an adjunct to P's further reorganization, a readjustment of continuing interests in property under a modified form and through which substantially all of P's shareholders retained an interest in P. Further, the dissenting shareholders of P owned 5 percent of P's stock and did not have sufficient control of P or X to cause the transaction to occur in order for it to be used as a device for the distribution of P's earnings and profits.

Accordingly, the receipt of cash from P by the dissenting shareholders will not cause the spin-off to be viewed as used principally as a device for the distribution of earnings and profits under section 355(a)(1)(B) of the Code. The cash received by the dissenting shareholders will be treated as a distribution to them by P in redemption of their P stock subject to the provisions and limitations of section 302.

Rev. Rul. 55-103 is distinguished.