Rev. Rul. 80-284

ISSUE

Will nonrecognition treatment under section 351(a) of the Internal Revenue Code be accorded to a transfer of 14 percent of the stock of a corporation (T) to another corporation (S) in exchange for S stock as part of a plan whereby S acquires the remaining 86 percent of the T stock for cash?

FACTS

T, a manufacturing corporation, had outstanding 1,000x shares of capital stock. The fair market value of T was 100,000x dollars, and the fair market value of each share of its outstanding stock was 100x dollars. T's president and chairman of the board, A, owned 140x shares of its capital stock (14 percent). The remaining 860x shares of T's capital stock (86 percent) were publicly held. P, a large publicly traded corporation unrelated to T, wished to purchase the stock of T and thereafter to have T's business continued by a wholly owned subsidiary. While the other shareholders of T were willing to accept cash for their T stock, A, who was of an advanced age and who had a very low basis in his 140x shares, was unwilling to sell the T stock for cash because the sale would result in recognition of taxable gain.

In order to accommodate A's wish to avoid recognition of gain, P and A agreed in January, 1980, to organize a new corporation, S, for the purpose of acquiring and holding all of the stock of T. Several months later, pursuant to the agreement, P transferred 86,000x dollars in cash together with other property to S solely in exchange for all of S's common stock, and A transferred his 140x shares of T stock to S solely in exchange for all of S's preferred stock. It was intended that this transaction would be a tax-free exchange under section 351(a) of the Code. Thereafter, and as part of the overall plan, S organized a new corporation, D, by transferring the 86,000x dollars in cash to D solely in exchange for all of D's stock. D was then merged into T under applicable state law, and pursuant thereto each share of T stock, except those shares transferred by A to S, was surrendered in exchange for 100x dollars in cash. The T stock acquired by D for cash was cancelled and, pursuant to state law, each share of D stock was converted into stock of T. Although S could theoretically have acquired the remaining 86 percent of the T stock directly from the T shareholders for cash, the acquisition was made pursuant to the state merger laws because this method was more expeditious and convenient. T remains in existence as an operating company, and S remains in existence as a holding company.

LAW AND ANALYSIS

Section 351(a) of the Code provides that no gain or loss is recognized if persons who control a corporation transfer property to the corporation solely in exchange for stock or securities. Section 351(a) is an exception to the general rule that gain or loss must be recognized on any sale or exchange of property. See section 1.1002-1(b) of the Income Tax Regulations, which states that exceptions to the general rule (including section 351(a)) "are strictly construed and do not extend either beyond the words or the underlying assumptions and purposes of the exception. Nonrecognition is accorded by the Code only if the exchange is one which satisfies both (1) the specific description in the Code of an excepted exchange, and (2) the underlying purpose for which such exchange is excepted from the general rule."

Thus, while A's exchange of common stock for preferred stock may satisfy all of the literal requirements of section 351 of the Code, it does not follow that Congress meant to cover such an exchange, even though "the facts answer the dictionary definition of each term used in the statute." See Helvering v. Gregory, 69 F.2d 809, 810 (2nd Cir. 1934) (Hand, J.), aff'd, 293 U.S. 465 (1935), Ct. D. 911, XIV-1 C.B. 193 (1935).

Section 351(a) of the Code is intended to apply to "certain transactions where gain or loss may have accrued in a constitutional sense, but where in a popular and economic sense there has been a mere change in the form of ownership and the taxpayer has not really 'cashed in' on the theoretical gain, or closed out a losing venture." Portland Oil Co. v. Commissioner, 109 F.2d 479, 488 (1st Cir. 1940), cert. denied, 310 U.S. 650 (1940). See also Rev. Rul. 73-472, 1973-2 C.B. 114. On the other hand, section 351(a) is not intended to apply to transactions that sufficiently resemble a sale so that gain is recognized in a popular and economic sense. Thus, the issue presented is whether, in terms of economic substance, there has been a mere change in the form of investment or a cashing in of that investment.

A's exchange of common stock for preferred stock is an integral part of a larger transaction. In the larger transaction, P, acting through its subsidiary S, acquires all the stock of an unrelated third corporation T. Thus, viewed from the perspective of all the parties, the larger transaction fits a pattern common to acquisitive reorganizations. Contrast Rev. Rul. 57-190, 1957-1 C.B. 121, and Rev. Rul. 57-464, 1957-2 C.B. 244 (which describe transfers to a controlled corporation as part of a larger transaction that fits a pattern common to divisive reorganizations).

A well-established continuity of interest test applies to acquisitive reorganizations. See section 1.368-1(b) of the Regulations and Rev. Rul. 66-224, 1966-2 C.B. 114. The object of the continuity of interest test is to identify acquisitive transactions that sufficiently resemble a sale so gain is recognized in the ordinary business sense. See Roebling v. Commissioner, 143 F.2d 810, 812 (3rd Cir. 1944), cert. denied, 323 U.S. 773 (1944).

Under the continuity of interest test, a substantial portion of the consideration paid must consist of stock in the acquiring corporation. See Southwest Natural Gas Co. v. Commissioner, 189 F.2d 332, 334 (5th Cir. 1951), cert. denied, 342 U.S. 860 (1951). If an acquisitive transaction fails the continuity of interest test, then the transaction as a whole sufficiently resembles a sale so all the parties recognize gain in the ordinary business sense.

The larger acquisitive transaction in which S obtains the stock of T fails the continuity of interest test. It follows that the transaction as a whole sufficiently resembles a sale so all the parties (including A) recognize gain in the ordinary business sense. Because section 351 of the Code is not intended to apply where gain is recognized in the ordinary business sense, A's exchange is not within the "underlying assumptions and purposes" of section 351. See section 1.1002-1(b) of the regulations.

No other conclusion would be consistent with the history and purpose of continuity of interest. In a series of decided cases, the courts have denied nonrecognition treatment to acquisitive transactions that lacked continuity of interest. See, e.g., in addition to the cases cited above, LeTulle v. Scofield, 308 U.S. 415 (1940), Ct. D. 1432, 1940-1 C.B. 151, Pinellas Ice & Cold Storage Co. v. Commissioner, 287 U.S. 462 (1933), Ct. D. 630, XII-1 C.B. 161 (1933), and Cortland Speciality Co. v. Commissioner, 60 F.2d 937 (2d Cir. 1932), cert. denied, 288 U.S. 599 (1933). The defect in each case was entirely one of substance; the transaction at issue satisfied all of the technical requirements for nonrecognition under the satutory provisions that were directly relevant. A defect of this kind cannot be remedied by means that are essentially formal. In particular it cannot be remedied merely by rearranging the form of an acquisitive transaction so that the technical requirements of section 351 of the Code are satisfied, but without altering the substance of the transaction.

In this ruling, the facts reveal an acquisitive transaction which does not meet the continuity of interest test and thus is equivalent to a sale. Accordingly, although the technical requirements of section 351(a) of the Code are satisfied, the transaction is beyond the underlying assumptions and purposes of section 351(a). Therefore, its substance as a sale remains the same, and the transaction will be treated as a taxable exchange. Compare Rev. Rul. 80-285, this page, this Bulletin, which reaches the same result when assets, instead of stock, are acquired under similar circumstances.

HOLDING

A's exchange of capital stock in T for preferred stock in S does not qualify for nonrecognition treatment under section 351(a) of the Code, and gain is therefore recognized on the exchange.