Rev. Rul. 80-239

ISSUE

Does section 301(c) of the Internal Revenue Code apply to the transaction described below?

FACTS

Individual A owned all of the stock of corporation X, which is engaged in a profitable manufacturing business. Over the years, X has accumulated substantial earnings and profits but had never paid a dividend. A decided to broaden the business operations of X into other unrelated manufacturing endeavors, and to this end A determined that a holding company would be necessary to oversee and control a multifaceted operation. A also wanted to initiate some new business ventures as a sole proprietor but did not have the necessary cash without withdrawing funds from X. To accomplish these objectives, A transferred the stock of X to Y, a newly created corporation. In exchange, therefor, A received the stock of Y and 100,000x dollars that Y had borrowed from a bank. The obligation of Y to the bank was guaranteed by X and secured by a pledge of the X stock to be received pursuant to the overall transaction. Subsequent to the transaction, Y repaid the bank loan with funds received from X.

LAW, ANALYSIS, AND HOLDING

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 such person or persons 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 351(b)(1) of the Code provides that if section 351 (a) would apply to an exchange but for the fact that there is received, in addition to the stock or securities permitted to be received under subsection (a), other property or money, then gain (if any) to such recipient will be recognized, but not in excess of the money received, plus the fair market value of such other property received. Under section 351(b)(1), the other property or money is treated as received by the shareholder in part or full payment in exchange for the assets transferred. Section 351(b)(2) provides that no loss will be recognized.

Section 1.351-2(d) of the regulations refers to section 301 of the Code with respect to the taxation of dividends where a distribution by a corporation of its stock in connection with an exchange subject to section 351(a) has the effect of the distribution of a taxable dividend.

Section 1.301-1(1) of the regulations provides that a distribution to shareholders with respect to their stock is within the terms of section 301 of the Code although it takes place at the same time as another transaction if the distribution is in substance a separate transaction whether or not connected in a formal sense.

Section 304(a)(1) of the Code provides, in part, that where one or more persons are in control, as defined in section 304(c), of each of two corporations and, in return for property, one of the corporations acquires stock in the other corporation from the person or persons so in control, the property received will be treated under section 302 as a distribution in redemption of stock of the corporation acquiring such stock. Section 304(c) provides, in part, that control means the ownership of stock possessing at least 50 percent of the total combined voting power of all classes of stock entitled to vote, or at least 50 percent of the total value of shares of all classes of stock.

Section 351 of the Code applies to the transfer by A of the X stock to Y in exchange for the Y stock because A was in control of Y (as defined in section 368(c)) immediately after the exchange. It must be determined, however, whether section 351(b) or section 304(a)(1) applies to the cash received by A from Y in the transaction.

A distribution of the cash directly by X to A would have been a distribution within the terms of section 301 of the Code. Although in the present case the cash distribution was arranged to be made by newly-organized Y corporation, this part of the transaction was in substance a disguised dividend distribution from X to A. The characterization of a distribution is not necessarily determinative for tax purposes and may be recharacterized to accord with the substance of a transaction. See Waterman Steamship Corp. v. Commissioner, 430 F.2d 1185 (5th Cir. 1970). Thus, the receipt of the 100,000x dollars by A is not governed under the provisions of section 351(b)(1) of the Code. See sections 1.351-2(d) and 1.301-1(1) of the regulations. Also, the provisions of section 304(a)(1) do not have any application to this situation since the substance of the transaction involves no actual receipt by A of "property" (cash) that is required to be distributed by Y, the acquiring-transferee corporation.

A distribution by one person (X) cannot be transformed for tax purposes into a distribution by another (Y) by using the latter as a conduit through which to pass the 100,000x dollars. Consequently, A will be treated as having received a dividend of 100,000x dollars from X to the extent provided in section 301 of the Code. See Gold v. Commissioner, T.C.M. 1958-2. Also see Minesota Tea Co. v. Helvering, 302 U.S. 609 (1938), Ct. D. 1305, 1938-1 C.B. 288, and Higgins v. Smith, 308 U.S. 473 (1940), Ct. D. 1434, 1940-1 C.B. 127.

Compare Rev. Bul. 80-240, page 116, this Bulletin, for tax treatment where the transferor borrowed money to purchase the stock transferred and the transferee corporation assumed the indebtedness.