Rev. Rul. 58-68

Advice has been requested relative to the status, for Federal income tax purposes, of a distribution by one corporation of the capital stock of a subsidiary and the subsequent merger of the former subsidiary with a third corporation.

Corporation X, operating an automobile dealership, owned all the stock of Y corporation which operated an automobile finance business. A certain stockholder owned all the stock of X, and he and his wife owned all the stock of Z corporation which was also engaged in the automobile finance business. Y owed its parent X for recent loans in an amount greater than Y's capital plus its surplus. The surplus of X was substantial.

Allegedly in order to eliminate duplication and increase borrowing capacity for possible expansion, the following plan was carried out:

1. (a) A contribution to capital was made by the parent X to the subsidiary Y through cancellation of the loans.

(b) The parent made a distribution to its sole stockholder of all of the capital stock of the subsidiary corporation without any surrender of stock by him.

2. Corporations Y and Z entered into a statutory merger pursuant to the corporation laws of their state, after which the two businesses were operated as one by Y, the surviving corporation. Both stockholders of Z received additional stock in Y in exchange for their stock in Z.

The Internal Revenue Service concludes that the transaction was used principally as a device for the distribution of the earnings and profits of the parent, because the distribution of the stock of the controlled corporation was immediately preceded by a very large contribution (through debt cancellation) to the capital of the subsidiary. In addition the distribution was immediately succeeded by the effective disposition of the stock distributed in a merger negotiated prior to the distribution. See section 355(a)(1)(B) of the Internal Revenue Code of 1954. Moreover, the active business requirements of section 355(b) of the Code were not met, since the transaction was preceded by a contribution to Y corporation resulting in a more than 100 percent increase in its net worth. Thus, more than half of the net assets of Y at the time of the distribution were not owned by it in connection with its active conduct of its trade or business during the five-year period ending on the date of the distribution.

In view of the foregoing, it is held that, although no income resulted to Y corporation from the contribution by its parent, under section 118 of the Code, the distribution by X corporation of all of the capital stock of Y constituted payment of a taxable dividend as defined in section 316(a) of the Code, to the sole stockholder of X, to the extent of the fair market value of such stock. The basis to this sole stockholder of the stock of Y thus acquired is its fair market value when received. The subsequent merger constituted a nontaxable reorganization under sections 368(a)(1)(A), 1032, 361(a), and 354(a) of the Code.