Rev. Rul. 73-233

Advice has been requested whether, under the circumstances described below, gain or loss is recognized to the shareholders of a party to a reorganization where the distribution of stock of the acquiring corporation is effected on a non pro rata basis as a result of a capital contribution immediately prior to the reorganization.

Y corporation wished to acquire by statutory merger all of the assets and liabilities of X corporation in exchange for 100 shares of stock of Y corporation. The stock of X was owned by three individuals, A, B, and C who are unrelated. A owned 60 percent of the stock of X and B and C each owned 20 percent of the stock of X. A two-thirds vote of the acquired corporation's shareholders in favor of the merger was required to meet the applicable merger laws of the State in which X was incorporated. B and C refused to vote in favor of the proposed merger unless they would each receive 25 shares of Y stock. In consideration for B and C voting in favor of the merger A agreed to permit B and C each to receive 25 shares of Y stock instead of the 20 shares of Y stock which they would have been entitled to receive had the distribution of Y stock to the X shareholders been in proportion to their stock ownership of X. In order to effectuate this agreement, A contributed one-third of his stock in X to the capital of X with the result that A's stock interest in X was reduced to 50 percent and B's and C's stock interests were each increased to 25 percent. The X shareholders then voted unanimously in favor of the merger which was thereafter consummated. A, B, and C received, respectively, 50, 25 and 25 shares of Y stock in exchange for their X stock.

Section 354(a)(1) of the Internal Revenue Code of 1954 provides that no gain or loss will be recognized if stock or securities in a corporation a party to a reorganization are, in pursuance of a plan of reorganization, exchanged solely for stock or securities in such corporation or in another corporation a party to the reorganization.

Section 61(a) of the Code provides that, except as otherwise provided, gross income means all income from whatever source derived.

Section 1001(a) of the Code provides that the gain from the sale or other disposition of property is the excess of the amount realized therefrom over the adjusted basis provided in section 1011 of the Code for determining gain, and the loss is the excess of the adjusted basis provided in such section for determining loss over the amount realized. Section 1001(b) of the Code provides in part that the amount realized from the sale or other disposition of property is the sum of any money received plus the fair market value of other property received.

Section 1002 of the Code provides that, except as otherwise provided, on the sale or exchange of property the entire amount of the gain or loss, determined under section 1001 of the Code, will be recognized.

Under the circumstances of this case the contribution of X stock by A to the capital of X prior to the merger will not be considered independently of the related events surrounding the contribution. The other related events to be considered are (i) the agreement of B and C with A to vote in favor of the merger if B and C would each receive five additional shares of Y stock, and (ii) the merger.

Accordingly, the overall transaction will be viewed as (1) a merger of X into Y with a distribution of 60, 20 and 20 shares of Y stock to A, B, and C, respectively, in exchange for their X stock, with no gain or loss being recognized to A, B, or C on this exchange under section 354 of the Code, and (2) a transfer by A of five shares of Y stock to B and five shares of Y stock to C in consideration for their voting in favor of the merger.

Gain or loss will be recognized to A on his transfer of 10 shares of Y stock, five to B and five to C, to the extent of the difference between the fair market value of the stock and the adjusted basis of the stock in A's hands at the time of the transfer. Sections 1001 and 1002 of the Code; United States v. Davis, 370 U.S. 65 (1962), 1962-2 C.B. 15.

Since the transfer by A of Y stock to B and C was in satisfaction of B and C voting for the merger which enabled A to acquire the Y stock, such transfer will be considered a capital expenditure and, therefore, not a deductible expense to A. See section 263 of the Code and the Income Tax Regulations thereunder, which preclude a deduction for capital expenditures. A will be permitted to adjust the basis of his remaining 50 shares of Y stock under section 1016 of the Code by increasing his basis in such stock by the fair market value of the 10 shares given up. The fair market value of the five shares of Y stock received by B and C, respectively, from A is includible in their gross incomes under section 61 of the Code.

The basis of the five shares of Y stock received by B and C, respectively, from A will be the fair market value of such stock at the time received.