Rev. Rul. 73-2

The Internal Revenue Service will not follow the decision of the United States Court of Appeals for the Sixth Circuit in Estate of Henry McK. Haserot v. Commissioner, 399 F.2d 828 (1968).

On facts similar to those in the example set forth below, the court held that when section 351 of the Internal Revenue Code of 1954 applies to an acquisition also described in section 304(a)(1) of the Code the transaction will be governed by section 351.

Corporation X and corporation Y have been engaged in business for many years and have only voting common stock outstanding. A, an individual, owned all of the outstanding Y stock. The Y stock in the hands of A was a capital asset, within the meaning of section 1221 of the Code. Of the 50 shares of X common stock that were outstanding, A owned 30 shares (60 percent of the outstanding stock) and unrelated individuals owned 20 shares.

Pursuant to a plan, X, for good business reasons, acquired all of the Y stock owned by A in exchange for sufficient X stock so that after the transaction A owned approximately 81 percent of the outstanding X stock. In addition, A received 65x dollars in cash. A realized a gain of 40x dollars as a result of the transaction. The remaining 19 percent of X stock was owned by individuals unrelated to A. At the time of the transaction X had earnings and profits of 80x dollars.

Section 304(a)(1) of the Code provides, in part, that for purposes of section 302 of the Code, if one or more persons are in control 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, then the property will be treated as a distribution in redemption of the stock of the corporation acquiring the stock. In any such case, the stock so acquired will be treated as having been transferred by the person from whom acquired, and as having been received by the corporation acquiring it, as a contribution to the capital of the corporation.

Section 304(c) of the Code provides, in part, that control, for purposes of section 304 of the Code, 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.

For purposes of Part 1 of Subchapter C of the Code (relating to distributions by corporations) which includes section 304 of the Code, property is defined in section 317(a) of the Code to mean money, securities, and any other property, but the term does not include stock in the corporation making the distribution (or rights to acquire such stock).

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 that corporation and immediately after the exchange the persons are in control (as defined in section 368(c) of the Code) 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 each other class of stock of the corporation. Thus, in the instant case, no gain is recognized by A upon the exchange of the Y stock for X stock under section 351(a) of the Code.

Section 351(b) of the Code provides that if property or money in addition to stock or securities is received, gain will be recognized, but not in excess of the amount of money plus the fair market value of the other property received.

The specific question presented is whether the cash received by A is subject to the provisions of section 304(a)(1) of the Code or whether it is subject to section 351(b) of the Code. If section 351(b) of the Code controls, the gain (40x dollars) is a capital gain to A, but if section 304(a)(1) of the Code controls, the 65x dollar cash payment is treated as distribution in redemption of the X stock subject to the provisions of section 302 of the Code.

Section 304 of the Code was specifically enacted to insure that the sale of stock by a shareholder to a related corporation is treated as a redemption. Whether the proceeds from the redemption are to be treated as dividends or as gain from the sale or exchange of stock is to be determined according to the rules provided in section 302 of the Code. See Samuel E. Radnitz, Jr. and Hattie Radnitz v. United States, 294 F.2d 577 (1961), in which the court stated as to section 302 that--

The clear intent of this provision is to make all sales of stock to related corporations subject to the rules of section 302. (Emphasis added).

Support for this view is found in the Senate Committee on Finance's explanation of section 304 of the Code that ". . . in any case in which 1 or more persons who are in control of each of 2 corporations (brother-sister corporations) sell the stock of one of the corporations to another of such corporations the proceeds of such sale shall be considered to be an amount distributed in redemption of the stock of the corporation which purchased the stock . . ." (Emphasis added). See Senate Report No. 1622, Eighty Third Congress, at page 239.

Section 304 of the Code is specifically directed at distributions in redemptions of stock through use of related corporations meeting the 50 percent stock control requirement of section 304(c) of the Code. Section 351 of the Code, on the other hand, generally applies to the formation of corporations in transactions where assets are transferred by a person or persons who, after the transfer, meet the 80 percent stock control requirement.

If section 351 of the Code were construed to apply to transactions described in section 304 of the Code, an individual owning between 80 percent and 100 percent of the acquiring corporation would fall under the mantle of section 351 of the Code, whereas an individual owning as much as 50 percent but less than 80 percent of the acquiring corporation's stock would come within the scope of section 304 of the Code, thereby raising the possibility of dividend treatment. Such an interpretation of section 351 of the Code would permit an 80 percent to 100 percent shareholder, who has the greater ability to shape the affairs of the corporation to his own ends, to be free of the effect of section 304 of the Code, but would subject the person with a lesser interest and, therefore, a lesser ability to control the policies of the corporation, to the more stringent requirements of section 304 of the Code. Such a construction of the statute is inconsistent with the purpose of section 304 of the Code as interpreted by the court in the Radnitz case and the explanation of section 304 of the Code in the Senate Committee Report.

In the instant case, the requirements of section 304(a)(1) of the Code are met with regard to the cash received by A for part of the Y stock since A was, at the time of the transaction, in control of both X and Y since he owned more than 50 percent of the outstanding stock of X and of Y, and cash meets the definition of "property" for purposes of section 304 of the Code.

Thus, since section 304(a)(1) of the Code is applicable, the cash received by A (but not the X stock received by A) is treated as a distribution in redemption of the X stock subject to the provisions of section 302 of the Code. Section 304(b)(1) of the Code provides that in applying section 302(b) of the Code, which treats certain redemptions as exchanges, reference is to be made to the shareholder's ownership of stock in the issuing corporation (Y). By reason of the application of the constructive ownership of stock rules of section 318(a) of the Code, which, pursuant to section 302(c) of the Code, are applicable in determining the ownership of stock for purposes of section 302 of the Code, A constructively owns approximately 81 percent of the stock of Y after the transaction. Thus, the "redemption" does not qualify under section 302(b)(2) of the Code as substantially disproportionate, or under section 302(b)(3) of the Code as a complete termination of interest. Furthermore, the reduction in A's ownership of the Y stock from 100 percent before the transaction to approximately 81 percent after is not a "meaningful reduction" in A's interest in Y. See United States v. Maclin P. Davis et ux., 397 U.S. 301 (1970), Ct. D. 1937, 1970-1 C.B. 62, holding that a distribution in redemption of stock must result in a "meaningful reduction" in the shareholder's proportionate interest in the corporation. Therefore, section 302(a) of the Code (which treats a distribution as an exchange if section 302(b) of the Code is applicable) does not apply and, pursuant to section 302(d) of the Code, the 65x dollars in cash received by A from X is treated as a distribution of property to which section 301 of the Code applies. Since the earnings and profits of X exceed the amount of cash received by A, such amount is a dividend pursuant to sections 301(c)(1) and 316 of the Code.

Furthermore, that part of the Y stock equivalent to the cash received is treated under section 304(a)(1) of the Code as having been acquired by X as a contribution to capital from A. Under section 1.304-2(a) of the Income Tax Regulations, A's basis for his X stock is increased by the basis of that part of the Y stock transferred equivalent to the cash received, and X's basis in that part of the Y stock received for cash is the same as A's basis in such Y stock.

The transfer by A of that part of the Y stock equivalent in value to the X stock received in exchange therefor, is treated as a transfer which is subject to the nonrecognition of gain or loss provisions of section 351(a) of the Code. Under section 358(a)(1) of the Code, A's basis in the X stock received in the transaction is the same as A's basis in that part of the Y stock transferred to X in exchange for X stock. Under section 362(a) of the Code, X's basis in that part of the Y stock received in the transaction is the same as A's basis in the Y stock exchanged for X stock.

Accordingly, in similar cases, the Service will apply section 304 of the Code and not section 351(b) of the Code to that portion of the transaction in which cash was received. Section 351 of the Code will be applied to that portion of the transaction in which stock of the acquiring corporation is received.