Rev. Rul. 78-422

ISSUE

In a transaction described in section 304(a)(1) of the Internal Revenue Code of 1954 and sections 351(a) and 357(a) of the Code, do the provisions of section 304(a)(1) prevail over the provisions of section 357(a)?

FACTS

A, an individual, who owns all of the stock of X corporation, purchased all of the stock of Y corporation for 250x dollars. 200x dollars of the purchase price was borrowed by A from a bank. Subsequently, A transferred the Y stock to X in return for the assumption by X of A's liability to the bank in the amount of 200x dollars and additional X stock. The assumption of the liability by X relieved A of all liability thereon. At the time of the transfer, the Y stock had a fair market value of 400x dollars and an adjusted basis in the hands of A of 250x dollars. During the time that A held the Y stock, A exercised all the rights of ownership of the stock including managing the operations of Y and receiving dividends therefrom. At the time of the transfer of the Y stock to X, X had earnings and profits in excess of 200x dollars.

LAW AND ANALYSIS

The applicable sections of the Code and Income Tax Regulations thereunder are 304(a)(1) and 1.304-1, relating to the acquisition of stock by related corporations (other than subsidiary); 302 and 1.302-1, relating to distributions in redemption of stock; 351 and 1.351-1, relating to the non-recognition of gain or loss on the transfer of property to a controlled corporation; and 357(a) and 1.357-1, relating to the assumption of liability.

In Rev. Rul. 73-2, 1973-1 C.B. 171, the Internal Revenue Service announced that it will not follow the decision of the United States Court of Appeals for the Sixth Circuit in Haserot v. Commissioner, 399 F.2d 828 (6th Cir. 1968). In Haserot, the court held that when section 351 of the Code applies to an acquisition also described in section 304(a)(1) the transaction will be governed by section 351. Rev. Rul. 73-2 holds, on facts similar to those in Haserot, that section 304 will apply to that portion of the transaction in which cash (property) was received whereas section 351 will apply to that portion of the transaction in which stock of the acquiring corporation is received. The Service's position that the transaction will be governed by section 304 was sustained by the United States Court of Appeals for the Ninth Circuit in Coates v. Commissioner, 480 F.2d 468 (9th Cir. 1973), cert. denied, 414 U.S. 1045 (1973). Further, in Maher v. Commissioner, 469 F.2d 225 (8th Cir. 1972) rev'g, 55 T.C. 441 (1970), Nonacq., 1977-2 C.B. 2, it was held that the assumption of a liability is "property" for the purposes of sections 304 and 317.

In the present case, the transaction meets the requirements of section 304(a)(1) of the Code with regard to the assumption by X of A's liability to the bank in exchange for the Y stock since A was, at the time of the transaction, in control of both X and Y as provided in section 304(c). The transaction is also described in sections 351(a) and 357(a).

HOLDING

Section 304(a)(1) of the Code is applicable, and not section 357(a), to that portion of the transaction in which the liability is assumed. Section 351(a) will be applied to that portion of the transaction in which stock of X is received.

Since section 304(a)(1) of the Code is applicable, the assumption by X of A's liability to the bank in the amount of 200x dollars is treated as a distribution in redemption of the X stock subject to the provisions of section 302.

Section 304(b)(1) provides that in applying section 302(b), 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), which, pursuant to section 302(c), are applicable in determining the ownership of stock for purposes of section 302, A constructively owns 100 percent of the stock of Y after the transaction. Thus, the "redemption" does not qualify under section 302(b)(2) as substantially disprportionate, or under section 302(b)(3) as a complete termination of interest.

Furthermore, since A's ownership of the Y stock is 100 percent before the transaction and 100 percent after, there is no "meaningful reduction" in A's interest in Y to qualify the "redemption" as not essentially equivalent to a dividend under section 302(b)(1) of the Code. See United States v. Davis, 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 for section 302(b)(1) to apply. Therefore, section 302(a) (which treats a distribution as an exchange if section 302(b) is applicable) does not apply and, pursuant to section 302(d), the assumption by X of A's liability to the bank in the amount of 200x dollars is treated as a distribution of property to which section 301 applies. Since the earnings and profits of X exceed the amount of A's liability to the bank assumed by X, that amount is a dividend pursuant to sections 301(c)(1) and 316, and is includable in A's income in the taxable year of the assumption. See Rev. Rul. 77-360, 1977-2 C.B. 86, which states that the Service will follow Maher, relating to when a distribution resulting from an assumption of a liability is taxable to a taxpayer.

In addition, that part of the Y stock equivalent in value to the amount of the liability assumed (200x dollars) 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 regulations, A's basis for the X stock owned prior to the transaction is increased by 125x dollars, the basis of that part of the Y stock transferred which is equivalent in value to the amount of the liability assumed (one-half of the Y stock was transferred as consideration for X's assumption of the liability; therefore, one-half (125x dollars) of A's total adjusted basis in the Y stock (250x dollars) is attributable to the assumption of the liability), and X's basis in that part of the Y stock received for the assumption of the liability (and treated by X as a contribution to its capital) is the same as A's basis in that Y stock, or 125x dollars, under section 362(a).

The transfer by A of that part of the Y stock equivalent in value to the X stock received in exchange therefor (200x dollars) 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), A's basis in the X stock received is the same as A's basis in that part of the Y stock transferred to X in exchange for X stock, or 125x dollars. Under section 362(a), X's basis in that part of the Y stock received is the same as A's basis in the Y stock exchanged for X stock, or 125x dollars.