Rev. Rul. 81-81

ISSUE

What is the proper treatment of cash distributed in lieu of fractional shares of section 306 stock to minority shareholders of a corporation in a recapitalization described in section 368(a)(1)(E) of the Internal Revenue Code?

FACTS

Corporation X is a domestic corporation with only one class of $15 par value, voting common stock outstanding. On April 30, 1980, X effected a recapitalization within the meaning of section 368(a)(1)(E) of the Code whereby, pursuant to a plan of recapitalization, one share of $10 par value, voting common stock and one-half share of $10 par value preferred stock were distributed to the shareholders in exchange for each share of $15 par value common stock outstanding. The preferred stock, when issued, was section 306 stock and was not redeemable by its terms for at least five years from the date of issuance. Any shareholder of X entitled to a fractional share of preferred stock received an amount of cash equal to the fair market value of the fractional share interest. The cash distributed represented less than one percent of the total fair market value of the stock distributed and was distributed solely to save X the expense and inconvenience of issuing fractional shares. Only ten shareholders, owning in the aggregate seven percent of the outstanding stock of X, were entitled to receive fractional shares in the transaction. These shareholders did not have control of X.

LAW AND ANALYSIS

Section 306(a)(2) of the Code provides that if a corporation redeems section 306 stock, the amount realized by the shareholder will be treated as a distribution of property to which section 301 applies.

Section 306(b)(4)(A) of the Code provides an exception to the general rules of section 306(a), if it is established to the satisfaction of the Secretary that the distribution, and the disposition or redemption, were not in pursuance of a plan having as one of its principal purposes the avoidance of federal income tax. The provision evidences a Congressional intent, in part, to provide an exception to the general rules in the case of isolated dispositions of section 306 stock by minority shareholders who do not in the aggregate have control of the distributing corporation; it was thought inappropriate to impute to noncontrolling shareholders an intention to bail-out earnings and profits at capital gains rates. S. Rep. No. 1622, 83rd Cong., 2d Sess. 243 (1954); see section 1.306-2(b)(3) of the Income Tax Regulations.

Rev. Rul. 69-34, 1969-1 C.B. 105, holds that cash payments received in a recapitalization in lieu of fractional share interests will be treated as distributions in redemption under section 302(a) where such payments are not substantially proportionate and represent the mere mechanical rounding off of the fractions resulting from the exchange rather than separately bargained-for consideration.

Rev. Rul. 66-365, 1966-2 C.B. 116, states that cash distributed in lieu of fractional shares that would be section 306 stock will be treated as a distribution in redemption to which section 301 of the Code applies unless the provisions of section 306(b)(4) are satisfied.

In the instant case, the shareholders receiving the cash distributions could not direct X to make a distribution that had a bail-out potential, since the shareholders were not in control of X. In addition, the deemed redemption of the fractional shares of preferred stock was an isolated disposition of the section 306 stock. Therefore, it is inappropriate to impute to the shareholders whose fractional shares were redeemed an intention to bail-out earnings and profits at capital gains rates.

HOLDING

Section 306(a) of the Code will not apply to the disposition of the fractional shares of section 306 stock by the minority shareholders by virtue of the applicability of section 306(b)(4)(A), and the cash will be treated as received in a redemption under section 302(a).

EFFECTS ON OTHER REVENUE RULINGS

Rev. Rul. 66-365 is amplified.