Rev. Rul. 78-375

Advice has been requested as to the treatment for federal income tax purposes of a "dividend reinvestment plan" where the shareholder may not only elect to receive stock of greater fair market value than the cash dividend such shareholder might have received instead, but also the shareholder may, through the plan, purchase additional stock from the corporation at a discount price which is less than the fair market value of the stock.

X is a corporation engaged in commercial banking whose shares of common stock are widely held and are regularly traded in the over-the-counter market. In order to raise additional equity capital for corporate expansion and to provide holders of X's common stock with a simple and convenient way of investing their cash dividends and optional payments in additional shares of X common stock without payment of any brokerage commission, X established an automatic dividend reinvestment plan. An independent agent will administer the plan and will receive the stock from X in the manner described below on behalf of a participating shareholder.

The plan provides the following:

(1) Shareholders can elect to have all their cash dividends (less a quarterly service charge of 3x dollars that is paid to an independent agent of the shareholder) otherwise payable on common stock registered in the name of the shareholder automatically reinvested in shares of X common stock. The service charge is paid to the agent for administering the plan and maintaining the stock certificates for the shareholders. The shareholders who elect to participate in the plan acquire X stock at a price equal to 95 percent of the fair market value of such stock on the dividend payment date. The shareholder's option to receive a dividend in additional common stock in lieu of a cash dividend is not transferable apart from a transfer of the common shares themselves.

(2) A shareholder who participates in the dividend reinvestment aspect of the plan as described in paragraph (1) above, in addition, has the option to invest additional amounts to purchase shares of X common stock at a price equal to 95 percent of the fair market value of such stock on the dividend payment date. Optional investments by a shareholder in any quarterly dividend period must be at least 4x dollars and cannot exceed 100x dollars. The shareholder's right to invest additional amounts under the plan is not transferable apart from a transfer of the common shares themselves.

There is no requirement to participate in the plan and shareholders who do not participate receive their cash dividend payments in full. Certain shareholders have chosen not to participate; therefore, they receive their regular quarterly cash dividend. While the plan continues in effect, a participant's dividends will continue to be invested without further notice to X.

Prior to the dividend payment date no cash dividend is available to either X's participating or nonparticipating shareholders. On the dividend payment date the participant receives written notification that X is acting to effectuate the participant's option to receive stock on that date. The crediting on the plan account and notification to the participant of the exact number of shares acquired (including fractional shares) takes place shortly after the dividend payment date.

A participant may withdraw from the plan at any time, upon written request. Upon withdrawal, certificates for whole shares credited to the participant's account under the plan will be issued and a cash payment based upon the market value of the participant's fractional share interest will be paid by X, through the participant's agent, to the participant. As an alternative, the shareholder may request that all or part of the whole shares credited to its account in the plan be sold for the shareholder's account. The sale will be made by an independent agent acting on behalf of such participant and the proceeds of the sale (less any brokerage commission and transfer tax) will be forwarded to the participant. With regard to the whole shares, X will neither purchase any shares of a participant nor pay any expense attributable to the sale of such stock. Upon a request for sale of a participant's shares, a cash payment equal to the market value of the participant's fractional share interest will be paid by X, through the participant's agent, to the participant. The purpose of the payment of cash is to save X the trouble, expense, and inconvenience of issuing and transferring fractional shares and is not designed to give any particular group of shareholders an increased interest in the assets or earnings and profits of X.

Section 305(a) of the Code provides that, with certain exceptions, gross income does not include the amount of any distribution of the stock of a corporation made by such corporation to its shareholders with respect to its stock. Section 305(d)(1) provides that for purposes of the foregoing the term "stock" includes rights to acquire such stock.

Section 305(b)(1) of the Code provides that section 305(a) will not apply, and the distribution will be treated as a distribution to which section 301 applies, if the distribution is, at the election of any shareholder (whether exercised before or after the declaration), payable either in the stock of the distributing corporation or in property.

Section 305(b)(2) of the Code provides that section 305(a) will not apply, and the distribution will be one to which section 301 applies, if the distribution (or a series of distributions of which such a distribution is one) has the result of (a) the receipt of property by some shareholders, and (b) an increase in the proportionate interest of other shareholders in the assets or earnings and profits of the corporation.

Section 1.305-3(b)(2) of the regulations provides that in order for a distribution of stock to be considered as one of a series of distributions, it is not necessary that such distribution be pursuant to a plan to distribute cash or property to some shareholders and to increase the proportionate interests of other shareholders. It is sufficient if there is an actual or deemed distribution of stock and, as a result of such distribution, some shareholders receive cash or property and other shareholders increase their proportionate interests. This is so whether the stock distributions and the cash distributions are steps in an overall plan or are independent and unrelated. In addition, section 1.305-3(b)(3) states that there is no requirement that both elements of section 305(b)(2) of the Code (receipt of cash or property by some shareholders and an increase in proportionate interests of other shareholders) occur in the form of a distribution or series of distributions as long as the result of a distribution of stock is that some shareholders' proportionate interests increase and other shareholders in fact receive cash or property.

Section 301 of the Code states that, except as otherwise provided, a distribution of property made by a corporation to a shareholder with respect to its stock shall be included in the gross income of the shareholder to the extent the amount distributed is a dividend as defined in section 316.

Rev. Rul. 76-53, 1976-1 C.B. 87, concerns a situation where a widely held corporation that regularly distributes its earnings and profits adopted a plan permitting the shareholders to choose to have all of the cash dividends, otherwise payable on common shares owned by the shareholder, automatically invested to purchase additional shares of the corporation's stock. The shareholders who elect to participate under this plan acquire the company's stock at a price equal to 95 percent of the fair market value of such stock on the dividend payment date. That Revenue Ruling concludes that the distributions made by the corporation while the plan is in effect are properly treated as payable either in stock or in cash at the election of the shareholder within the meaning of section 305(b)(1) of the Code, and, therefore, such participating shareholders will be treated as having received a distribution to which section 301 applies by reason of section 305(b)(1).

Rev. Rul. 77-149, 1977-1 C.B. 82, concerns a situation where a corporation established a dividend reinvestment plan administered by a local bank, acting as agent for the shareholders. At a shareholder's direction the shareholder's cash dividends would be received by the participating shareholders' agent, the bank, who would then purchase the corporation's stock on the open market at 100 percent of fair market value. That Revenue Ruling held that section 301 applies directly to the cash dividends without reference to section 305(b)(1) because the distribution is payable by the corporation only in cash, and the shareholders of the corporation do not have the election of receiving their dividend distribution from the corporation in either stock or cash.

In the present case, the distributions made by X while the plan is in effect are properly treated as payable either in X's stock or in cash at the election of X's common shareholders within the meaning of section 305(b)(1) of the Code. The acquisition of stock through the dividend reinvestment aspect of the plan is identical to the situation in Rev. Rul. 76-53. Further, the present case and Rev. Rul. 76-53 are distinguishable from Rev. Rul. 77-149 because the distribution described in Rev. Rul. 77-149 was payable by the corporation only in cash, and the shareholder, through the agent, purchased the corporation's stock on the open market.

The optional investment aspect of the present case results in an increase in the proportionate interests of the shareholders making the purchase at a 5 percent discount, and this event increases their proportionate interests in the assets or earnings and profits of X within the meaning of section 305(b)(2)(B) of the Code. Furthermore, the fact that X shareholders who do not participate in the plan receive cash dividends constitutes a receipt of property by those shareholders within the meaning of section 305(b)(2)(A).

Accordingly, under the circumstances described above, it is held as follows:

(a) A shareholder of X who participates in the dividend reinvestment aspect of the plan will be treated as having received a distribution to which section 301 of the Code applies by reason of the application of section 305(b)(1). Pursuant to section 1.305-1(b) of the regulations, the amount of the distribution to a participating shareholder (including participating corporate shareholder) will be the fair market value of the X stock received on the date of the distribution (sections 1.301-1(b) and (d)), plus, pursuant to section 301, 3x dollars, the service charge subtracted from the amount of the shareholder's distribution.

(b) The basis of the shares credited to the account of a participating shareholder pursuant to the dividend reinvestment aspect of the plan will equal the amount of the dividend distribution, as provided in section 301(c) of the Code, measured by the fair market value of the X common stock as of the date of the distribution both as to noncorporate and corporate shareholders, pursuant to section 301(d). Section 1.301-1(h)(1) and (2)(i) of the regulations. The quarterly service charge paid by a participant who is an individual for the production of income or for the management, conservation, or maintenance of property held for the production of income, is deductible in the year paid by such participant under section 212, provided the individual itemizes deductions. See Rev. Rul. 70-627, 1970-2 C.B. 158, and Rev. Rul. 75-548, 1975-2 C.B. 331. The quarterly service charge, which is paid in carrying on a trade or business by a participant who is an individual, is deductible in the year paid by such participant under section 162. A participant who is a corporation may deduct the service charge under section 162.

(c) A shareholder of X who participates in the optional payment aspect of the plan will be treated as having received a distribution to which section 301 of the Code applies by reason of the application of section 305(b)(2). Pursuant to section 1.305-3(a) of the regulations, the amount of the distribution to a participating shareholder will be the difference between the fair market value on the dividend payment date of the shares purchased with the optional payment and the amount of the optional payment. Section 1.305-3(b)(2).

(d) The basis to the shareholder who participates in the optional payment aspect of the plan is the excess of fair market value of the shares purchased with the optional payment over the optional payment (provided that this deemed distribution is taxable as a dividend under section 301(c)(1) of the Code) pursuant to section 301(d) and sections 1.301-1(h)(1) and 2(i) of the regulations, plus the amount of the optional payment, pursuant to section 1012.

(e) A participant in the plan will not realize any taxable income upon receipt of certificates for whole shares that were credited to the participant's account pursuant to the plan. Rev. Rul. 76-53. Any cash received by an X shareholder in lieu of a fractional share interest will be treated as a redemption of that fractional share interest, subject to the provisions and limitations of section 302 of the Code. See Rev. Rul. 66-365, 1966-2 C.B. 116.

(f) A participant will recognize gain or loss pursuant to section 1001 of the Code when shares are sold or exchanged on behalf of the participant upon the participant's withdrawal from the plan, or when the participant sells the shares after its withdrawal from the plan. In accordance with section 1001, the amount of such gain or loss will be the difference between the amount that the participant receives for the whole shares and the participant's tax basis. Any cash received by the participants, who withdraw from the plan, in lieu of their fractional share interests will be treated as a redemption of that fractional share interest, subject to the provisions and limitations of section 302. See Rev. Rul. 66-365.

Rev. Rul. 77-149 is distinguished.