Rev. Rul. 79-273
Does a statutory merger in which shareholders of a corporation (P) receive cash from the acquiring corporation (X) and also receive stock in a subsidiary corporation of P represent a sale by the shareholders of part of their P stock to the acquiring corporation, and a redemption of the remainder of the P stock under section 302(b)(3) of the Internal Revenue Code?
X and P are domestic manufacturing corporations that have unrelated shareholders. X and P have only common stock outstanding and their stock is widely held. For many years, P had been engaged directly in one business, and indirectly in a different business through its wholly owned subsidiary, S; P has transferred no property to S within the past 5 years and will transfer none prior to the transaction described below. The fair market value of the outstanding P stock was 100x dollars. The fair market value of the S stock held by P was 15x dollars. P has both current and accumulated earnings and profits. X desired to purchase for cash the stock in P, but X did not desire to acquire the S business.
Under a plan designed to make P a wholly owned subsidiary of X, the following steps were taken:
(1) X formed corporation Z as a wholly owned subsidiary and contributed 85x dollars cash to Z.
(2) Z was then merged into P under applicable state law and P was the surviving corporation. The 85x dollars cash transferred by X to Z was, upon merger, transferred by P pro rata to the P shareholders in exchange for P stock of equal value. Also, in the merger, the Z stock held by X was automatically converted into P stock of equal fair market value by operation of state law.
In addition, pursuant to the merger agreement, all the stock in S was transferred by P pro rata to the P shareholders in exchange for the remainder of their P stock. X thus became the sole shareholder of P, and the former P shareholders held all of the stock of S. P and S continued their respective businesses.
LAW AND ANALYSIS
The applicable sections of the Code and Income Tax Regulations thereunder are 368 and 1.368-2(a) relating to corporate reorganizations, 302 relating to redemptions treated as distributions in part or full payment for the stock; 355 and 1.355-2(c) relating to the nonapplicability of the nonrecognition provisions of section 355 to certain transactions where shareholders sell stock in either the distributing or the controlled corporation, and 1001 relating to the recognition of gain or loss on the sale or exchange of property.
Section 1.368-2(a) of the regulations provides that a transaction will not qualify as a reorganization defined in section 368(a)(1) of the Code if there is no continuity of interest on the part of the transferor or its shareholders in the properties transferred.
Section 302(b)(3) of the Code provides that section 302(a) of the Code will apply to redemptions that are a complete termination of a shareholder's stock interest in the redeeming company. Section 302(a) of the Code provides that a distribution of property shall be treated as in part or full payment in exchange for the stock.
Section 1001 of the Code provides for the recognition of gain from the sale or other disposition of property to the extent of the excess of the amount realized therefrom over the property's adjusted basis, and for the recognition of loss to the extent of the excess of the property's adjusted basis over the amount realized.
Section 1.355-2(c) of the regulations states that section 355 contemplates a continuity of interest in all or part of the business enterprise on the part of those persons who were the owners of the enterprise prior to the distribution or exchange. Where such continuity does not exist, section 355 of the Code will not apply to the transaction.
Rev. Rul. 73-427, 1973-2 C.B. 301, holds that the transitory existence of a new subsidiary corporation, and the transfer to it of parent stock, will be disregarded where such subsidiary is organized by the parent corporation to participate in a statutory merger merely as a conduit to enable parent to acquire stock of another corporation (target). In the merger, the subsidiary goes out of existence and the parent's stock received by the target corporation in the merger is issued to its shareholders in exchange for their stock in the target corporation. In addition, the parent's stock in the transitory subsidiary is automatically converted into target corporation stock by operation of state law. Rev. Rul. 73-427, states that the net effect of the steps for federal income tax purposes is a direct acquisition by the parent of target corporation's stock from the target shareholders in exchange for stock of the parent.
As in Rev. Rul. 73-427, the net effect here of steps (1) and (2) is a direct acquisition by X of 85 percent of P's stock from the P shareholders. Since X acquired P stock solely for cash this acquisition is not a reorganization as defined in section 368(a)(1) of the Code because the P shareholders did not continue their interest in P.
Under the rationale of Zenz v. Quinlivan, 213 F.2d 914 (6th Cir. 1954) termination of a shareholder's interest under section 302(b)(3) of the Code will result where a shareholder disposes of his or her entire stock interest in a company partly through redemption and partly through sale, or gift, pursuant to an integrated plan. Rev. Rul. 55-745, 1955-2 C.B. 223, and Rev. Rul. 77-226, 1977-2 C.B. 90.
The transfer of the S stock by P to its shareholders in exchange for 15 percent of their P stock and the P shareholders' sale to X of the other 85 percent of their P stock were pursuant to an integrated plan that terminated their entire stock interest in P, in accord with the Zenz rationale.
The distribution by P of the S stock does not meet the requirements of section 355 of the Code because the P shareholders did not have a continuing stock interest in P after the transaction.
The cash acquisition by X of 85 percent of the P stock, by means of a statutory merger, represents a sale of such stock by the P shareholders to X. The distribution by P to its shareholders of its S stock in exchange for 15 percent of their P stock, together with their sale of the other 85 percent of their P stock to X, completely terminate the interest of the P shareholders in P within the meaning of section 302(b)(3) of the Code. Gain or loss is recognized to the P shareholders on the sale and redemption of their P stock in accordance with the provisions of section 1001.
Section 311(d)(1) of the Code, which provides, in general, that gain is recognized to a corporation that distributes appreciated property to a shareholder in redemption of stock, is not applicable to the distribution by P to its shareholders of the S stock because under the facts the exception to the application of section 311(d)(1) contained in section 311(d)(2)(B) is applicable.