Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 76-14

1976-1 C.B. 97

Section 306
Section 356
Section 368

IRS Headnote

Recapitalization; common stock for cash; section 306 stock for common. In a recapitalization qualifying under section 368(a)(1)(E) of the Code, a corporation's controlling shareholder who exchanges voting common stock for cash and also preferred section 306 stock for nonvoting common stock (not section 306 stock) will be considered as receiving the cash first in exchange for the section 306 stock and to that extent the cash will be treated as a distribution under the provisions of section 356(e).

Full Text

Rev. Rul. 76-14

Advice has been requested concerning the treatment of cash received in a recapitalization, qualifying as a reorganization under section 368(a)(1)(E) of the Internal Revenue Code of 1954, under the circumstances described below.

All of the outstanding stock of corporation X was owned by A and B who are not related. B was a key employee of X. A owned 10 shares of X voting common stock with a fair market value of 10x dollars and 10 shares of X preferred stock with a fair market value of 10x dollars. The preferred stock was "section 306 stock" as defined in section 306(c) of the Code. B owned 2 shares of X voting common stock with a fair market value of 2x dollars.

A desired to retire from the business and to relinquish control of X to B. To provide for A's retirement, a plan and agreement of reorganization (recapitalization) was entered into whereby A exchanged his 10 shares of X voting common stock for 10x dollars in cash and also exchanged the 10 shares of X preferred stock for 10 shares of a new class of nonvoting common stock, which is not section 306 stock. These exchanges were specifically set forth in the plan and agreement of reorganization and effectuated according thereto. The transaction qualified as a reorganization under section 368(a)(1)(E) of the Code.

Section 354(a)(1) of the Code provides, in part, that no gain or loss will be recognized if stock in a corporation a party to the reorganization is, in pursuance of a plan of reorganization, exchanged solely for stock in such corporation or in another corporation a party to the reorganization.

Section 356 of the Code provides rules for treating gain or loss where property (or money) is received as part of the exchange of stock described in section 354(a)(1).

Section 356(e) of the Code provides that notwithstanding any other provision of section 356, to the extent that any of the other property (or money) is received in exchange for section 306 stock, an amount equal to the fair market value of such other property (or the amount of such money) shall be treated as a distribution of property to which section 301 applies.

Section 1.356-4 of the Income Tax Regulations states, in part, that the determination of whether section 306 stock is surrendered for other property (including money) is a question of fact to be decided under all of the circumstances of each case and that, ordinarily, the other property (including money) received will first be treated as received in exchange for any section 306 stock owned by a shareholder prior to such transaction.

In the instant case, even though the exchange agreement recited that the cash was in exchange for the old X common stock, this identification will not be accorded substantive effect for tax purposes since A had control of X so that he could direct X to distribute the cash in exchange for his X voting common stock in an attempt to avoid the application of section 356(e) of the Code. X had no other shareholders who would be in any way adversely affected by the form of the exchanges that were not negotiated among A, B, and X but were directed by A who controlled X. Furthermore, the new common stock is not section 306 stock.

Accordingly, under the provisions of section 356(e) of the Code and section 1.356-4 of the regulations, 10x dollars of cash will first be considered as received in exchange for the section 306 stock and to that extent will be treated as a distribution of property to A to which section 301 applies.

Compare Rev. Rul. 76-15, this page, where, pursuant to a recapitalization qualifying as a reorganization under section 368(a)(1)(E) of the Code, shareholders of a corporation, whose stock is widely held and publicly traded, exchanged their common stock for new common stock and cash and exchanged their old nonvoting preferred stock, which was section 306 stock, for new voting preferred stock, which was also section 306 stock. Rev. Rul. 76-15 concludes that the old section 306 stock will not be considered as exchanged for money under section 356(e) because the exchange was negotiated at arms length between the corporation and the shareholders, who exercised no form of control over the corporation, and the new preferred stock was section 306 stock.