Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 77-11

1977-1 C.B. 93

Section 302
Section 311
Section 351
Section 355
Section 368

IRS Headnote

Reorganization; spin-off; division of assets. The tax consequences are shown of a situation in which two corporations, whose stock is owned equally by two unrelated shareholders, form a third corporation by transferring one-half the assets of each to the new corporation in exchange for a proportionate share of its stock and then transfer the stock of the new corporation to one of the shareholders in exchange for all the stock held by that shareholder in the two original corporations.

Full Text

Rev. Rul. 77-11

Advice has been requested concerning the Federal income tax treatment of the transaction described below.

Corporations X and Y were each engaged in the construction business. Both businesses were active businesses within the meaning of section 355(b)(2) of the Internal Revenue Code of 1954. Two unrelated shareholders, A and B, each owned 50 percent of the stock of X and Y. A and B had each owned the X and Y stock for a period in excess of 5 years. X had a net worth with a value of 3,700x dollars, and Y had a net worth with a value of 700x dollars. For valid business reasons it was decided that B should be the sole owner of a corporation engaged in the construction business.

Pursuant to an integrated plan to achieve the desired objective, which was not a device to distribute the earnings and profits within the meaning of section 355 of the Code, the following actions were taken.

(a) X transferred to Z, a newly formed corporation, a portion of its assets relating to its construction business having a value of 1,850x dollars in exchange for 1,850 shares of Z voting common stock.

(b) Y transferred to Z a portion of its assets relating to its construction business having a value of 350x dollars, in exchange for 350 shares of Z voting common stock. The fair market value of the assets transferred exceeded Y's adjusted basis in the assets. One of the assets transferred by Y to Z was a license held by Y that enabled Y to engage in the construction business in state W. The transfer of the license was necessary in order to enable Z to engage in the construction business in state W.

(c) X distributed all the Z stock to B in exchange for all of B's stock in X.

(d) Y distributed all of the Z stock to B in exchange for all B's stock in Y.

(e) As a result of the above, A owned all of the stock of X and Y, and B owned all of the stock of Z. X, Y, and Z were each engaged in the active conduct of the construction business after the transaction.

Section 351(a) of the Code provides that no gain or loss will be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock or securities in such corporation if immediately after the exchange the transferors are in control of the corporation as defined in section 368(c).

Section 368(c) of the Code provides that the term "control" means ownership of stock possessing at least 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of each other class of stock of the corporation.

Section 351(c) of the Code provides that in determining control for purposes of section 351(a) the fact that any corporate transferor distributes part or all of the stock that it receives in the exchange to its shareholders will not be taken into account.

Section 368(a)(1)(D) of the Code provides, in part, that the term "reorganization" includes a transfer by a corporation of all or a part of its assets to another corporation if immediately after the transfer the transferor, or one or more of its shareholders (including persons who were shareholders immediately before the transfer), or any combination thereof, is in control of the corporation to which the assets are transferred, but only if, in pursuance of the plan, stock or securities of the corporation to which the assets are transferred are distributed in a transaction to which section 355 applies.

Section 355(a) of the Code provides, in part, that if: (i) a corporation distributes to its shareholders in exchange for its stock, solely the stock of a corporation that it controls (within the meaning of section 368(c)) immediately before the distribution; (ii) the transaction is not used principally as a device for the distribution of earnings and profits; and (iii) the requirements of section 355(b) (relating to the active conduct of a trade or business) are satisfied, no gain or loss will be recognized to the shareholders upon the distribution.

Section 1.355-3 of the Income Tax Regulations indicates, in pertinent part, that section 355 of the Code does not apply in an instance where the substance of a transaction is merely an exchange between shareholders of stock in one corporation for stock in another corporation. The regulations specifically illustrate this rule with an example. The example used in the regulations indicates that if two individuals, C and D, each own directly 50 percent of the stock of Corporation M and 50 percent of the stock of Corporation N, section 355 would not apply to a transaction in which C and D transfer all of their stock in Corporation M and Corporation N to a new Corporation P, for all of the stock of Corporation P, and Corporation P then distributes the stock of Corporation M to C and the stock of Corporation N to D.

Section 302(a) of the Code provides, in part, that if a corporation redeems its stock and if section 302(b)(3) applies, such redemption will be treated as a distribution in exchange for the stock. Section 302(b)(3) provides that section 302(a) will apply if the redemption is in complete redemption of all of the stock of the corporation owned by the shareholder.

Section 311(a) of the Code provides, in part, that no gain or loss will be recognized to a corporation on the distribution, with respect to its stock, of property, except as provided in sections 311(b), 311(c), and 311(d). Under section 311(d)(1), gain is recognized to a corporation upon a distribution of appreciated property (property the fair market value of which exceeds its adjusted basis in the hands of the distributing corporation) in redemption of its stock. Section 311(d)(1) does not, in general, apply to redemptions to which section 355 applies. (See section 311(d)(1)(A) and section 1.311-2(a)(2) of the regulations.) Also, section 311(d)(1) does not apply where, as provided by section 311(d)(2)(A), a distribution is in complete redemption of all of the stock of the shareholder who, at all times within the twelve-month period ending on the date of distribution, owns at least 10 percent in value of the outstanding stock of the corporation, but only if the redemption qualifies under section 302(b)(3). In the instant case, the transfers by X and Y of some of their assets to Z in exchange for all of the voting stock of Z qualify under the provisions of section 351(a) of the Code because X and Y are in control of Z immediately after the exchanges. Under section 351(c), the fact that X and Y distributed the Z stock that they received in their respective exchanges to B is not to be taken into account for purposes of determining whether the control requirement of section 351(a) is met.

Accordingly, no gain or loss is recognized by X or Y upon the transfer of property to Z, and pursuant to section 362(a) Z has a carryover basis for the property received from X and Y.

In the instant case, the distribution by X of the Z stock to B in exchange for B's stock in X qualifies under section 355 of the Code because X was in control of Z by reason of its owning more than 80 percent of the Z stock immediately before the distribution (1,850 shares of the 2,200 shares outstanding) and the other requirements of section 355 were satisfied.

Accordingly, no gain or loss is recognized to B under section 355 of the Code upon the exchange of all of B's X stock for Z stock. Also, no gain or loss is recognized by X under section 311(a) because B received the Z stock in a distribution that qualified under section 355.

The transaction described in this Revenue Ruling falls outside the above cited portion of section 1.355-3 of the regulations and the example contained therein because of two distinguishing factors. These distinguishing factors are: (1) Z is not availed of in the instant case for the purpose of effecting, in a disguised form, a stock exchange at the shareholder level because Z receives operating assets that will be used in its business; (2) there is no exchange of stock by A and A continues uninterruptedly as a shareholder of X and Y. Thus, there is in substance no exchange of stock between A and B and for this reason section 1.355-3 is inapplicable to the facts of this Revenue Ruling.

The distribution by Y of the Z stock to B in exchange for all of B's Y stock does not qualify under section 355 of the Code because Y owned less than 80 percent of the Z stock immediately before the distribution (350 shares of the 2,200 shares outstanding) and, therefore, was not in control of Z for purposes of section 355.

The exchange by B of all of B's Y stock for Z stock is treated as a redemption under section 302 of the Code. Since the redemption terminated B's interest in Y, within the meaning of section 302(b)(3), it is treated as a sale or exchange under section 302(a). Furthermore, by reason of the provisions of section 311(d)(2)(A) no gain or loss will be recognized by Y under section 311(d)(1).

In addition to the fact that X's transfer of property to Z joined with Y's transfer of property to Z qualify as a transfer to a controlled corporation for purposes of section 351 of the Code, X's transfer of property to Z also qualifies as a reorganization under section 368(a)(1)(D) because immediately after the transfer, X, being in control of Z (within the meaning of section 368(c)) distributed, in pursuance of the plan, the stock of Z to a shareholder, B, in a transaction qualifying under section 355. Consequently, in addition to the nonrecognition treatment X receives under section 351(a), it is also given nonrecognition treatment under section 361(a) and, in addition to the carryover basis Z receives under 362(a) for the property contributed by X, Z also is given a carryover basis for such property under section 362(b).

Accordingly, no gain or loss is recognized to Y upon the transfer of property by it to Z in exchange solely for stock of Z under section 351(a) of the Code. No gain or loss is recognized to X upon the transfer of property by it to Z in exchange solely for stock of Z under section 361(a). Under section 362(a), the basis of the property received by Z from X and Y in the hands of Z is the same as the basis of such property in the hands of X and Y immediately prior to the transfer.