Internal Revenue Service
Revenue Ruling
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smRev. Rul. 79-4
1979-1 C.B. 150
Section 61
Section 301
Section 316
Section 368
Section 1001
Section 1012
IRS Headnote
Reorganizations; solely for voting stock; repayment of shareholder's debt. The solely for voting stock requirement of section 368(a)(1)(B) of the Code is violated by the repayment of an acquired corporation's debt that is treated as a debt of its guarantor-shareholder (who has exchanged stock in the acquired corporation for stock in the acquiring corporation) and that is repaid, as a condition for the exchange of stock, by the acquired corporation with funds furnished by the acquiring corporation.
Full Text
Rev. Rul. 79-4
ISSUE
Is the "solely for * * * voting stock" requirement of section 368(a)(1)(B) of the Internal Revenue Code of 1954 violated in the situation described below where an acquired corporation's debt that is treated for federal income tax purposes as a debt of its guarantor-shareholder is repaid by the acquired corporation with funds furnished to it by the acquiring corporation? FACTS
A, an individual, was the sole shareholder of corporation Y, and was the guarantor on an unsecured note of Y in the principal amount of 200x dollars issued to Z, an unrelated party, in exchange for a loan. Because of Y's inadequate capitalization, Z required that A guarantee the note as to principal and interest. The facts and circumstances, including but not limited to Y's thin capitalization, resulted in Z being treated for federal income tax purposes as having made the loan to A rather than Y and A being treated as having made a capital contribution of the 200x dollar loan proceeds to Y. A's initial basis in A's Y stock (100x dollars) was therefore increased to 300x dollars pursuant to section 1.118-1 of the Income Tax Regulations. Payments of principal and interest by Y to Z with respect to the loan were treated as discharging A's obligation to Z, and such amounts were taxable to A as constructive distributions under section 301 of the Code. In addition, Y's interest payments on the loan were considered as having been made by A. See Plantation Patterns, Inc. v. Commissioner, 462 F.2d 712 (1972), aff'g T.C.M. 1970-182. For financial accounting purposes, however, the loan was considered as made to Y and listed among its liabilities. At the time of the situation described below, Y had made all previous principal and interest payments on the loan as they became due.
In accordance with an agreement and plan of reorganization, X acquired all of the outstanding stock of Y from A in exchange for voting stock of X. The fair market value of the Y stock was calculated at 400x dollars with the 180x dollar remaining indebtedness on the Z loan being included in such calculation as an indebtedness of Y. A received 390x dollars of X stock, an amount equal to the 400x dollar fair market value of the Y stock at the date of the exchange less 10x dollars consideration for X's agreement to contribute 180x dollars to Y to satisfy the indebtedness to Z. The satisfaction of such indebtedness would eliminate A's potential liability as guarantor and would improve A's borrowing ability. X was willing to satisfy the indebtedness immediately to strengthen Y's financial position and to prevent a suit for reimbursement that would have arisen if A, as guarantor, had been required to pay the indebtedness on Y's default.
LAW AND ANALYSIS
Because the contribution of cash by X to Y and the repayment by Y of the indebtedness plus accrued interest was a condition for the exchange of the Y stock for the X stock, such contribution and repayment constitute additional consideration for the Y stock within the meaning of section 1.368-2(c) of the regulations and the "solely for * * * voting stock" requirement contained in section 368(a)(1)(B) of the Code is not satisfied. Consequently, the nonrecognition provisions of section 354(a)(1) are inapplicable and gain or loss realized on the exchange is recognized under section 1001.
In addition, because under Plantation Patterns, the indebtedness of Y to Z is considered as indebtedness of A to Z despite Y's timely payment of principal and interest to Z, and because the repayment of the outstanding indebtedness by Y was a condition for exchange of stock, A has received income in the amount of such repayment. Section 61 of the Code, and Douglas v. Willcuts, 296 U.S. 1 (1935), XIV-2 C.B. 250. Therefore, pursuant to section 1001, A will realize and recognize a gain on the exchange to the extent such income and the fair market value of the X stock received exceeds A's basis in the Y stock:
income from Y's repayment of indebtedness ___________________ 180x
fair market value of X stock received _______________________ 390x
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Total ______________________________________________ 570x
Less A's basis in Y stock ___________________________________ 300x
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gain realized by and recognized to A ________________________ 270x
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A will therefore realize and recognize a gain of 270x dollars on the exchange, and A's basis in the X stock received will be 400x dollars, its cost in Y stock exchanged. Section 1012 of the Code.
HOLDING
The "solely for * * * voting stock" requirement of section 368(a)(1)(B) of the Code is violated when the debt of Y (which is treated for federal income tax purposes as the debt of A) is repaid by Y with funds furnished by X, if such repayment is a condition for the exchange of the X and Y stock.