Prearranged Stock Transfers Qualify under Sec. 351

E Corp. engages in businesses A, B and C. X  Corp. (unrelated to E) also engages in business A, through Y, its wholly owned domestic subsidiary. E and X want to consolidate their  A operations into a new corporation within a holding company structure. The fair market values (FMVs) of E’s A, B and C businesses are $4, $3 and $3 million, respectively. The FMV of Y stock is $3 million.

Under a prearranged binding agreement with X:

1. E forms Z Corp. by transferring all of its A assets to Z in exchange for all of the Z stock (the “first transfer”).

2. E then contributes all of the Z stock to Y in exchange for Y stock (the “second transfer”).

3.Simultaneous with the second transfer, X contributes $3 million to Y, to meet the capital needs of the A business, for additional Y stock (the “third transfer”).  As a result, E and X own 40% and 60% of Y’s stock, respectively.

4. Y then transfers the $3 million and its A assets to Z (the “fourth transfer”).

Analysis

When viewed separately, the first transfer, the combined second and third transfers and the fourth transfer each qualifies under Sec. 351. However, because the first and second transfers are undertaken pursuant to a prearranged binding agreement, it is necessary to determine whether the second transfer causes the first one to fail to satisfy the Sec. 351 control requirement.

Sec. 351 is a deliberate attempt by Congress to facilitate the incorporation of ongoing businesses and to eliminate any economically unsound technical constructions (Hempt Bros., Inc., 490 F2d 1172 (3d Cir. 1974), cert. den.). It is intended to apply to “certain transactions where gain or loss may have accrued in a constitutional sense, but where in a popular and economic sense there has been a mere change in the form of ownership and the taxpayer has not really cashed in on the theoretical gain, or closed out a losing venture” (Portland Oil Co., 109 F2d 479 (1st Cir. 1940), cert. den). A transaction described under Sec. 351 “lacks a distinguishing characteristic of a sale, in that, instead of the transaction having the effect of terminating or extinguishing the beneficial interests of the transferors in the transferred property. . . the transferors continue to be beneficially interested in the transferred property and have dominion over it by virtue of their control of the new corporate owner of it” (American Compress & Warehouse Co., 70 F2d 655 (5th Cir. 1934), cert. den.).

Courts have held that the Sec. 351 control requirement is not met when, pursuant to a binding agreement entered into by the transferor before the transfer of property to the corporation in exchange for stock, the transferor loses control of the corporation by a taxable sale of all or part of that stock to a third party that does not also transfer property to the corporation in exchange for stock. A property transfer followed by such a prearranged sale of the stock received in a Sec. 351 transfer is not consistent with Congress’s intent to facilitate the rearrangement of the transferor’s interest in its property. However, treating a property transfer followed by a nontaxable disposition of the stock received as a Sec. 351 transfer is not necessarily inconsistent with Sec. 351. Accordingly, the control requirement may be satisfied in such a case, even if the stock received is transferred pursuant to a binding commitment in place on the transfer of the property in exchange for stock.

For example, in Rev. Rul. 84-111, a partnership’s property transfer to a transferee corporation qualified as a Sec. 351 transfer, even though the partnership relinquished control of the transferee within the meaning of Sec. 368(c) via a prearranged plan to transfer its transferee stock.

In Rev. Rul. 70-140, a transfer of assets to a transferor’s wholly owned subsidiary, followed by an exchange of the subsidiary’s stock for stock of another corporation, was recast as a direct asset transfer to the unrelated, widely held corporation in a taxable transaction. In that ruling, no alternative form of transaction would have qualified for nonrecognition treatment.

In contrast, in this case, E’s transfer of the A assets to Z was not necessary for E and X to combine their A assets in a holding company structure in a manner that would qualify for nonrecognition of gain or loss under Sec. 351. A transfer of E’s A assets to Y for Y stock as part of a plan that included X’s transfer of $3 million to Y for Y stock, and Y’s transfer of the A assets and $3 million to Z for all of the Z stock, would have qualified as successive Sec. 351 transfers; see Rev. Ruls. 83-34 and 77-449. Accordingly, Rev. Rul. 70-140 is distinguishable.

Even though the first transfer is followed by a transfer of the stock received, treating the first transfer as a Sec. 351 transfer is not inconsistent with Sec. 351. Accordingly, the second transfer will not cause the first transfer to fail to satisfy that section.

Rev. Rul. 2003-51, IRB 2003-21, 938