Rev. Rul. 78-397: Circular flow of cash is disregarded for tax purposes

In Rev. Rul. 78-397, the IRS held that a circular flow of cash contributed to meet state law requirements was disregarded for federal tax purposes.
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Citations: Rev. Rul. 78-397; 1978-2 C.B. 150

Rev. Rul. 78-397


Will amounts paid to Z by its parent Y in order to meet minimum state capitalization requirements upon Z's incorporation be reflected in Y's basis in the Z stock when as part of the total transaction such amounts are returned to Y?

Will the repayment of the funds by Z be treated as a redemption of a portion of its stock held by Y?


X corporation, a state chartered banking corporation, had outstanding 2,000x shares of common stock which were publicly held. In order to better promote its growth and to provide expanded financial services for its customers, X decided that its stock should be owned directly by a corporation.

Accordingly, the following steps were taken:

(1) Incorporators representing X formed Y corporation in the same state as X. For organizational purposes each incorporator was issued one share of Y common stock in exchange for cash at $100 per share. Each share issued to an incorporator was subject to repurchase by Y at the issuance price.

(2) Five persons acting as incorporators organized Z corporation, under the banking laws of the same state, solely for the purpose of merging X into Z. Ten x shares of Z stock were subscribed for by each of the five organizers-directors at $15 per share. At the same time, to meet the minimum state capitalization requirements, Y subscribed for 200x shares of Z stock at the same price per share. The funds used by Y to capitalize Z were provided to Y for this purpose through a demand loan from X.

(3) X was merged with and into Z pursuant to applicable state law, with Z acquiring substantially all of the net assets of X and assuming all of X's liabilities.

(4) The outstanding stock of X was exchanged by the X shareholders for common stock of Y on a share-for-share basis, and 2,000x shares of Z common stock were issued by Z to Y.

Immediately after the merger and as part of the plan of reorganization, the following additional steps were taken:

(1) Z repurchased for cash at $15 per share all of the 200x shares of its common stock previously issued to Y and the 50x shares previously issued to its directors as qualifying shares for organizational purposes.

(2) Y repaid Z, as the survivor of X, all funds advanced for the initial capitalization of Z which were provided by the demand loan from X.

(3) The shares of Y common stock issued for organizational purposes were redeemed by Y for the same price at which they were issued.

No shareholders dissented to the merger. As a result of the transaction the former shareholders of X owned all of the outstanding stock of Y which, in turn, owned all of the outstanding stock of Z, and the cash obtained by Y and used by it to capitalize Z was returned by it in satisfaction of the demand loan.


The merger of X into Z qualified as a reorganization under section 368(a)(1)(A) of the Internal Revenue Code of 1954 by reason of section 363(a)(2)(D). See section 1.368-2(b)(2) of the Income Tax Regulations, which states that section 368(a)(2)(D) may apply whether or not the controlling corporation or the acquiring corporation is formed immediately before the merger, in anticipation of the merger, or after preliminary steps have been taken to merge directly into the controlling corporation. See also Rev. Rul. 77-428, 1977-2 C.B. 117, (Situation 1), which holds that section 368(a)(2)(D) applies, where the requirements of that section are otherwise met, even though, as part of the transaction, both the acquiring corporation and the controlling corporation were newly formed and even though a related corporation was acquired in the transaction.

In Helvering v. Alabama Asphaltic Limestone Co., 315 U.S. 179 (1942), 1942-1 C.B. 214, the assets of an insolvent corporation were acquired by a new corporation in exchange for its stock. It was contended that the transaction did not qualify as a reorganization within the meaning of section 112(i)(1) of the Revenue Act of 1928 since the properties at the time of their acquisition belonged to the creditors committee. In rejecting this contention the Supreme Court stated:

Yet, the separate steps are integrated parts of a single scheme. Transitory phases of an arrangement frequently are disregarded under these sections of the revenue acts where they add nothing to the completed affair. Gregory v. Helvering, 293 U.S. 465; Helvering v. Bashford, 302 U.S. 454. Here they were no more than intermediate procedural devices utilized to enable the new corporation to acquire all the assets of the old one pursuant to a single reorganization plan.

The principle of disregarding transitory steps occurring as part of the plan of reorganization has also been applied in cases in which allegedly disqualifying interim steps were undertaken in order to comply with applicable law. See Thurber v. Commissioner, 84 F.2d 815 (1st Cir. 1936), Gunby, Inc. v. Commissioner, 122 F.2d 203 (D.C. Cir. 1941), and Hoboken Land and Improvement Co., 46 B.T.A. 495 (1942).

In Rev. Rul. 74-564, 1974-2 C.B. 124, a parent corporation (P) contributed cash, to satisfy capitalization requirements, and shares of its voting common stock to a new corporation (Z) formed by P for the purpose of merging Z into another corporation (R), whose stock was 98-percent owned by S corporation, all of whose stock was owned by P. The cash transferred by P to Z and then by Z to R in the merger, was then transferred from R to S and then from S to P. Rev. Rul. 74-564 states that this circular flow of cash is to be disregarded and has no tax consequences.

In the instant case, the circular cash flow was undertaken in order to comply with minimum state capitalization requirements and in the absence of such a requirement would not have occurred. At the conclusion of the transaction, the cash returns to the party in which it originally resided. Further, the relationships created by the initial capitalization are cancelled in accordance with the plan of reorganization to an extent such that the parties are in a position identical to that which would have obtained if the transitory cash flow had not occurred.


The cash borrowed by Y from X which was transferred to Z in purchase of 200x shares of Z's stock, then returned by Z to Y in repurchase of the 200x shares of the Z stock held by Y, and thereafter returned by Y to Z, as the survivor of X in repayment of the demand loan, is disregarded and has no federal income tax consequence as an investment in the Z stock or as a redemption of the 200x shares of Z stock held by Y. The cash transferred by the organizing directors to Y and Z and returned to them upon surrender of the Y and Z stock in the transaction is likewise disregarded.

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