Rev. Rul. 60-49

Advice has been requested whether a surplus account on the balance sheet of a corporation represents, and in what proportions it represents, paid-in capital and/or earned surplus in computing a shareholder's ratable share of the corporation's earnings and profits accumulated after February 28, 1913, for purposes of applying section 333 of the Internal Revenue Code of 1954 in the event the corporation is liquidated thereunder.

The instant corporation is a mutual irrigation company (exempt from Federal income taxation) which was formed to acquire, store and distribute water for the benefit of its stockholders. The by-laws provide that each share of stock shall entitle the owner thereof to receive a specific amount of water, delivered to the outlet nearest his property, and that stock shall not be issued so as to grant any such entitlement in excess of the corporation's supply. All share holders use the water for business purposes.

The by-laws also provide for assessing the stockholders in order to raise funds for the corporate purposes. Assessment, like the water entitlement, is based upon the number of shares owned.

On February 28, 1913, the corporation's operations had resulted in a deficit of 17 x dollars. Because of subsequent operations, however, the deficit has been eliminated and a surplus of 80 x dollars has been accumulated. The surplus has resulted from an excess, over corporate expenses, of receipts derived primarily from noncapital assessments and, to a small extent, consisting of penalty payments and payments for water sold (either to dispose of excess quantities thereof, or in emergency to relieve persons whose normal supply was interruped).

It is now planned to liquidate the corporation under section 333 of the Code.

Although the transaction involves a liquidation, a part of the amount distributed will in fact constitute a return of excessive noncapital assessments rather than a distribution in cancellation or redemption of the stock. This part of the amount distributed, to the extent that such assessments were not only deductible but also yielded a tax benefit to the distributee, should be restored to income by him when recovered. Section 333 was enacted to permit stockholders to receive liquidating distributions in property without being taxed one so much of the realized gain as results from prior appreciation in the corporate property. Congress did not intend to thereby inhibit application of the tax-benefit rule so as to allow a taxpayer to retain a tax advantage which has proven unwarranted in view of the larger transaction viewed as a whole.

Congress intended, on the contrary, upon the final computation of earnings and profits for purposes of section 333, `to bring into account all items of accrued expense or accrued income' even of cash-method corporations, so that the shareholders thereof would not be treated differently from those of accrual-method corporations. See Senate Report No. 627, 78th Cong., C.B. 1944, 1009. Accordingly, sections 333 (e) and (f) require that the earnings and profits `be determined as of the close of the month' of the liquidating distribution and that this be done `by including all amounts accrued up to the date' thereof.

Based on the foregoing facts, it is held that:

(1) the amounts distributed are to be treated, to the extent of the assessments paid and deductible by each shareholder, as a rebate thereof to him, like a premium refund by way of dividend declared by an insurance company. See D. J. Jorden v. Commissioner , 11 T.C. 914, acquiescence, C.B. 1949-2,2;

(2) the shareholder should include in ordinary income the amount of assessments paid and deductible by him, and now rebated to him, to the extent of the amount thereof which previously yielded a tax benefit to him, and he should treat the excess thereof as a nontaxable rebate; see G.C.M. 10798 and I.T. 2646, C.B. X1-2, 58 and 59(1932), respectively;

(3) the shareholder should apply any additional amount distributed to him as a recovery of his basis and should treat any balance thereafter as gain which is taxable (a) in the case of a noncorporate shareholder, as a dividend or as capital gain, and (b) in the case of a corporate shareholder, as capital gain, but in either case only as and to the extent provided in section 333 of the Code;

(4) since the distributing corporation's surplus reflects net noncapital assessments received in each year after taking into account any rebates made in that year (See Revenue Ruling 56-225, C.B. 1956-1, 58), it should now charge the total amount which is deemed rebated by it against its surplus account, thereby reducing the amount to be treated as earnings and profits under section 333 of the Code;

(5) it should include as earnings and profits accumulated after February 28, 1913, the entire amount (97 x dollars) attributable to operations thereafter without adjustment for the deficit (17 x dollars) resulting from operations theretofore. ( Commissioner v. Grace H. Kelham , 192 Fed.(2d) 785, certiorari denied, 343 U.S. 927); and

(6) since the corporation is a tax-exempt entity, the shareholders may not treat any amount received therefrom as qualifying for the dividends received credit under section 34(c)(3)(A) of the Code, or as qualifying for the 50 dollar dividends-received exclusion under section 116(b)(3)(A) of the Code.