Rev. Rul. 63-107

Advice has been requested whether, under certain circumstances, an association is considered to have been liquidated and its associates subject to the provisions of section 331 of the Internal Revenue Code of 1954 if, for taxable years beginning after December 31, 1960, it is no longer classified as an association taxable as a corporation for Federal income tax purposes.

In determining whether an organization should be classified as an association taxable as a corporation, for Federal income tax purposes, for taxable years beginning before January 1, 1961, the provisions of section 39.3797 of Federal Income Tax Regulations 118 are applicable pursuant to the authority of Treasury Decision 6091, C.B. 1954-2, 47. For taxable years beginning after December 30, 1960, the rules or standards to be used in determining whether an association is to be classified for Federal income tax purposes as an association taxable as a corporation are set forth in sections 301.7701-2 through 301.7701-4 of the current Income Tax Regulations.

The current regulations differ from the corresponding provisions of Regulations 118 in that two new association criteria, i.e. (1) limited liability, and (2) free transferability of interests have been added and also in that a preponderance test has been substituted. See section 301.7701-2(a)(3) of the regulations. As a result, organizations which were in some instances classified as associations under the old regulations will not be so classified under the new regulations because they do not have a preponderance of corporate characteristics.

This change in status has not come about by any action of the parties but soley by operation of a change in the regulations; there is accordingly no voluntary act of liquidation by the taxpayers and no tax consequence by way of a constructive liquidation should flow from the involuntary change in classification.

Under the provisions of section 301.7701-2(a)(4) of the regulations, an organization in existence on November 17, 1960, with a taxable year beginning within the period January 1, 1961 through September 30, 1961, whose classification was changed by the new regulation was permitted to amend its operating agreement before October 1, 1961, so its classification under the new regulations is the same as under the old regulations. Such an amended agreement is effective as of the beginning of the taxable year.

In those cases where an organization properly classified as an association taxable as a corporation amends its operating agreement so that thereafter it is properly classified as a partnership, the change in status is treated as the liquidation of a corporation. By its own action, the organization has so changed the relationship among its associates to each other and to the organization that its existence as an association taxable as a corporation is terminated. As with all corporations, the termination of its existence results in the liquidation of the organization.

Section 331 of the 1954 Code, relating to gain or loss to shareholders in corporate liquidations, is applicable in determining the tax consequences to the associates on the termination of their organization's classification as a corporation. It provides that amounts distributed in complete liquidation shall be treated as in full payment for the stock. The `stock' of an association taxable as a corporation consists of the interests of the associates in the organization. Therefore, on the effective date of the amendment to an organization's operating agreement which changes its Federal tax classification from that of a corporation to a partnership, the organization is considered as liquidated and gain or loss is recognized to each of its associates to the extent of the difference between the fair market value of the associate's pro rata share of the assets and his adjusted basis for his interest in the association.

In the following situations, the classification of the organization is subject to change, not because of an amendment to its operating agreement, but because of a change in the applicable rules or standards to be used in classifying an organization for Federal tax purposes.

Situation 1 . An organization in existence on November 17, 1960, had, under its operating agreement, sufficient corporate characteristics to be classifiable as an association under the tests of Regulations 118 but did not have the corporate characteristics of limited liability and free transferability of interests. The organization's taxable year begins on January 1. No action was taken by the members and for the taxable year 1961 the organization continued to operate under the same agreement. Lacking a preponderance of corporate characteristics, for the taxable years beginning after December 31, 1960, it is classified as a partnership and not as an association taxable as a corporation for Federal tax purposes.

In this situation, the operating agreement of the organization was not amended. Neither the association nor its associates have taken any action whatsoever. There has not been any transfer of the assets of the organization to another entity or any change in the relationships of the associates to each other or to the organization.

Under these circumstances, the change in classification by itself does not constitute, nor is it equivalent of, dissolution or liquidation of the association. The associates in such a case will not be subject to the provisions of section 331 of the 1954 Code. The basis of property in the hands of the organization and the basis of each associate's interest in the organization will not be affected by the change in classification.

Situation 2 . An organization in existence on November 17, 1960, had, under its operating agreement, sufficient corporate characteristics, including, specifically, continuity of life, to be classificable as an association under the tests of Regulations 118. However, it did not have the corporate characteristics of limited liability and free transferability of interests. The organization's taxable year begins on January 1.

On March 1, 1961, the agreement was amended so that the organization dissolves upon the death, retirement, insanity, bankruptcy, or expulsion of a member-thereby destroying the corporate characteristic of continuity of life.

For the reasons given under Situation 1 , the organization is classified as an association taxable as a corporation for taxable years beginning prior to January 1, 1961. However, before the amendment of the agreement, although it had the corporate characteristics of centralization of management and continuity of life, it did not have the corporate characteristics of limited liability and free transferability of interests. Since it did not and does not have more corporate than noncorporate characteristics for taxable years beginning after December 31, 1960, it is classified as a partnership and not as an association taxable as a corporation for Federal tax purposes.

In this situation the classification of the organization was changed as of the beginning of the taxable year, January 1, 1961, solely by virtue of the application of the provisions of sections 301.7701-2 through 301.7701-4 of the regulations. Therefore, in this situation, as in Situation 1 , the organization will not be considered as having been liquidated as of December 31, 1960. The amendment of the agreement on March 1, 1961, eliminating the corporate characteristic of continuity of life, did not affect the classification of the organization or result in its liquidation since, even before the amendment, it was classifiable as a partnership from the beginning of the year.