Rev. Rul. 70-531

Advice has been requested as to what portion of the distribution in redemption described below was chargeable to earnings and profits for the purpose of computing the amount of the accumulated earnings and profits available for the payment of dividends.

Y corporation, a calendar year taxpayer incorporated subsequent to March 1, 1913, had outstanding at all times prior to December 31, 1965, only 10x shares of common stock that had each been issued for cash of 8x dollars. Y had at no time issued any other stock and prior to December 31, 1965, had had no transactions affecting its paid-in capital.

On December 31, 1965, when shareholders A and B each held 5x shares (50 percent) of the Y stock, Y redeemed for cash the 50 percent held by A at its fair market value of 225x dollars in circumstances that permitted the redemption to be treated by A as a distribution in full payment in exchange for the stock under section 302(a) of the Internal Revenue Code of 1954. No other distribution was made by Y in 1965 with respect to its stock.

At the close of December 31, 1965, before reflecting the redemption of the stock of A, Y's tax basis balance sheet was:

 Cash ___________________________________________  $270x

Section 312(e) of the Code provides an exception to section 316(a) of the Code. Section 312(e) of the Code provides that in the case of amounts distributed in partial liquidation or in a redemption to which section 302(a) or 303 of the Code applies, the part of such distribution that is properly chargeable to capital account shall not be treated as a distribution of earnings and profits. The term capital account as used in this section is not defined in the Code or regulations.

Section 562(b)(1)(A) of the Code provides that the part of the amount distributed in liquidation which is properly chargeable to earnings and profits accumulated after February 28, 1913, shall be treated as a dividend for purposes of computing the dividends paid deduction.

Sections 1.562-1(b)(1)(i) and (ii) of the Income Tax Regulations provide that in determining the part of a distribution in complete or partial liquidation (including a redemption to which section 302 of the code applies) properly chargeable to earnings and profits there must be deducted from the amount of the distribution that part allocable to the capital account. This section provides further that for this purpose the capital account includes not only amounts representing the par or stated value of the stock with respect to which the distribution in liquidation is made, but also the proper portion of the paid-in-surplus and of any other similar items. For income tax purposes, similar items are those which are treated like capital in the sense that when distributed they are not taxed as dividends but instead are applied against and reduce the basis of the stock with respect to which they are distributed. The section further provides that ordinarily the remainder of the distribution in liquidation is properly chargeable to earnings and profits accumulated after February 28, 1913.

The answer to the question in the instant case depends upon the meaning of the term "capital account" and the determination of what portion of a distribution in redemption is properly chargeable thereto under section 312(e) of the Code. The courts, in determining the taxable status of distributions and the amount of the dividends paid deduction (dividends paid credit under prior law), have used various methods of determining the amount of capital and how to allocate the capital with respect to each of a series of distributions and how to allocate between the shares redeemed and those remaining outstanding.

G.C.M. 23460, C.B. 1942-2, 190, states that the decisions in Woodward Investment Co. v. Commissioner, 46 B.T.A. 648 (1942), acquiescence, C.B. 1942-2, 20 (suit to determine the allowable dividends paid credit) and in William D. P. Jarvis v. Commissioner, 43 B.T.A. 439 (1941), acquiescence, C.B. 1942-2, 10, affirmed, 123 F. 2d 742 (1941) (suit to determine taxable status of a distribution), are not inconsistent and that they merely reflect necessary differences in the application of a general principle to different types of situations.

In Woodward, the question was to determine, in the absence of a redemption, the amount of the allowable dividends paid credit for the first of a series of distributions in complete liquidation of the corporation. The court held that the amount of the distribution chargeable to capital (which included pre-March 1, 1913, earnings and appreciation at February 28, 1913, realized thereafter) and to earnings and profits respectively is based upon the respective ratios of the capital and the earnings and profits to the sum of the capital and the earnings and profits.

In Jarvis, it was held that for the purpose of determining the accumulated earnings and profits available for dividends in years subsequent to a redemption the charge to capital upon the redemption should be such an amount that the ratio between the charge to capital and the capital prior to retirement would be the same as the ratio between the number of shares retired and the number of shares outstanding prior to retirement. That is, a proportionate part of the capital was considered as standing behind each of the shares redeemed. The balance of the distribution was thus charged to earnings and profits, even though in excess of the ratable share attributable to the stock redeemed. The corporation was not in existence in 1913. Similarly, in F. & R. Lazarus & Co. v. Commissioner, 1 T.C. 292 (1942), acquiescence, C.B. 1943, 14, it was held for the purpose of determining the allowable dividends paid credit upon the retirement of certain stock a proportionate part of the capital paid in or considered paid in for stock must be considered as standing behind each of the shares outstanding at any particular time, and the portion of the distribution in excess of the amount of capital allocated to the share redeemed was properly chargeable to earnings and profits.

In the computations in Jarvis, where the corporation was not in existence in 1913, the Board of Tax Appeals held that capital was only the amount paid in to the corporation (comprising only the par value and the paid-in surplus) for stock at the adjusted basis for Federal income tax purposes. With one exception not here pertinent, this was also the result in Lazarus. In Woodward, the Board treated the capital as consisting of the amount paid in for stock, paid in surplus, pre-March 1, 1913 earned surplus, and appreciation at March 1, 1913 realized in subsequent years.

In the instant case, the corporation was not in existence in 1913. In this case, to consider capital to be only amounts paid in for stock produces an implausible result because the amount of the distribution in redemption of the stock (225x dollars) exceeds by 25x dollars the sum of the total paid-in capital and the total accumulated earnings and profits of Y (200x dollars, i.e., 80x dollars plus 120x dollars). Therefore, the capital account for purposes of section 312(e) must include all other similar attributes such as unrealized appreciation (appraisal or valuation) surplus.

Treating unrealized appreciation (appraisal or valuation) surplus as part of the capital account is consistent with business practice, financial accounting, and local law. Many jurisdictions permit a corporation to distribute dividends out of valuation surplus. See, for example, Randall v. Bailey, 288 N.Y. 280 (1942); Commissioner v. George M. Gross, 236 F. 2d 612 (1956). Congress has recognized that such distributions are not out of earnings and profits. See House Report No. 767, Sixty-fifth Congress, C.B. 1939-1 (Part 2), 86 at 88. Moreover, in the income tax statutes, the term "paid-in or earned surplus and undivided profits" does not include "appreciation of values over cost." See LaBelle Iron Works v. United States, 256 U.S. 377, Ct. D. 12, C.B. 4, 373 (1921); Edwards, Collector v. Archibald Douglas, 269 U.S. 204, 214, T.D. 3797, C.B. V-1, 158, at 163 (1925).

Unlike the term "paid-in * * * surplus" at issue in LaBelle Iron Works, the term in section 312(e) of the Code is "capital account." Just as the "capital account" for purposes of the predecessors of section 312(e) and section 562(b)(1)(A) of the Code includes pre-1913 earnings and profits (see, for example, Benjamin B. Foster v. United States, 303 U.S. 118, 121, n. 9, Ct. D. 1308, C.B. 1938-1, 295 (1938), and Woodward), the "capital account" as used in section 312(e) of the Code necessarily includes other attributes such as unrealized appreciation surplus. This is consistent with the purposes of the predecessors of section 312(e) and section 316 of the Code to prevent tax avoidance. See, for example, House Report No. 767, and Statement of the Changes in the Revenue Act of 1921 by H.R. 6715 and Reasons therefor, Sixty-eighth Congress, 3 (Comm. Print 1924).

Accordingly, with respect to the amount distributed in the above circumstances, the proper charge to the capital account includes not only the allocable portion of the capital paid in for stock at its basis for Federal income tax purposes but also the prorata share of the other attributes including unrealized appreciation surplus of the corporation. The charge to earnings and profits is the prorata portion of the total earnings and profits of the corporation thereof attributable to the shares redeemed. Therefore, the part of the distribution to A of 225x dollars in redemption of 5x shares of Y stock that is properly chargeable to the capital account under section 312(e) of the Code is 40x dollars plus 125x dollars or 165x dollars. The 40x dollars is the paid-in capital ratably attributable to the shares redeemed (1/2 of 80x dollars). The 125x dollars is the amount of other attributes including unrealized appreciation surplus attributable to the shares redeemed (the excess of (a) the amount paid in redemption of the 5x shares (225x dollars) over (b) the portion (1/2) of the sum of the total paid-in capital (80x dollars) and the total earnings and profits (120x dollars) ratably attributable to the shares redeemed, that is, 1/2 of 200x dollars or 100x dollars). The part of the distribution that is properly chargeable to earnings and profits is 60x dollars, A's pro rata share.

The rule is likewise applicable when the amount of the distribution is less than the portion of the sum of the paid-in capital and earnings and profits ratably attributable to the shares redeemed. Thus, for example, if in the instant case the redemption price of A's stock were 65x dollars, then the part of the distribution that is properly chargeable to the capital account under section 312(e) of the Code would be 40x dollars less 35x dollars or 5x dollars. The paid-in capital ratably attributable to the shares redeemed is 40x dollars, as above. The amount of other attributes including unrealized depreciation surplus is 35x dollars, that is, the excess of 100x dollars ((b) above) over 65x dollars, the amount paid in redemption. The charge to earnings and profits would be 60x dollars, as above.

The above rule is also applicable to a distribution in redemption or in partial liquidation to which section 303 or 346 of the Code applies.

In view of the foregoing the acquiescence has been withdrawn and non-acquiescence substituted therefor in Jarvis. See page xxii, this Bulletin. The acquiescences have been withdrawn and acquiescences in result only substituted therefor in Woodward and Lazarus. See pages xxi and xx, this Bulletin.

G.C.M. 23460, C.B. 1942-2, 190, is revoked.