Rev. Rul. 72-440

Advice has been requested whether a distribution from an exempt employees' trust was made on account of an employee's separation from the service, within the meaning of section 402(a)(2) of the Internal Revenue Code of 1954, under the circumstances described below.

X corporation maintained a non-contributory profit-sharing trust that qualified under section 401(a) of the Code and was exempt from tax under section 501(a).

Pursuant to an agreement and plan of reorganization, Y, an unrelated corporation, acquired all of the assets and assumed all of the liabilities of X in exchange for shares of the common stock of Y. As part of the plan of reorganization, Y formed a wholly-owned subsidiary, Z corporation. Z took title to the assets and continued the business of X. Following the transfer of its assets, X, in exchange for all of its own stock, distributed to its shareholders the stock of Y that it received in the exchange with Y.

Incident to the reorganization, the profit-sharing plan of X was amended to give each employee of X the option of either withdrawing his entire interest within one taxable year on a fixed date following the reorganization or deferring distribution until his separation from the service of Z. Z made no contributions to the trust.

Prior to the reorganization, A, an employee of X, participated in X's profit-sharing plan. After the reorganization, A became an employee of Z. He served in the same capacity and under the same supervisors, both before and after the reorganization. Under the terms of the plan, as amended, A chose to receive the total distribution payable to him within one taxable year. His employment in the same capacity with Z continued after the distribution.

Subject to the limitations contained in section 402(a)(5) of the Code, section 402(a)(2) provides that if the total distributions payable to an employee from an exempt employees' trust are paid to him within one taxable year on account of his separation from the service, the distribution shall be treated as a long-term capital gain to the extent it exceeds any amounts contributed by the employee. The portion of such a distribution that is denied long-term capital gain treatment by section 402(a)(5) of the Code is entitled to the income averaging treatment provided by section 72(n) of the Code.

Revenue Ruling 58-94, C.B. 1958-1, 194, holds that an employee is deemed to have "separated from the service" of an employer, within the meaning of section 402(a)(2) of the Code where, under a reorganization, within the meaning of section 368(a)(1)(C), all the assets and liabilities of a company are transferred to a corporation which then transfers such assets and liabilities to a wholly owned subsidiary of the latter, and the employees of the predecessor company become employees of the subsidiary. Therefore, the Revenue Ruling concludes that a distribution, within one taxable year, of the total amount standing to the credit of the participants under the predecessor company's qualified employees' pension trust which is terminated by reason of the reorganization, may be considered a gain from the sale or exchange of a capital asset held for more than six months, to the extent that it exceeds the amount contributed by the employee. Other Revenue Rulings similarly holding that employees have separated from the service of the employer corporation where the employer corporation goes out of existence as a result of a liquidation or reorganization, even though the employees continue to perform services for the successor corporation, are Revenue Ruling 58-95, C.B. 1958-1, 197; Revenue Ruling 58-96, C.B. 1958-1, 200; Revenue Ruling 58-97, C.B. 1958-1, 201; Revenue Ruling 58-98, C.B. 1958-1, 202; Revenue Ruling 58-383, C.B. 1958-2, 149; and Revenue Ruling 65-147, C.B. 1965-1, 180.

Those Revenue Rulings, referring to the legislative history of section 402(e) of the Code, conclude that a separation from the service is not produced by a corporate liquidation or reorganization that brings about a change in employment relationship in no more than a formal or technical sense. However, they indicate that a formal or technical change in the employment relationship will constitute a separation from the service if accompanied by a real change in the ownership of the business. These concepts are also applied in Revenue Ruling 58-99, C.B. 1958-1, 202, which holds that the employees of a corporation were not separated from the service where the parent of the corporation transferred its stock control to a previously unrelated corporation.

The above Revenue Rulings have been criticized in several court decisions. See, for example, United States v. Ophelia Johnson, et al., 331 F.(2d) 943 (1964); United States v. William L. Haggart, et ux., 410 F.(2d) 449 (1966); and Victor S. Gittens v. Commissioner, 49 T.C. 419 (1968). Those court decisions disagreed with the interpretation of legislative history, contained in the Revenue Rulings, that would permit capital gains treatment for distributions received from an exempt employees' trust incident to the reorganization or liquidation of the employer corporation after 1954. In the Johnson case, at page 949, the court stated:

* * * After 1954 distributions will not qualify for capital gain treatment if they are made as a result of the termination of a plan incident to a corporate reorganization, even if the corporate employer is completely liquidated. * * * In other words, after 1954 a separation from service would occur only on an employee's death, retirement, resignation, or discharge; not when he continues on the same job for a different employer as a result of a liquidation, merger or consolidation of his former employer. * * *

This quotation from the Johnson case was repeated with approval by the court in the Haggart case, at page 452.

In the light of the above-cited court decisions, it is now concluded that an employee will be considered separated from the service, within the meaning of section 402(a)(2) of the Code, only on his death, retirement, resignation, or discharge, and not when he continues on the same job for a different employer as a result of the liquidation, merger, consolidation, etc. of his former employer.

The employee in this case did not die, retire, or resign; nor was he discharged from his job, but on the contrary remained on that job for his new employer after the reorganization. Therefore, he was not separated from the service.

Accordingly, it is held that the distribution from the exempt employees' trust was not made on account of the employee's separation from the service within the meaning of section 402(a)(2) of the Code.

Revenue Rulings 58-94, 58-95, 58-96, 58-97, 58-98, 58-383, and 65-147 are hereby revoked, and Revenue Ruling 58-99 is hereby modified, since the rationale in those Revenue Rulings is inconsistent with the rationale in this Revenue Ruling. However, pursuant to the authority granted by section 7805(b) of the Code, this Revenue Ruling will not be applied to deny long-term capital gain treatment to any distribution made on or before September 18, 1972, the date of publication of this Revenue Ruling, if such long-term capital gain treatment would have been permitted by any of the Revenue Rulings revoked herein.