Rev. Rul. 74-338

Advice has been requested concerning the method of determining the pro rata portion of the total earnings and profits of a corporation attributable to the shares redeemed under the circumstances described below.

Situation 1.

M, a domestic corporation, files its Federal income tax returns on the basis of a calendar year. On July 1, 1973, M corporation redeemed for cash, 25 percent of its outstanding common stock in a transaction that qualified as a distribution in redemption of its stock under section 302(a) of the Internal Revenue Code of 1954. As of January 1, 1973, M corporation had earnings and profits accumulated after February 28, 1913, of $2,000. For the taxable year 1973, M had earnings and profits (current earnings) of $12,000. On June 1 and August 31, 1973, M corporation made ordinary distributions of $1,000 and $4,000, respectively, to its shareholders with respect to its stock.

Situation 2.

Assume the same facts as in Situation 1 except that M corporation had current earnings of only $2,000.

Section 316 of the Code defines a dividend as follows:

(a) General Rule.--For purposes of this subtitle, the term "dividend" means any distribution of property made by a corporation to its shareholders--

(1) out of its earnings and profits accumulated after February 28, 1913, or

(2) out of its earnings and profits of the taxable year (computed as of the close of the taxable year without diminution by reason of any distributions made during the taxable year), without regard to the amount of the earnings and profits at the time the distribution was made. Except as otherwise provided in this subtitle, every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits. To the extent that any distribution is, under any provision of this subchapter, treated as a distribution of property to which section 301 applies, such distribution shall be treated as a distribution of property for purposes of this subsection.

Section 1.316-1(a)(1) of the Income Tax Regulations provides, in part, that the earnings and profits of the taxable year shall be computed as of the close of such year, without diminution by reason of any distributions made during the taxable year. For the purpose of determining whether a distribution constitutes a dividend, it is unnecessary to ascertain the amount of the earnings and profits accumulated since February 28, 1913, if the earnings and profits of the taxable year are equal to or in excess of the total amount of the distributions made within such year.

Section 1.316-2(b) of the regulations provides, in part, that if the earnings and profits of the taxable year (computed as of the close of the year without diminution by reason of any distributions made during the year and without regard to the amount of earnings and profits at the time of the distribution) are sufficient in amount to cover all the distributions made during that year, then each distribution is a taxable dividend. See section 1.316-1. If the distributions made during the taxable year consist only of money and exceed the earnings and profits of such year, then that proportion of each distribution which the total of the earnings and profits of the year bears to the total distributions made during the year shall be regarded as out of the earnings and profits of that year. The portion of each such distribution which is not regarded as out of earnings and profits of the taxable year shall be considered a taxable dividend to the extent of the earnings and profits accumulated since February 28, 1913, and available on the date of the distribution. In any case in which it is necessary to determine the amount of earnings and profits accumulated since February 28, 1913, and the actual earnings and profits to the date of a distribution within any taxable year cannot be shown, the earnings and profits for the year in which the distribution was made shall be prorated to the date of the distribution not counting the date on which the distribution was made.

When the amount of ordinary distributions made during a taxable year is greater than the current earnings the amount of any distribution which is made from current earnings and the amount, if any, which is made from accumulated earnings and profits must be determined under the rules provided in section 1.316-2(b) of the regulations.

When a corporation makes a distribution in redemption of its common stock under section 312(e) of the Code, the part of such distribution which is properly chargeable to capital account is not treated as a distribution of earnings and profits. The charge to earnings and profits is the pro rata portion of the total earnings and profits thereof attributable to the shares redeemed regardless of the actual amount of the distribution. See Rev. Rul. 70-531, 1970-2 C.B. 76. However, when both ordinary distributions and redemption distributions are made during the same taxable year, ordinary distributions take priority over redemption distributions as to current earnings and profits. See Rev. Rul. 74-339, page 103,

The application of the foregoing rules to the described factual situations is as follows:

Situation 1;

Step 1. Determine the amount of current earnings available for distributions.

Ordinary distributions of $5,000 ($1,000 + 4,000) are charged against current earnings of $12,000.

The remainder of current earnings ($7,000) is available for other distributions.

Step 2. Determine the total earnings and profits available for distributions made during the taxable year 1973.

Accumulated earnings and profits at January 1, 1973 ______ $2,000

Step 1. Determine the pro rata portion of each ordinary distribution made during the taxable year 1973 which is chargeable to the $2,000 of current earnings.

                                                 Portion paid from

 Accumulated earnings and profits at