Rev. Rul. 77-468

Advice has been requested whether a corporate distribution, under the circumstances described below, qualifies as a distribution in partial liquidation under section 346(a)(2) of the Internal Revenue Code of 1954.

Corporation Y was engaged in the business of manufacturing various products in several divisions. Sixty percent of the stock of Y was owned by corporation X, and the remaining stock of Y was owned by corporation Z. X, Y, and Z report their income on the basis of the calendar year. Due to a change of business conditions, Y proposed to sell one of its manufacturing divisions and to distribute pro rata the proceeds thereof to X and Z in redemption of a part of their Y stock. Y adopted a plan of partial liquidation on January 1, 1972, and sold the assets of the affected manufacturing division on June 30, 1973. As a result of the sale of the manufacturing division and the related reductions in manufacturing capacity and number of employees, the business activity of Y was significantly reduced. Although Y was able to distribute the proceeds of the sale by December 31, 1973, the directors of Y (who were also the officers and directors of X and Z) voted to transfer the sale proceeds to a special investment account for the purpose of preserving the funds and to delay the distribution of the sale proceeds until June 30, 1974.

Section 331(a)(2) of the Code provides that amounts distributed in partial liquidation of a corporation (as defined in section 346) shall be treated as in part or full payment in exchange for the stock.

Section 346(a)(2) of the Code provides that a distribution shall be treated as in partial liquidation of a corporation if it is not essentially equivalent to a dividend, is in redemption of a part of the stock of the corporation pursuant to a plan, and occurs within the taxable year in which the plan is adopted or within the succeeding taxable year.

Section 346(b) of the Code provides that a distribution shall be treated as a distribution described in section 346(a)(2) if (1) the distribution is attributable to the corporation's ceasing to conduct, or consists of assets of, a trade or business that has been actively conducted throughout the 5-year period immediately before the distribution, which trade or business was not acquired by the corporation within such period in a transaction in which gain or loss was recognized in whole or in part, and (2) immediately after the distribution the liquidating corporation is actively engaged in the conduct of a trade or business that was actively conducted throughout the 5-year period ending on the date of the distribution and was not acquired by the corporation within such period in a transaction in which gain or loss was recognized in whole or in part.

Section 1.346-1(a) of the Income Tax Regulations provides that a distribution resulting from a genuine contraction of the corporate business is an example of a distribution that will qualify as a partial liquidation under section 346(a)(2) of the Code.

Section 331(a)(2) of the Code has been interpreted as mandatory to any transaction fitting the definition of a partial liquidation, as described in section 346. See Rev. Rul. 65-80, 1965-1 C.B. 154.

Since the sale of Y's manufacturing division resulted in a genuine contraction of its corporate business and was in redemption of a part of the Y stock held by X and Z pursuant to a plan of partial liquidation, the issue to be resolved is whether Y's intentional delay of the distribution of sale proceeds beyond the period described in section 346(a)(2) of the Code will prevent the distribution from qualifying as one in partial liquidation.

Although S. Rep. No. 1622, 83d Cong., 2d Sess. 262 (1954), demonstrates that Congress intended to make the concept of "corporate contraction" the primary characteristic of partial liquidations, judicial authority indicates that each of the requirements of section 346(a)(2) of the Code must be met in order for a distribution to qualify thereunder. See McCarthy v. Conley, Jr., 341 F.2d 948, 954 (2nd Cir. 1965), wherein the court states: "The requirements in section 346(a)(2) are not in the disjunctive. Thus, for a distribution to receive tax treatment as a partial liquidation, three requisites must be met: (1) It must not be essentially equivalent to a dividend; (2) It must be in a redemption of part of the stock pursuant to a plan; and (3) It must occur within the taxable year."

Further, section 346(b) of the Code creates a statutory safe harbor by defining a situation that will automatically qualify as a "corporate contraction" within the general intendment of section 346. If the requirements of section 346(b)(2) are met, a distribution attributable to the cessation of a business described in section 346(b)(1) will be "not essentially equivalent to a dividend" within the meaning of section 346(a)(2). Therefore, since section 346(b) is applied through section 346(a)(2) and is not a self-contained operative section, distributions intending to qualify under section 346(b) must meet the requirements of section 346(a)(2) as well as those contained in section 346(b)(1) and (2). See Baan v. Commissioner, 51 T.C. 1032, 1045 (1969), aff'd, 424 F.2d 378 (2d Cir. 1970).

Accordingly, in this case the distribution of the proceeds from the sale of the manufacturing division was not a distribution in partial liquidation under section 346(a)(2) of the Code because the distribution was not made within the taxable year in which the plan was adopted nor within the succeeding taxable year. Further, even if the manufacturing division sold by Y had constituted an active trade or business within the meaning of section 346(b)(1) of the Code and the requirements of section 346(b)(2) had been met, the delayed distribution of the proceeds attributable to the sale of the manufacturing division would not have qualified as a distribution in partial liquidation under section 346(a). Therefore, in either case, the pro rata distribution of the proceeds of the sale of the manufacturing division in redemption of a portion of the Y stock held by X and Z should be treated as redemptions pursuant to the provisions and limitations of section 302.

Compare Rev. Rul. 77-150, 1977-1 C.B. 88, which holds that section 337 of the Code does not apply to a transaction in which a corporation sold its assets and deliberately delayed the liquidation distribution beyond 12 months from the date of adoption of the plan of liquidation.

For the treatment under section 346(a)(2) of the Code of distributions to shareholders of the proceeds from the sale of part of a corporation's business that were temporarily invested by the corporation to preserve the funds and the investment resulted in a profit or a loss, see Rev. Rul. 76-279, 1976-2 C.B. 99.