Rev. Rul. 77-245

Advice has been requested concerning the number of shares of stock considered redeemed in a partial liquidation under section 346 of the Internal Revenue Code of 1954 when no shares are actually surrendered.

X corporation had actively operated two separate manufacturing businesses for more than 5 years. X's outstanding stock (a single class of common) is traded on a stock exchange. On January 2, 1977, X sold one of its businesses for cash with the purchaser assuming the liabilities of the business. X then adopted a plan of partial liquidation and, after deducting the expenses and taxes of the sale and the expenses of the distribution, transferred the balance of the sales proceeds to an independent escrow agent for immediate distribution to the shareholders in a specified amount ($50) per share.

Instead of actually surrendering shares of stock for cancellation, the X shareholders voted to reduce the capital of X by reducing the par value of the X stock. In order to receive the distribution a shareholder must present the certificate(s) representing the shares to the escrow agent who will affix a sticker to the certificate showing the amount of the distribution on the shares represented by the certificate. If the funds held by the escrow agent are not claimed by the shareholders during the statutory period prescribed by the applicable state law they will escheat to the state at the end of the statutory period under such law. Under no circumstances will the funds held by the escrow agent be used for the benefit of X. After the transfer by X of the funds to the escrow agent, X continued the operation of its remaining business.

The transfer by X of the funds to the escrow agent qualified as a distribution in partial liquidation as defined in section 346(a)(2) of the Code. As provided in section 331(a)(2), the amount distributed in partial liquidation is treated by the X shareholders receiving the distributions as in part or full payment in exchange for their stock. Under section 1001(a) the gain to a shareholder is the excess of the amount of the distribution received over the adjusted basis (section 1011) of the stock deemed surrendered therefor, and loss is the excess of the adjusted basis over the amount received. Situation 1.

The taxpayer owned 100 shares of X stock, all of which were represented by a single stock certificate. The taxpayer's adjusted basis for each share of stock was $40. The taxpayer presented the stock certificate to the escrow agent for payment of the liquidating distribution and received $5,000 ($50 per share distribution X 100 shares). The mean between the highest and lowest quoted selling price per share of the X stock on the exchange just prior to the time that the stock was traded ex distribution was $100. A public announcement of the distribution in partial liquidation had been made by X prior to the date the distribution was first made available to the X shareholders.

Situation 2.

The facts are the same as in Situation 1 except that the X stock was owned by a relatively small number of shareholders, was not traded on a stock exchange, and was not traded under circumstances necessary to realistically establish its value based on its trading price. Immediately before X transferred the funds to the escrow agent, each share of X's outstanding stock had a value, based on the principles set forth in Rev. Rul. 59-60, 1959-1 C.B. 237, of $95.

In both Situation 1 and Situation 2 the amount of gain or loss realized by the taxpayer on the partial liquidation distribution under section 1001 of the Code depends on the amount of the taxpayer's total adjusted basis ($4,000) in the X stock that is to be offset against the amount realized ($5,000). Therefore, it is necessary to determine the number of shares of stock deemed surrendered in exchange for the liquidating distribution so that the adjusted basis of these shares can be offset against the amount realized. For this purpose the taxpayer in both Situation 1 and Situation 2 will be considered to have surrendered that number of shares the total fair market value of which equals the amount of the distribution.

The determination of the fair market value of stock depends upon the circumstances in the particular case. However, since valuation is not an exact science, reasonableness must be exercised in making determinations of value. Generally, the prices at which a stock is traded in a free and active market best reflects the value of the stock. Where a stock is not so traded, some other measure of value must be used. Rev. Rul. 59-60, 1959-1 C.B. 237, sets forth the general approach, methods, and factors to be considered in valuing stock and will be applied in determining the fair market value of stock deemed surrendered in a partial liquidation.

In Situation 1, the mean between the highest and lowest selling price per share of the X stock on the exchange on the date that the distribution was first made available to the X shareholders was $100. Therefore, the amount of stock deemed to be surrendered by the taxpayer in the partial liquidation is determined by the relationship between the per share amount distributed to the taxpayer ($50) and the per share fair market value of the X stock immediately before the distribution ($100).

Accordingly, the taxpayer is deemed to have surrendered one-half of the 100 shares of X stock owned, or 50 shares, in exchange for the $5,000 distribution. Under section 1001, the taxpayer realized a gain of $3,000 (the amount realized on the distribution, $5,000, less the total adjusted basis of $2,000 of the 50 shares deemed surrendered ($40 adjusted basis per share X 50 shares)).

In Situation 2, where the X stock was not traded under circumstances necessary to realistically establish its fair market value based on its trading price, it was determined under the principles set forth in Rev. Rul. 59-60 that the X stock had a per share fair market value of $95 immediately before the distribution.

Accordingly, the taxpayer is deemed to have surrendered 52.63 shares of X stock in exchange for the $5,000 distribution ($5,000 distribution divided by $95, the fair market value per share, equals 52.63 shares). Under section 1001 of the Code, the taxpayer realized a gain of $2,894.80 (the amount realized on the distribution, $5,000, less the total adjusted basis of $2,105.20 of the 52.63 shares ($40 basis per share) deemed surrendered).

In both Situation 1 and Situation 2, the taxpayer's adjusted basis of the X stock must be reduced by the amount of the adjusted basis used in determining the gain on the partial liquidation.

Rev. Rul. 56-513, 1956-2 C.B. 191, concerns a partial liquidation of a corporation under section 346 of the Code. Rev. Rul. 56-513 states that for purposes of determining gain or loss to the shareholders, the number of shares of stock deemed to be surrendered at the time of the partial liquidation distribution is that number that bears the same ratio to the total number of shares outstanding as the amount of the distribution bears to the total fair market value of the net assets of the corporation immediately prior to the distribution. Thus, in Rev. Rul. 56-513 the fair market value of a share of stock is determined by that share's proportionate part of the total fair market value of the corporation's net assets. This determination of the amount of stock surrendered is based on the fact that the stock was not traded under circumstances necessary to realistically establish its value by its trading price, and the fact that the net value of the corporation's assets realistically reflected the fair market value of the stock, although these facts are not stated in Rev. Rul. 56-513.

Rev. Rul. 59-240, 1959-2 C.B. 112, also concerns a partial liquidation of a corporation under section 346 of the Code. The stock of the corporation was widely held. Rev. Rul. 59-240 states that, for purposes of determining the amount of gain or loss to the shareholders, the amount of stock deemed to be surrendered at the time of the partial liquidation distribution is determined by the relationship between the amount distributed in partial liquidation and the fair market value of the stock immediately before the distribution. This determination of the amount of stock surrendered is based on the fact that the stock was traded on an exchange, although this fact is not stated in Rev. Rul. 59-240.

Rev. Rul. 56-513 and Rev. Rul. 59-240 are clarified.