Rev. Rul. 81-3

ISSUE

May a pro rata distribution by a corporation to its shareholders qualify as a partial liquidation under section 346(a)(2) of the Internal Revenue Code if there is no actual redemption of stock pursuant to a plan?

FACTS

Corporation X is engaged in the manufacturing business and has operated two divisions. In order to concentrate on the most profitable of the two divisions and reduce overall operations, X sold all of the assets of its larger division to an unrelated party for cash and the assumption of liabilities that had arisen in connection with the operation of that division. X then adopted a plan of partial liquidation and distributed the net proceeds of the sale pro rata to its shareholders within the taxable year in which the plan was adopted. The shareholders of X did not surrender any of their stock in exchange for the cash X distributed. X continued the operation of the remaining division on a relatively unchanged basis.

LAW AND ANALYSIS

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

Both the definitional section 346(a)(2) of the Code and its operative provision, section 331(a)(2), and sections 1.346-1 and 1.331-1 of the Income Tax Regulations, contemplate an exchange by the shareholder of stock for the distribution of property in partial liquidation. Therefore, in determining whether section 301 or section 331 applies to the distribution in the instant case, the question arises whether an actual surrender of stock is necessary in order to make section 346(a)(2) applicable.

The term "partial liquidation" as used in section 346(a)(2) of the Code primarily involves the concept of a corporate contraction. See S. Rep. No. 1622, 83rd Cong., 2d Sess. 49 and 262 (1954). While a contraction of business, which indicates that a distribution is not essentially equivalent to a dividend within the meaning of section 346(a)(2), is the principal determinant of a partial liquidation, the other requirements of that provision also must be met for the distribution to qualify thereunder. Rev. Rul. 77-468, 1977-2 C.B. 109.

In Fowler Hosiery Co. v. Commissioner, 36 T.C. 201 (1961), aff'd, 310 F.2d 394 (7th Cir. 1962), a distribution from a wholly-owned subsidiary to its parent corporation consisting of a major portion of the proceeds from the sale of the subsidiary's assets was found to be a partial liquidation under section 346 of the Code rather than a dividend even though there had been no actual redemption of stock or formal plan of liquidation. The court held that where there is only one shareholder of a corporation, and the corporation distributes a substantial portion of its assets after termination of its business activities, the question of whether the formality of a surrender of stock must be observed, for purposes of section 346, is one of fact, since the shareholder's interest in the corporation was the same whether or not any portion of the stock was retired.

In Rev. Rul. 79-257, 1979-2 C.B. 136, a wholly-owned subsidiary distributed all of the operating assets of one of its businesses to its corporate parent. As in Fowler Hosiery Co., the actual surrender of stock was found to be meaningless, since the parent remained the sole shareholder whether or not any stock was redeemed.

The sale of the assets of X and the distribution of the proceeds is a genuine contraction of business for purposes of section 346(a)(2) of the Code. Since the distribution was pro rata, the actual redemption of stock, as was the case in Rev. Rul. 79-257, would have been a meaningless gesture. The shareholders of X will be deemed to have constructively surrendered that number of shares the total fair market value of which equals the amount of the distribution. The requirement of a redemption may be deemed satisfied by these constructive exchanges.

HOLDING

The pro rata distribution of property by X to its shareholders is a distribution in partial liquidation of X within the meaning of section 346(a)(2) of the Code, since there was a genuine contraction of business and the surrender of stock by the shareholders would have been a meaningless gesture.

See Rev. Rul. 77-245, 1977-2 C.B. 105, for computation of the tax consequences to the shareholders of X resulting from the partial liquidation.

EFFECT ON OTHER REVENUE RULINGS

Rev. Rul. 79-257 is amplified.