Rev. Rul. 79-376

ISSUE

As a result of a redemption distribution in exchange for common stock pursuant to section 302(a) of the Internal Revenue Code, what is the correct method for determining the proper charge to the capital account of a corporation, incorporated subsequent to March 1, 1913, under section 312(e), and the resulting charge to its earnings and profits?

LAW AND ANALYSIS

Section 316(a) of the Code provides that, except as otherwise provided in subtitle A, every distribution is made out of earnings and profits to the extent thereof, and from the most recently accumulated earnings and profits.

Section 312(e) of the Code provides an exception to section 316(a). Section 312(e) provides that in the case of amounts distributed in partial liquidation or in a redemption to which section 302(a) or 303 applies, the part of such distribution that is properly chargeable to capital account shall not be treated as a distribution of earnings and profits. The term capital account as used in this section is not defined in the Code or regulations.

In Jarvis v. Commissioner, 43 B.T.A. 439 (1941), nonacq. 1970-2 C.B. xxii, affirmed, 123 F.2d 742 (4th Cir. 1941), it was held that for the purpose of determining the accumulated earnings and profits available for dividends in years subsequent to a redemption the charge to capital upon the redemption should be such an amount that the ratio between the charge to capital and the capital prior to retirement would be the same as the ratio between the number of shares retired and the number of shares outstanding prior to retirement. That is, a proportionate part of the capital was considered as standing behind each of the shares redeemed. The balance of the distribution was thus charged to earnings and profits, even though in excess of the ratable share attributable to the stock redeemed. In Jarvis the Board of Tax Appeals construed the term "capital account" as representing only the amount paid in to the corporation (comprising only the par value and the paid-in surplus) for stock at the adjusted basis for federal income tax purposes.

Rev. Rul. 70-531, 1970-2 C.B. 76, maintains that the term "capital account" as used in section 312(e) of the Code includes more than just the shareholders' contributed capital as construed in Jarvis. Rev. Rul. 70-531 provides that the "capital account" also contains the unrealized appreciation attributable to the assets owned by the distributor corporation, i.e., the excess of the fair market value of the corporate assets over the adjusted basis of those assets. The formula contained in Rev. Rul. 70-531 to determine the part of a redemption distribution which is "properly chargeable to capital account" results in the redeemed shares' pro rata portion of earnings and profits first being determined and subtracted from the amount of the distribution with the remainder of the distribution constituting the "proper charge to capital account."

In Anderson v. Commissioner, 67 T.C. 522 (1976), the Tax Court held that the formula approved in Jarvis, rather than the formula prescribed in Rev. Rul. 70-531, is the correct computation to apply in determining the proper charge to capital account in a redemption distribution under section 312(e) of the Code and the resultant charge to earnings and profits of the redeeming corporation. The basis of the Tax Court's repudiation in Anderson of the formula set forth in Rev. Rul. 70-531 is that it is contrary to the statutory language of section 312(e), which requires computation of the charge to capital first followed by a charge of the balance of the distribution to earnings and profits.

In view of Anderson, the Internal Revenue Service will follow the formula contained in Jarvis, rather than the formula presented in Rev. Rul. 70-531, to determine the part of a redemption distribution which is chargeable to the capital account under section 312(e) of the Code.

HOLDING

As a result of a redemption distribution in exchange for common stock pursuant to section 302(a) of the Code, the correct method for determining the proper charge to the capital account of a corporation, incorporated subsequent to March 1, 1913, under section 312(e) is the method in which the ratio between the charge to capital and the capital prior to retirement is the same as the ratio between the number of shares retired and the number of shares outstanding prior to retirement. The resulting charge to the corporation's earnings and profits is the balance of the redemption distribution.

EFFECT ON OTHER DOCUMENTS

In view of foregoing the nonacquiescence has been withdrawn and acquiescence substituted in Jarvis. See page 2, this Bulletin. The Commissioner acquiesces in Anderson. See page 1, this Bulletin.

Rev. Rul. 70-531, 1970-2 C.B. 76, is revoked.