Rev. Rul. 79-257

ISSUE

May a distribution by a wholly owned subsidiary to its sole corporate shareholder qualify as a partial liquidation under section 346(a)(2) of the Internal Revenue Code of 1954 if there is no redemption of stock pursuant to a plan?

FACTS

Corporation P and its wholly owned subsidiary, S, filed separate federal income tax returns for the calendar year 1977. On June 15, 1977, S, which operated three divisions, declared a dividend in kind to P of all the assets of one of these divisions, subject to their related liabilities. Certain other assets of S representing working capital of the division being distributed were also transferred to P. P continued the operation of the business of the division distributed on a relatively unchanged basis. None of the S stock held by P was surrendered in exchange for, or with respect to, the distribution by S. Except for the absence of an exchange of stock, the distribution met the definition of a partial liquidation under section 346(a)(2) of the Code.

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.

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 Sen. Rep. No. 1622, 83rd Cong., 2d Sess. 49 and 262 (1954). While a contraction of business indicating 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 that 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. The court also held that a plan of liquidation need not be one so denominated in a formal resolution of the shareholders but may be found to have been adopted by action of the corporation, whether formal or informal.

The transaction in the instant case, like the one in Fowler Hosiery, more closely resembles a partial liquidation than a dividend. S distributed to P all of the operating assets of one of its major businesses, subject to their liabilities. Such a reduction in S's operations is considered a contraction of business for purposes of section 346(a)(2) of the Code. In addition, since P would have remained the sole shareholder of S regardless of whether any stock of S were redeemed from P, the facts indicate that the actual surrender of any stock would have been a meaningless gesture under the rationale of the Fowler Hosiery decision. See Morgan v. Commissioner, 288 F.2d 676 (3d Cir. 1961), cert. denied, 368 U.S. 836 (1962), which has employed this approach in another context involving a sole shareholder where there was no exchange of stock. Moreover, the fact that the distribution to P resulted from a contraction of the business of S indicates that it was made pursuant to a plan of liquidation, although an informal one. As such, the distribution was within the time period prescribed in section 346(a)(2) of the Code.

HOLDING

In view of the foregoing, since there was a genuine contraction of business and the surrender of stock by P would have been a meaningless gesture, the distribution of property by S to P is a distribution in partial liquidation of S within the meaning of section 346(a)(2) of the Code.

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