SERVICE RULES THAT TRANSITION RELIEF FROM REPEAL OF GENERAL UTILITIES DOCTRINE APPLIES TO SHAREHOLDERS AS WELL AS CORPORATIONS.

Rev. Rul. 87-4

ISSUE

Pursuant to the transition rule of section 633(d) of the Tax Reform Act of 1986, Pub. L. 99-154, 100 Stat. 2085 (the "Act"), for qualified corporations, can the shareholders of these corporations that adopt plans of complete liquidation make an election under section 333 of the Internal Revenue Code for liquidations completed after December 31, 1986? If so, how is the recognition of shareholder-level gain determined under the transition rule?

LAW

Section 333 of the Code generally provides the shareholders of a corporation with an election to defer the recognition of shareholder- level gain that would otherwise result from distributions made in complete liquidation of the corporation. Notwithstanding a valid election under section 333, gain realized by a shareholder is recognized to the extent of the greater of (i) the shareholder's ratable share of earnings and profits of the liquidated corporation or (ii) the portion of the assets received by the shareholder that consists of money or of certain stock or securities distributed by such corporation.

Section 631(e)(3) of the Act, contained in subtitle D of title VI ("subtitle D"), repeals section 333 of the Code. Subtitle D also provides for the repeal of the General Utilities doctrine. Section 633(a)(1) of the Act, in effect, provides that the repeal of section 333 and the General Utilities doctrine does not apply to liquidations completed on or before December 31, 1986.

Section 633(d)(1) of the Act provides a transition rule for certain corporations ("qualified corporations") that completely liquidate after 1986 and prior to January 1, 1989 (the "transition period"). Subject to the exceptions made for the liquidating sale or distribution of certain items specified in section 633(d)(2), this transition rule, in effect, defers the effective date of the amendments made in subtitle D for qualified corporations with an "applicable value" up to $5,000,000 and provides partial relief from those amendments for corporations with an applicable value in excess of $5,000,000 but not in excess of $10,000,000. If the applicable value of a liquidating corporation exceeds $5,000,000, the relief is only partial because gain or loss realized by the corporation is recognized to the extent that the gain or loss exceeds the "applicable percentage" of each gain or loss.

Under section 633(d)(3) of the Act, the applicable percentage equals 100 percent reduced by the amount that bears the same ratio to 100 percent as the excess of the applicable value over $5,000,000 bears to $5,000,000. Section 633(d)(4) defines "applicable value" as the fair market value of all of the stock of the corporation on the date of the adoption of the plan of complete liquidation (or, if greater, on August 1, 1986).

Section 633(d)(5) of the Act generally defines "qualified corporation" as any corporation of which more than 50 percent (by value) of the stock is held by 10 or fewer "qualified persons," as defined in section 633(d)(6), and the applicable value of which does not exceed $10,000,000.

ANALYSIS AND HOLDINGS

The amendments in subtitle D repeal section 333 of the Code and the General Utilities doctrine for liquidations that are completed after December 31, 1986. Section 633 (d)(l) of the Act provides a transition rule for qualified corporations by making the amendments in subtitle D inapplicable to "the applicable percentage of each gain or loss which (but for [the transition rule]) would be recognized by reason of [those] amendments."

All of the amendments made by subtitle D are covered by the terms of the transition rule for qualified corporations. Therefore, even though most of the amendments in subtitle D concern gain or loss to be recognized by a corporation, the shareholders of the corporation also would recognize gain by reason of the amendment that repeals of section 333 of the Code. Thus, the language of the transition rule for qualified corporations extends transition relief not only with respect to corporate-level gain, but also with respect to gain that would otherwise be recognized at the shareholder level. Furthermore, the Conference Report nowhere suggests any intention to preclude the present-law treatment of complete liquidations for the shareholders of qualified corporations during the transition period. 2 H.Rep. No. 99-841 (Conf. Rep.), 99th Cong., 2d Sess. II-206 to - 207 (1986). Accordingly, an election under section 333 is available for the shareholders of a qualified corporation that completely liquidates before January 1, 1989.

In general, relief under the transition rule is subject to the limitation for items specified in section 633(d)(2) of the Act and is otherwise phased out as a corporation's applicable value approaches $10,000,000. Section 633(d) of the Act achieves this limitation and phase-out for shareholders as a result of the interaction between the application of the transition rule at the corporate level and the provisions of section 333. The amount of realized gain that is recognized by the liquidating corporation under the transition rule (less income tax thereon properly taken into account), including gain recognized with regard to items specified in section 633(d)(2) and any gain recognized under the phase-out provided in section 633(d)(3), increases the earnings and profits of the corporation. Accordingly, the shareholders' ratable share of the earnings and profits of the corporation are also increased. Thus, a phase-out for the shareholder-level transition relief from the repeal of section 333 results in most cases from the phase-out for the corporate-level relief from the repeal of the General Utilities doctrine.

EXAMPLE

Partial relief under the transition rule for a shareholder of a qualified corporation in the context of a liquidation under section 333 of the Code is illustrated by the following example. Assume X is a qualified corporation with an applicable value of $7,500,000. The earnings and profits of X accumulated after February 28, 1913, is zero. A is the sole shareholder of X and has a basis of $6,500,000 in A's X stock. The only property X owns is a parcel of undeveloped land that it has held for more than 6 months. The land has a basis of $6,500,000 and a value of $7,500,000. If X is completely liquidated under section 333 during the transition period, X recognizes $500,000 of gain (that is, one-half of its realized gain) since the applicable percentage is 50 percent. In turn, X's earnings and profits are increased by the excess of the $500,000 gain recognized as a result of the liquidation over the income tax thereon properly taken into account. Accordingly, there is an increase in A's ratable share of earnings and profits and in the amount of realized gain that A must recognize under section 333.

If X had owned the land for less than six months, X recognizes $1,000,000 of short-term capital gain, and X's earnings and profits are increased by the excess of that gain over the income tax thereon properly taken into account. Accordingly, there is an increase in A's ratable share of earnings and profits and in the amount of realized gain that A must recognize under section 333.

On the other hand, if the land has a basis of $7,500,000, X recognizes no gain in the liquidation, and X's earnings and profits are not increased. Thus, there is no increase in A's ratable share of X's earnings and profits nor in the amount of gain that A must recognize under section 333 of the Code.