Rev. Rul. 56-214

Advice has been requested whether continuation in the service of the employer by employees who no longer participate in the profits of the employer, under the employer's profit-sharing plan, precludes such employees from availing themselves of the long-term capital gain provisions of section 402(a)(2) of the Internal Revenue Code of 1954 (section 165(b) of the 1939 Code), with respect to lump-sum distributions made at the time of discontinuance of participation in the plan.

A profit-sharing plan and trust established by an employer, for the benefit of his employees, covers all employees with a stated minimum number of years of service. The plan provides that at the close of the year in which an employee reaches age 60, the employee retires from the plan or terminates his profit-sharing employment and is eligible for a lump-sum distribution of the total amount standing to his credit in the trust. Should the employee continue to work for the employer, after retiring from the plan at age 60, the employee's records indicate that he is no longer eligible for profit-sharing. The profit-sharing plan and trust have been held to be qualified, under section 401(a) of the 1954 Code (section 165(a) of the 1939 Code), for exemption from Federal income tax under section 501(a) of the 1954 Code (section 165(a) of the 1939 Code).

Section 402(a)(2) of the 1954 Code provides that in the case of an employees' trust described in section 401(a), which is exempt from tax under section 501(a), if the total distributions payable with respect to any employee are paid to the distributee within one taxable year of the distributee on account of the employee's death or other separation from the service, or on account of the employee's death after separation from service, the amount of such distribution, to the extent exceeding the amounts contributed by the employee, shall be considered a gain from the sale or exchange of a capital asset held for more than six months.

Section 402(a)(3)(C) defines the term `total distributions payable' as meaning the balance to the credit of an employee which becomes payable to a distributee on account of the employee's death or other separation from the service, or on account of his death after separation from the service.

An employee, in order to obtain the benefit of the long-term capital gain provision of section 402(a)(2) of the 1954 Code, must have completely severed his employment relationship with the employer at the time the distributions are received by him, for otherwise the distributions cannot be said to have been received on account of the employee 's separation from the service. See Frank B. Fry et al. v. Commissioner , 19 T.C. 461, affirmed, 205 Fed.(2d) 517, in which it was held that the taxpayer's continued receipt of his regular salary required the conclusion that he had not severed his connection with his employer and, therefore, was not entitled to the benefit of the capital gain treatment.

Accordingly, it is held that an employee who, for any reason, terminates his participation in an employees' profit-sharing plan and trust, qualified under section 401(a) of the 1954 Code for exemption from tax under section 501(a) of the 1954 Code, but who continues his employment with his employer whether under his previous employment agreement or another employment agreement, is not deemed to have been separated from the service, within the purview of section 402(a)(2) of the 1954 Code. Therefore, the benefit of long-term capital gain treatment will not be accorded a lump-sum distribution of the total amount standing to the employee's credit in the trust in such a case.