Rev. Rul. 58-94

Advice has been requested whether an employee is deemed to have separated from the service of his employer, within the meaning of section 402(a)(2) of the Internal Revenue Code of 1954, where, under a reorganization, the qualified employees' pension plan and trust are terminated and all the assets and liabilities of the employer company are transferred to a corporation which then transfers such assets and liabilities to a wholly owned subsidiary of the latter and the employees of the predecessor company become employees of the subsidiary corporation.

The M company entered into an agreement and plan of reorganization with the P corporation and the S corporation whereby all the assets and liabilities of the M company were transferred to the P corporation in exchange for common stock of the P corporation. After acquiring these assets and liabilities, the P corporation then transferred them to the S corporation in exchange for shares of common stock of the S corporation. The S corporation is a wholly owned subsidiary of the P corporation. The reorganization was one within the meaning of section 368(a)(1)(C) of the Code wherein the term "reorganization" is defined, in part, as meaning the acquisition by one corporation, in exchange solely for all or a part of its voting stock (or in exchange solely for all or a part of the voting stock of a corporation which is in the control of the acquiring corporation), of substantially all of the property of another corporation. The places of business formerly operated by the M company were then operated by the S corporation and virtually all the employees of M company became employees of the S corporation. The M company continued in existence after the effective date of the transfer of its assets only for purposes of liquidation.

The employees' pension plan and trust established by the M company, which have been held to qualify under section 401(a) and the trust to be exempt under section 501(a) of the Code, were terminated. A distribution of the total amount standing to the credit of each employee of M company was made in one taxable year to each such employee.

Distributions from a qualified employees' trust are taxable in accordance with section 402(a) of the Code. Paragraph (1) of such section provides, in part, that amounts actually distributed or made available shall be taxable in the year in which distributed or made available, under section 72 of the Code except that section 72(e)(3) shall not apply. Section 402(a)(2) of the Code provides that if the total distributions payable under a qualified trust, 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 the 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.

Unlike section 165(b) of the Internal Revenue Code of 1939, which was silent as to any distinction, section 402 of the 1954 Code differentiates between distributions on account of a "separation from the service" of an employer and distributions as a result of "the complete termination of" the plan of an employer, at least where the employer is a corporation. Distributions on account of "separation from the service" of an employer which otherwise meet the tests of section 402(a)(2) are given long-term capital gain treatment thereunder, but under section 402(e) distributions resulting from the complete termination of a stock bonus, pension, or profit-sharing plan of a corporation, if the termination of the plan is incident to the complete liquidation of the corporation, whether or not such liquidation is incident to a reorganization as defined in section 368(a) of the Code, are to be considered as distributions on account of separation from service only if made after December 31, 1953, and before January 1, 1955, and only if the liquidation occurs before August 16, 1954.

It is clearly brought out by the legislative history of section 402 of the 1954 Code that the phrase "separation from the service" in section 402(a)(2) of the Code as finally enacted does not extend to distributions resulting from the liquidation or reorganization of a corporate employer, which do not involve a substantial change in the make-up of employees, except as section 402(e) of the Code requires such distributions to be considered on account of separation from service for the limited period to which that subsection is applicable. Section 402(e), in substantially its present form, was added to the proposed legislation in the Senate as a partial substitute for similar provisions contained in section 402(a)(2) and (3)(B)(ii) of the House bill, which were eliminated in the Senate. Those provisions of the House bill would have extended long-term capital gain treatment prospectively to distributions by reason of the termination of a plan "as a result of the complete termination of the business of the employer," which was defined in section 402(a)(3)(B)(ii) to mean "in the case of an employer which is a corporation, the complete liquidation of such corporation whether or not such liquidation qualifies as a complete liquidation under section 336 and whether or not such liquidation is incident to a corporate acquisition of property, a statutory merger, or consolidation," which was treated as a cause of distribution distinct from separation from service. As was stated most clearly at page 54 of the report of the Senate Committee on Finance, the provisions of the House bill regarding distributions resulting from the termination of a plan because of the complete liquidation of the business of a corporate employer had been intended to extend capital gain treatment to situations such as arise upon the merger of a firm with a pension plan with another firm without such a plan, with the result that the plan of the first corporation is terminated; but it was deemed necessary to eliminate, prospectively, any such extension of capital gain treatment "to eliminate the possibility that reorganizations which do not involve a substantial change in the make-up of employees might be arranged merely to take advantage of the capital gains provision." See section 402 of Senate print of H. R. 8300, 83d Cong., as referred to the Committee on Finance, March 23, 1954; print of H. R. 8300 dated July 2, 1954, with engrossed Senate amendments, pages 173-178, inclusive. See also H. R. Report No. 1337, 83d Cong., page A147; Senate Report No. 1622, 83d Cong., pages 54 and 289; and the H. R. Report, No. 2543, 83d Cong., pages 11, 41, and 42, as to Senate Amendment No. 83.

It is nevertheless the position of the Internal Revenue Service that Congress did not intend in section 402 to discriminate against the employees of a corporate employer by extending to them less favorable treatment than would be accorded under section 402(a)(2) in cases involving separation from the service of a noncorporate employer. The legislative history of section 402 discloses instead an attempt to deal, in the first instance favorably but in the ultimate outcome unfavorably, so far as concerns the prospective effect of the section, with a phase of the subject of separation from employment which is peculiar to the termination of plans of corporate employers by reason of corporate liquidations or reorganizations. This history makes it plain that a corporate liquidation or reorganization which brings about a change in employment relationship in no more than a formal or technical sense, and which does not involve a substantial change in the make-up of employees, is not enough to constitute a "separation from the service" under section 402(a)(2). Nothing in the language of section 402 or in its legislative history, however, suggests that a separation from the service of a corporate employer does not occur where a corporate liquidation or reorganization is not itself the cause of termination of the employer's plan but is merely incident to such a change in the ownership of the business as might occur in the case of a noncorporate employer. If, for example, the termination of a corporate employer's plan is incident to a sale of its stock to another corporation for cash, followed by the immediate merger of the employer corporation into the purchasing corporation, distributions to its employees under the plan may be on account of a separation from service, just as in the case of an individual or partnership employer which has sold its assets for cash, even though substantially all employees of the former business are re-employed by the purchaser. In that regard, see Rev. Rul. 58-95, page 21, this Bulletin.

The instant case does not involve the disposition of either the stock or the assets of the employer corporation for cash but the disposition of assets for stock of a corporation in control of the acquiring corporation in a section 368(a)(1)(C) reorganization. Factually, the case is similar to Mary Miller et al v. Commissioner, 22 T. C. 293, affirmed 226 Fed. (2d), 618, acquiescence page 5, but that case arose under section 165(b) of the 1939 Code and for the reasons stated above is not considered controlling for purposes of section 402(a)(2) of the 1954 Code. Nevertheless, a separation from service would have occurred in the instant case within the meaning of section 402(a)(2) had the employer been an individual or partnership disposing of its assets for stock in a previously unrelated corporation, at least where the transferor or transferors were not in control of the transferee corporation immediately after its acquisition of the assets. There is as real a change in the ownership of the business in the instant case as if the employer had not been a corporation, and the fact that there is sufficient continuity of interest to allow the transaction to be treated as a tax-free reorganization under section 361(a) and 368(a)(1)(C) of the Code, so far as concerns the employer corporation and its stockholders, should not prevent viewing it as involving a separation from service for the purposes of section 402(a)(2) as to the affected employees.

Accordingly, it is held that an employee is deemed to have "separated from the service" of an employer, within the meaning of section 402(a)(2) of the 1954 Code where, under a reorganization, within the meaning of section 368(a)1)(C) of the Code, all the assets and liabilities of a company are transferred to a corporation which then transfers such assets and liabilities to a wholly owned subsidiary of the latter, and the employees of the predecessor company become employees of the subsidiary. Therefore, a distribution, within one taxable year, of the total amount standing to the credit of the participants under the predecessor company's qualified employees' pension trust which is terminated by reason of the reorganization, may be considered a gain from the sale or exchange of a capital asset held for more than six months, to the extent that it exceeds the amount contributed by the employee.