Partial liquidations.

Corporate

PARTIAL LIQUIDATIONS

The proclivity of corporations to restructure, together with what is likely to be a reduction in tax rates for capital gain, suggests partial liquidations may regain popularity. A partial liquidation distribution, although resembling a dividend or pro rata stock buyback, is nevertheless treated by the recipient shareholder as a sale or exchange of stock, thus giving rise to a capital gain.

Under IRC section 302(b)(4), two requirements for partial liquidation treatment are

1. That stock be redeemed.

2. That the redemption be in partial liquidation within the meaning of section 302(e). This section imposes a three part test: The distribution must be "not essentially equivalent to a dividend," must occur pursuant to an adopted plan of partial liquidation and must take place within the year of plan adoption or the following year.

Much of the law centers on the "not essentially equivalent to a dividend" test, which is satisfied if the distribution results from a "genuine contraction" of the corporation's business. This contraction occurs if the restructuring transaction yields a 15% or greater reduction in the corporation's gross revenues, net fair value of assets and employees.

The other requirement set forth in section 302(b)(4) is the stock redemption test. At issue here is whether an actual surrender of stock is required. Recently, in revenue ruling 90-13, the IRS reaffirmed the notion that the deemed surrender that occurs in a pro rata distribution satisfies the redemption requirement in a partial liquidation. In such a case, an actual surrender is dismissed as a meaningless gesture because each shareholder's proportionate interest remains unchanged. However, an actual surrender appears necessary when a corporation has more than one class of stock or other rights (such as warrants or convertible securities) affecting the stock.

Observation: If a partial liquidation is successfully effected, a shareholder is treated as selling an amount of stock having a value equal to the amount of the distribution. The excess of the distribution over the basis of the shares deemed surrendered is taxed at capital gain rates. This treatment, however, is not available to corporate shareholders. They are charged with dividend income with respect to which the benefits of the dividends-received deduction are effectively lost because the dividend is automatically classified as extraordinary.