Recent private letter rulings prove partial liquidations are alive and well.

Background

Before the repeal of the General Utilities doctrine, partial liquidation treatment was highly prized. The distribution of assets in kind avoided corporate gain, shareholders recovered an allocable part of their basis on the receipt of the distributions, and capital gain rates -- significantly lower man ordinary income rates -- made the transaction attractive to shareholders. In addition, during the early 1980s, partial liquidations within the context of a consolidated return avoided the recapture rules of old section 334(b)(2) of the Internal Revenue Code, without jeopardizing a step-up in asset basis from a recent stock purchase.

The demise of the General Utilities doctrine, the narrowing of the ordinary income/capital gain rate differential, and the introduction of section 338 reduced the efficacy of partial liquidations. Ultimately, partial liquidations suffered the ignominy of the repeal of section 346 and the enactment of a subsection in the redemption rules (section 302(b)(4)). As evidenced by two recently released private letter rulings (Letter Ruling No. 9836027 (June 9, 1998) and Letter Ruling No. 199902001 (Oct. 30, 1998)), however, partial liquidations are alive and well.

Partial Liquidations

Section 302(b)(4) of the Code permits a redemption to be treated as "a distribution in part or full payment in exchange for the stock" (i.e., as a capital transaction rather than as a dividend) if both (1) it is a redemption from a noncorporate shareholder, and (2) it is a redemption in partial liquidation of the distributing corporation.

Section 302(e)(1) provides that a distribution will be treated as a partial liquidation if (1) the distribution is "not essentially equivalent to a dividend" and (2) the distribution is pursuant to a plan and occurs no later than the end of the tax year following the tax year in which the plan is adopted. The second of these requirements permits a maximum of eight quarterly "dividend" payments within a two-tax-year period to be under the umbrella of the partial liquidation.

The first requirement can be complicated. The term "not essentially equivalent to a dividend" for purposes of section 301(e)(1) does not have the same meaning that term has for purposes of section 302(b)(1). The former focuses on the effect of the transaction on the distributing corporation and the latter on the distributee shareholders. For purposes of section 301(e)(1), the phrase articulates the corporate contraction doctrine. The history of that doctrine is littered with contradictory results, and the entire genuine contraction approach to partial liquidation treatment has been roundly criticized. Moreover, the IRS will not ordinarily issue a ruling on the "genuine contraction" requirement unless there has been at least a 20-percent reduction in gross revenue, net fair market value of assets, and number of employees. Rev. Proc. 98-3, 1998-1 I.R.B. 100, [sections] 4.01(22). In many cases, it is difficult to achieve a partial liquidation using the "contraction" theory, because the 20-percent rule requires a significant reduction in the size of the distributing corporation.

Fortunately, the entire morass can be avoided if the distribution satisfies the safe harbor conditions of section 302(e)(2)'s "termination/retention" test. This safe harbor route to partial liquidation treatment not only sidesteps many thorny issues accompanying a genuine contraction analysis, but it may be undertaken without a significant reduction in the size of distributing's business. For example, although it is not apparent from the ruling itself, in Letter Ruling No. 9619050 (Feb. 8, 1996), the liquidated business constituted a mere two percent of the total value of the distributing corporation. Moreover, a partial liquidation under the termination/retention test can be consistent with a growing and expanding corporation. Thus, past imprudent business acquisitions might be unwound using a termination/retention partial liquidation, even if the corporation as a whole remains in an acquisitive mode.

Satisfaction of the termination/retention safe harbor is not, however, without its own hazards. Section 302(e)(2) provides that the "not essentially equivalent to a dividend" requirement will be satisfied if the distribution is a distribution of a "qualified business" (or is attributable to the distributing corporation's ceasing to conduct a "qualified business"), and the distributing corporation continues to be actively engaged in a "qualified business" immediately after the distribution. A "qualified business" is a business that has been actively conducted throughout the five-year period ending on the date of the distribution and that was not acquired within that period in a taxable transaction. The section 346 regulations -- which continue to apply to partial liquidations even though the statutory authority for partial liquidations has been moved to section 302 -- provide that "active conduct" for this purpose will have the same meaning as it does under section 355. See Treas. Reg. [sections] 1.355-3. Thus, the distributed "qualified business" (or the proceeds thereof) must have been (or must be considered to have been) operated directly by the distributing corporation. The distributing corporation will be considered to have operated the distributed business directly if the business (or proceeds from the sale of the business) is acquired by the distributing corporation in a section 381 transaction.

Although decided in the context of the genuine contraction route to partial liquidation, two revenue rulings are relevant to this "active conduct" inquiry. In Rev. Rul. 75-223, 1975-1 C.B. 109, the IRS determined that a distributing corporation could liquidate a wholly owned subsidiary and distribute the subsidiary's business, or the subsidiary could sell its business and liquidate under section 332 and then the distributing corporation could distribute the sales proceeds. In either case, the distribution could qualify as a partial liquidation.

In the second, Rev. Rul. 79-184, 1979-1 C.B. 143, the IRS determined that distribution of proceeds from the sale of subsidiary stock would not qualify as a partial liquidation, because the distributing corporation would not be considered to have directly conducted the subsidiary's business. If the distributing corporation (seller) and the buyer jointly elected section 338(h)(10) for the stock sale, however, distribution of the sales proceeds could qualify as a partial liquidation, because the distributing corporation would be considered to have received the proceeds from the sale of the subsidiary's business in a section 332 liquidation.(1)

Finally, the termination/retention safe harbor encompasses a requirement that is not imposed on the genuine contraction route: all of the proceeds attributable to the terminated business must be distributed.(2) Distribution of anything less could nullify partial liquidation treatment.

In both genuine contraction and retention/termination partial liquidations, neither investment gain nor interest earned on the proceeds pending distribution can be part of the distributable partial liquidation amount.(3) If these amounts are in fact distributed, they will be treated as dividends. Investment loss will reduce the distributable amount,(4) but the net distributable amount can be increased by working capital associated with the business that is no longer needed.(5) This would presumably include cash and other liquid assets on hand to meet payroll, to provide for a revolving fund to pay short-term expenses, to secure payment of inventory, and to retain a minimum deposit in a business bank account.

Recent Private Letter Rulings

Letter Ruling No. 9836027 (June 9, 1998) focuses on the amount of the proceeds to be distributed in a section 302(e)(2) (termination/retention) partial liquidation. In the ruling, domestic selling corporation (Parent) owns 100 percent of the stock of Target. Target is engaged in businesses C and D, both five-year active trades or businesses. Target also owns all of the stock of F-Sub, which is also engaged in businesses C and D, albeit in a different geographical area from the corresponding businesses conducted by Target. Parent sells all of the stock of Target to corporate Buyer and a section 338(h)(10) election is made to treat the transaction as if Target had sold three assets to Buyer (business C, business D, and F-Sub stock).(6) The primary issue is whether Parent had to distribute the proceeds attributable to both businesses C and D or could it choose to distribute either one. The issue is complicated by the fact that business C and business D are replicated in F-Sub. Thus, the sub-issue is whether the C business (or the D business) conducted by the Target counterpart in F-Sub constitutes part of the Target C (or Target D) businesses for determining the amount of proceeds that must be distributed in partial liquidation.

In theory, the distribution of "all the proceeds" requirement could have been met in any of four different ways. "All the proceeds" could have been defined as (1) all the proceeds attributable to Target's D business, (2) all the proceeds attributable to Target's D business plus those proceeds attributable to F-Sub's D business,(7) (3) all the proceeds attributable to both Target's C and D businesses, or (4) all of the proceeds attributable to Target's C and D businesses plus those proceeds attributable to F-Sub's C and D businesses.

The IRS resolved the issue by according the taxpayer a great deal of flexibility. The ruling permitted Parent to distribute the proceeds of Target's D business to the Parent's shareholders and gave Parent the option to distribute the proceeds of the sale of the C business later, as long as those proceeds were distributed within one year of the adoption of the plan to distribute the D business. Because the section 338(h)(10) liquidation at the Target-- ... evel did not invoke a similar section 338(h)(10) election at the F-Sub level, Target was deemed to sell to Buyer its divisional assets and F-Sub stock (not F-Sub assets). Thus, consistent with Rev. Rul. 75-223, the proceeds attributable to the D and C businesses of F-Sub (as a result of the deemed sale by Target of F-Sub stock) were not distributable in partial liquidation and were retained by Parent. The IRS also ruled that the amount distributable, as determined above, had to be reduced by liabilities associated with the business --Oincluding taxes and transaction costs).

The second private letter ruling (Letter Ruling No. 199902001 (Oct. 30, 1998)) is a genuine contraction partial liquidation, and it too expands partial liquidation flexibility. As required for a genuine contraction partial liquidation, the representations recite that the taxpayer's gross revenues, number of employees, and net fair market value of assets will each be reduced by 20 percent. At least 80 percent of the net proceeds of the contraction will be distributed, echoing the fact that the distribution of "all the proceeds" is not required in a genuine contraction.

Letter Ruling No. 199902001 expands the scope of genuine contraction partial liquidations by permitting the proceeds of the contraction to be moved up a chain of subsidiaries via stock distributions. Heretofore, most practitioners believed that a lower-tier subsidiary that sold assets (either directly or by a deemed sale under section 338(h)(10)) could bring the proceeds of that sale to Parent (and eventually out to the Parent shareholders) only through seriatim liquidations of the lower-tier subsidiaries up the chain to the Parent.(8) Letter Ruling No. 199902001 permits a third-tier subsidiary (that generated liquidation proceeds on the sale of fourth-tier subsidiary stock coupled with a section 338(h)(10) election) to be moved up the chain and become a first-tier subsidiary of Parent by successive stock distributions. The former third-tier subsidiary was then liquidated directly into Parent, without the concurrent liquidations of the first-tier and second-tier subsidiaries. As long as section 381 (carryover of attributes) applies to fuse the proceeds of sale at the lower-tier level with the Parent's assets, the partial liquidation will apparently be valid. Thus, even a tax-free reorganization of the third-tier subsidiary directly into Parent with some newly issued Parent stock being transferred to the former third-tier subsidiary shareholder (the second-tier subsidiary) should position Parent to do a partial liquidation with the proceeds of the third-tier subsidiary's contraction.

Another interesting aspect of the ruling is that the distributing Parent corporation is publicly held. A public corporation that wants to sell discrete divisions and return to its core business should be an ideal candidate for application of the partial liquidation rules. Nevertheless, practitioners may have believed that public companies would be loathe to employ any distribution mechanism involving the word "liquidation." The corporation in Letter Ruling No. 199902001 seems to have overcome any such concerns.

Finally, the facts of the second ruling demonstrate that the distribution may be pro-rata or accomplished via a series of redemptions. A pro-rata partial liquidation can be particularly attractive if the distributing corporation has both corporate and noncorporate shareholders, because the noncorporate shareholders can receive sale or exchange treatment and the corporate shareholders can receive a dividend normally eligible for the dividends-received deduction. The corporate shareholders, however, may need to reduce their bases in the stock of the distributing corporation by the nontaxed portion of the dividend received. This reduction would be required even if the corporate shareholder had held the distributing corporation stock for more than two years.(9) As amended by the Taxpayer Relief Act of 1997, section 1059(a)(2) requires immediate gain recognition whenever the basis of stock with respect to which any extraordinary dividend was received would be reduced below zero. If the partial liquidation is pro-rata, an actual surrender of shares should not be necessary (though the IRS may balk if there are outstanding options or convertible securities and no adjustment is made to these financial instruments), and the repurchasing corporation should therefore be able to save administrative expenses.(10)

Conclusion

The partial liquidation, long out of vogue, still has much to commend it. Recent private letter rulings confirm that what is old is new and that partial liquidations are alive and well.

(1) See Letter Ruling Nos. 9007036 (Oct. 20, 1989) and 9619050 (Feb. 8, 1996).

(2) See Gordon v. Commissioner, 424 F.2d 378 (2d Cir. 1970); Kenton Meadows Co. v. Commissioner, 766 F.2d 142 (4th Cir. 1985).

(3) Rev. Rul. 71-250, 1971-1 C.B. 112.

(4) Rev. Rul. 76-279, 1976-2 C.B. 99.

(5) Rev. Rul. 60-232, 1960-2 C.B. 115.

(6) A section 338(h)(10) liquidation at the Target level did not invoke a similar section 338(h)(10) election at the F-Sub level. A corporation that is subject to section 338(h)(10) must be a domestic corporation. Treas. Reg. [sections] 1.338(h)(10)-1(c)(1). Thus, Target was deemed to sell to Buyer its divisional assets and F-Sub stock (not F-Sub assets).

(7) In each of the first two situations, C could be substituted for D, such that P could have the flexibility of distributing all of the proceeds attributable to the C business of Target (in lieu of the D business) or all the proceeds attributable to the C business residing in Target and F-Sub (in lieu of the D business of Target and F-Sub).

(8) See Rev. Rul. 75-223, 1975-1 C.B. 109.

(9) I.R.C. [subsections] 1059(a); 1059(e); Treas. Reg. [sections] 1.1059(e)-1.

(10) See Rev. Rul. 90-13, 1990-1 C.B. 65.

GILBERT D. BLOOM is a partner in the Washington National Tax Practice (Mergers & Acquisitions) of KPMG LLP. He is a former Branch Chief of the IRS Corporate Reorganization Branch, whose years at KPMG have included frequent appearances before congressional and IRS committees, numerous contributions to tax publications (including a quarterly column in the Journal of Corporate Taxation), and most recently, an appointment as Adjunct Professor of Law at Georgetown University Law Center.