Experience tells us that when a share distribution by a corporation qualifies as a distribution in a partial liquidation, the shares are treated as a distribution “in full payment in exchange” for a portion of the shareholders’ stock. Of course, this is true for shareholders other than the ones that are, themselves, C corporations.
Indeed, this is a highly desirable characterization of the distribution. For one thing, the recipient shareholders are entitled to recover the basis of the shares surrendered. That means the recipients need only report income (which will, invariably, be classified as capital gains) to the extent the amount distributed exceeds the basis of the shares surrendered.
A distribution so qualifies if it is:
- in redemption of stock;
- to a shareholder other than a C corporation;
- pursuant to a plan, and occurs within the year such plan is adopted or within the succeeding taxable year; and
- not “essentially equivalent to a dividend.”
Note that a distribution is not essentially equivalent to a dividend if it results from a genuine contraction of the corporation’s business. In fact, the Internal Revenue Service will only rule that a genuine contraction has taken place when, (1) the distribution reduces the corporation’s gross revenues, net fair market value of assets, and employees by no less than 20 percent; or (2) under a “safe harbor,” found in Sec. 302(e)(2), the distribution is attributable to the corporation’s ceasing to conduct a “qualified business,”—but only if, immediately after such distribution, the corporation is actively engaged in the conduct of at least one other qualified business.
Again, a clarification is needed here : A qualified business is one that has been actively conducted throughout the five-year period ending on the date of the distribution, and was not acquired within such five-year period in a transaction in which gain or loss was recognized in whole or in part.
It’s irrelevance is relevant
For corporations that come under the safe harbor, size is seemingly irrelevant. To be sure, in contrast to the IRS’ refusal to rule that a genuine contraction has occurred absent a 20 percent reduction in the above “business attributes,” the size of the business (terminated) has been ruled to be irrelevant. (See Rev. Rul 77-376.)
The distribution, to qualify as a distribution in partial liquidation, must be in redemption of stock. Nevertheless, it has been held that stock need not be redeemed in cases where an actual surrender of stock would be a “meaningless gesture.” (See Rev. Ruls. 81-4 and 90-13.)
To date, however, the IRS has only acknowledged one scenario in which it concludes that such an actual surrender would be a meaningless gesture. The unusual case is one in which the corporation had only a single class of stock and no “rights” (such as options, warrants, convertible securities and rights of first refusal) affecting the stock, and where the distribution—with respect to such lone, unencumbered class of stock—was accomplished on a pro rata basis.
Since it is a rare corporation that possessed such a “pristine” capital structure, most distributions that constitute a distribution in partial liquidation requires an actual surrender of stock to satisfy Sec. 302(b)(4)’s redemption requirement.
A Helpful IRS Concession
Now, without any fanfare, we can report that the IRS has relaxed its views. In cases where the corporation has a more complex capital structure, the IRS will rule that an actual surrender of stock (which in the case of a widely-held corporation can be unduly expensive and cumbersome) is a meaningless gesture, and hence, unnecessary. Witness LTR 200229005. There a corporation sold one of its numerous qualified businesses and sought to distribute the net sales proceeds (after taxes and expenses—which it had committed, for safekeeping, to a segregated account—to its shareholders in a distribution that would qualify for partial liquidation status. (See Rev. Ruls. 71-250 and 76-279).
The corporation, however, had issued options (to a single employee) to acquire its stock. At the time of the planned distribution, these options had not yet been exercised, and therefore remained outstanding.
The distribution, effected on a pro rata basis with respect to the corporation’s shareholders, was unaccompanied by an actual surrender of stock. The ruling, nevertheless, concludes that an actual surrender would have been a meaningless gesture. Thus, the requirements of Sec. 302(b)(4) were met via a “deemed surrender” of the shareholders’ stock.
An actual surrender was ruled to be a meaningless gesture because, in conjunction with the distribution, the terms of the options were duly adjusted to eliminate the “dilutive effect” caused by distributing assets in a partial liquidation without an actual redemption of shares. (Presumably the strike price of the options was lowered and the number of shares to which the options pertained was increased.)
No (actual) Surrender
In short, economically, the option holder was placed in the same position he or she would have occupied had there been an actual retirement of a portion of the shareholder’s shares. As a result, it can now be concluded that when the holder of “rights” (affecting the stock) is “made whole,” the IRS—to its great credit—is now willing to rule that the redemption requirement, ingrained in Sec. 302(b)(4), can be met through a deemed (as opposed to an actual) surrender of stock.
The number of shares considered redeemed, the IRS said, is determined in accordance with the principles set forth in Rev. Rul. 77-245. The number considered redeemed, for purposes of determining the shareholder’s gain or loss, is a number that bears the same ratio to a shareholder’s total holdings, as the amount distributed bears to the value of the corporation’s stock immediately before the distribution.
This is a major concession on the part of the IRS, and will greatly diminish the costs to a public corporation of effecting a distribution in partial liquidation. In cases where the public corporation has a complex capital structure, executives would have felt constrained to conduct a self-tender offer, with its attendant costs, to satisfy Sec. 302(b)(4)’s redemption requirement. This is now unnecessary.
Moreover, the concession eliminates the need to test the approach, advanced by Professors Ginsburg and Levin in their classic research on buyouts, for “finessing” the redemption requirement. The professors suggested that the redemption requirement could be satisfied, on a cost-efficient basis, through the declaration of a 100 stock dividend that was followed by the adoption of a plan of partial liquidation and a distribution of the net sales proceeds “in redemption” of the stock dividend previously declared. (The shares to which such dividend was attributable would never be issued). Also note that the proceeds must be derived from the genuine contraction, or the termination of a qualified business.
It’s likely that this strategy would have been effective. But it no longer has to be attempted now that the IRS has expanded the meaningless gesture rule.