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.