REDEEMED SHAREHOLDER NEED NOT SURRENDER STOCK FOR PRO RATA DISTRIBUTION IN PARTIAL LIQUIDATION TO QUALIFY AS A REDEMPTION.

Rev. Rul. 90-13

ISSUE

Must shareholders surrender stock in the distributing corporation to qualify for partial liquidation treatment under section 302(b)(4) and (e) of the Internal Revenue Code, if the distribution is pro rata?

FACTS

Corporation X operated two divisions of equal size and had one class of stock outstanding, which was owned by individuals A and B. There were no outstanding rights, such as warrants, options, convertible securities, shareholder agreements or rights of first refusal, affecting the stock of X.

Pursuant to a plan of partial liquidation, X sold one of its divisions to an unrelated party for cash and distributed the cash proceeds of the sale to A and B pro rata. A and B did not surrender any stock in exchange for the cash distributed by X.

Except for the question as to whether there must be a surrender of stock by the shareholders, the transaction qualifies as a partial liquidation under section 302(b)(4) and (e) of the Code.

LAW AND ANALYSIS

Section 331(a)(2) of the Code, prior to the enactment of the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), provided that amounts distributed in partial liquidation of a corporation (as defined in pre-TEFRA section 346) were treated by a shareholder as payment in exchange for stock.

Section 346(a)(2) of the Code, prior to the enactment of TEFRA, provided that a distribution was treated as in partial liquidation of a corporation if the distribution was not "essentially equivalent to a dividend", was in redemption of a part of the stock of the corporation pursuant to a plan, and occurred within the tax year in which the plan was adopted or within the succeeding tax year. Before amendment by TEFRA, section 346(b) provided a safe-harbor rule under which the "not essentially equivalent to a dividend" requirement of former section 346(a)(2) was considered satisfied.

TEFRA transferred the treatment of distributions in partial liquidation from former section 331(a)(2) of the Code to section 302(b)(4), added by TEFRA, and the definition of the term "partial liquidation" from former section 346(a)(2) and (b) to section 302(e), also added by TEFRA. Section 222 of TEFRA, 1982-2 C.B. 462,498-500.

Section 302(a) of the Code provides that, if a corporation redeems its stock (within the meaning of section 317(b)), and if section 302(b) applies, the redemption is treated as a distribution in part or full payment in exchange for stock.

Section 317(b) of the Code provides that, for purposes of certain sections, including section 302, stock is treated as redeemed by a corporation if the corporation acquires its stock from a shareholder in exchange for property.

Section 302(b)(4) of the Code provides that section 302(a) applies to a distribution if the distribution is both (A) in redemption of stock held by a shareholder who is not a corporation, and (B) in partial liquidation of the distributing corporation.

Section 302(e)(1) of the Code provides that, for purposes of section 302(b)(4), a distribution is treated as in partial liquidation of a corporation if it is not "essentially equivalent to a dividend" (determined at the corporate level rather than at the shareholder level), is pursuant to a plan, and occurs within the tax year in which the plan is adopted or within the succeeding tax year. Section 302(e)(2) and (3) provides a safe-harbor rule similar to the safe-harbor rule in former section 346(b).

Under section 302(b)(4)(A) and (B) of the Code, respectively, two requirements for partial liquidation treatment are that (1) stock be redeemed and (2) the redemption be in partial liquidation within the meaning of section 302(e). The second requirement can be satisfied (as the facts here indicate it has been satisfied) irrespective of an actual stock surrender because under section 302(b)(4)(B) and (e) this requirement is tested at the corporate level, not the shareholder level, and is not concerned with stock ownership.

However, the first requirement -- that stock be redeemed -- is tested at the shareholder level. Moreover, the reference to section 317(b) of the Code in section 302(a) raises the question whether an actual surrender of stock is required for a transaction to be treated as a partial liquidation under section 302(b)(4).

Rev. Rul. 79-257, 1979-2 C.B. 136, concerning facts similar to the facts here, held that an actual surrender of stock by a sole shareholder was not required in partial liquidation under pre-TEFRA section 346 of the Code. A surrender of stock was seen as a meaningless gesture because the sole shareholder's interest in the corporation would have remained unchanged. In Rev. Rul. 81-3, 1981-1 C.B. 125, the Internal Revenue Service extended this holding to include all pro rata distributions in connection with partial liquidations under former section 346. But see Rev. Proc. 89-3, 1989- 1 C.B. 761, 766, Section 5.07.

The TEFRA conference report, in explaining the treatment of partial liquidations, states:

Under present law, a distribution in partial liquidation may take place without an actual surrender of stock by the shareholders (Fowler Hosiery Co. v. Commissioner), 301 F.2d 394 (7th Cir. 1962). A constructive redemption of stock is deemed to occur in such transactions (Rev. Rul. 81-3, 1981-1 C.B. 125). The conferees intend that the treatment of partial liquidations under present law section 346(a)(2) and (b) is to continue for such transactions under new section 302(e).

H.R. Conf. Rep. No. 760, 97th Cong., 2nd Sess. 530 (1982), 1982-2 C.B. 600, 628-29.

Section 317(b) of the Code requires a corporation to acquire its stock in order for a transaction to be treated as a redemption under section 302. As indicated by the above-quoted committee report, a deemed surrender of stock in a pro rata distribution satisfies the redemption requirement of sections 302 and 317(b) in partial liquidation transactions, just as a deemed surrender satisfied the redemption requirement under pre-TEFRA section 346(a)(2). In the situation presented by this revenue ruling, the requirement of sections 302 and 317(b) is met by a deemed surrender of stock.

HOLDING

The pro rata distribution by X to its shareholders, individuals A and B, qualifies as a distribution in redemption of stock held by A and B in partial liquidation of X under section 302(b)(4) and (e) of the Code, even though the shareholders did not surrender any of their stock.

See Rev. Rul. 77-245, 1977-2 C.B. 105, for computation of the tax consequences to A and B resulting from the partial liquidation.

EFFECT ON OTHER REVENUE RULINGS

Rev. Ruls. 81-3 and 79-275 are obsoleted.

DRAFTING INFORMATION

The principal author of this revenue ruling is Michael Danbury of the Office of Assistant Chief Counsel (Corporate). For further information regarding this revenue ruling contact Mr. Danbury on (202) 566-3544 (not a toll-free call).