Rev. Rul. 73-490

Advice has been requested concerning the treatment of distributions received by a shareholder in the situations described below where a corporation liquidates and the sole shareholder elects to recognize the gain realized in the manner prescribed by section 333 of the Internal Revenue Code of 1954.

Situation 1

All of the stock of X, a domestic corporation, was owned by A, an individual who files his Federal income tax return on the basis of a calendar year. X had assets consisting of cash of 35x dollars, land with a fair market value of 50x dollars, and machinery with a fair market value of 25x dollars. A's basis in his X stock, which he had acquired in a single block, was 21x dollars. X executed a plan of complete liquidation pursuant to the provisions of section 333 of the Code. In accordance with the plan X distributed to A, within the calendar month of August 1972, all of its assets except 20x dollars in cash which X retained as a reserve to cover a potential adverse judgment in a pending lawsuit. On August 31, 1972 X had accumulated earnings and profits of 30x dollars. A timely and properly elected to have the benefits of section 333 apply to the gain realized by him on the liquidation. It was determined upon audit of X's Federal income tax return that the arrangements in establishing the reserve were made in good faith and the amount set aside was reasonable. A judgment was subsequently rendered in favor of X and, in April 1973, X distributed the 20x dollars of retained cash to A.

Situation 2

The facts are the same as in Situation 1 except that a judgment was rendered against X, and X used all of the 20x dollars to satisfy the judgment in 1973.

Situation 3

The facts are the same as in Situation 2 except that A sold the land, which was a capital asset in his hands, in August 1972 for 50x dollars, under circumstances where it is certain that the land was sold by A and not by X. Furthermore, A retained the piece of machinery, which he used in his business, and began taking depreciation deductions in 1972.

The retention by a corporation of a reasonable amount of cash to meet contingent liabilities in a distribution otherwise meeting the requirements of section 333 of the Code does not violate the requirement of subsection 333(a)(2) that the transfer of all the property under the liquidation must occur within some one calendar month. See section 1.333-1(b) of the Income Tax Regulations; also see Rev. Rul. 56-286, 1956-1 C.B. 172.

Section 333(e) of the Code provides:

(e) NONCORPORATE SHAREHOLDERS.--In the case of a qualified electing shareholder other than a corporation--

(1) there shall be recognized, and treated as a dividend, so much of the gain as is not in excess of his ratable share of the earnings and profits of the corporation accumulated after February 28, 1913, such earnings and profits to be determined as of the close of the month in which the transfer in liquidation occurred under subsection (a)(2) but without diminution by reason of distributions made during such month; but by including in the computation thereof all amounts accrued up to the date on which the transfer of all the property under the liquidation is completed; and

(2) there shall be recognized, and treated as short-term or long-term capital gain, as the case may be, so much of the remainder of the gain as is not in excess of the amount by which the value of that portion of the assets received by him which consists of money, or of stock or securities acquired by the corporation after December 31, 1953, exceeds his ratable share of such earnings and profits.

Section 334(c) of the Code provides that the basis of assets received in a liquidation to which section 333 applies shall be the same as the shareholder's basis in the stock, decreased by money received and increased by gain recognized under section 333(e). Section 1.334-2 of the regulations provides, in part, that the amount thus arrived at will be allocated to the various assets received in accordance with their fair market values.

In situations 1, 2, and 3, A realized a gain on the liquidation for the taxable year 1972 of 69x dollars (fair market value of total distribution received, 90x dollars, less A's basis in the X stock, 21x dollars). A, in accordance with section 333(e)(1) of the Code, recognized this gain to the extent of 30x dollars (the accumulated earnings and profits of X on August 31, 1972) and treated this amount as a dividend in his income tax return for 1972. No part of the gain was recognized as capital gain under section 333(e)(2) of the Code since the amount of money received by A (15x dollars) did not exceed the accumulated earnings and profits of X on August 31, 1972.

The 20x dollars received during 1973 is additional gain realized by A on the liquidation of X and is recognized to the extent and in the same manner in 1973 as if it had been received during the one calendar month of August 1972. Thus, if A had received the 20x dollars during August 1972, the amount of gain realized on the liquidation and treated as a dividend under section 333(e)(1) of the Code would still have been 30x dollars (the accumulated earnings and profits of X on August 31, 1972), but the amount of gain treated as a capital gain under 333(e)(2) would have been 5x dollars (the amount by which the money received, 35x dollars, exceeded the accumulated earnings and profits of X on August 31, 1972, 30x dollars). Accordingly, the 5x dollars is treated as a capital gain realized by A in 1973, the year in which the 20x dollars was received.

For the sole purpose of determining the basis of the assets received, the 20x dollars in cash retained by X is considered as if it had been distributed in August 1972. Thus, in situation 1, pursuant to section 334(c) of the Code and the regulations thereunder, the basis of the land was 14x dollars and the basis of the machinery was 7x dollars in A's hands (A's basis in X stock, 21x dollars, decreased by the money received, 35x dollars, and increased by the gain recognized, 35x dollars, with the amount thus arrived at, 21x dollars, allocated to the land and the machinery in accordance with their fair market values at the date of distribution, 50x dollars and 25x dollars, respectively).

The subsequent distribution of the 20x dollars in April 1973 requires no adjustments to the bases of the assets received since their bases were computed in August 1972 as if the 20x dollars had been received by A at that time.

In situation 2, since the 20x dollars was used to satisfy the judgment against X, the basis of the assets received in 1972 would be adjusted in 1973 to reflect the fact that A never received the cash. Thus, after this adjustment, the land would have a basis of 24x dollars and the machinery would have a basis of 12x dollars (A's basis in the X stock, 21x dollars, decreased by the money received, 15x dollars, and increased by the gain recognized, 30x dollars, with the amount thus arrived at, 36x dollars, allocated to the land and the machinery in accordance with their respective fair market values at the date of distribution, 50x dollars and 25x dollars, respectively).

In situation 3, A would recognize gain of 36x dollars on the sale of the land which would be reported in his income tax return for 1972 as capital gain (amount realized, 50x dollars, less basis of 14x dollars). However because the 20x dollars was expended by X in April 1973 to satisfy the judgment, A will be considered to have sustained a capital loss of 10x dollars in 1973 to reflect the fact that the 20x dollars was treated as though it had been distributed as part of the liquidation distribution in August 1972 for the purpose of determining the basis of the land in computing the amount of gain on its sale. Furthermore, since A retained the machinery and had begun taking depreciation deductions in 1972 using a basis of 7x dollars, an adjustment to the basis in April 1973 because the 20x dollars was not distributed would entitle A to increase his basis to 12x dollars for 1973 with a related increased allowable depreciation deduction starting in 1973. After the adjustment in April 1973, the unrecovered basis of the machinery would be 12x dollars less the depreciation deduction for 1972.