Rev. Rul. 74-396

Advice has been requested whether the "tax-benefit rule" applies under the circumstances described below.

The shareholders of X corporation sold all their stock to Y corporation for a price in excess of the adjusted basis of X's assets. Subsequently, X was completely liquidated in a transaction governed by sections 332 and 334(b)(2) of the Internal Revenue Code of 1954. Neither X nor Y reported gain or loss on the distribution of X's assets under the provisions of sections 336 and 332, respectively. Y determined the basis of the property received from X in liquidation under section 334(b)(2) by allocating the purchase price of the X stock to the relative fair market values of the assets on the date of liquidation.

75x dollars of the purchase price was allocated by Y to supplies of tools, dies, and molds with a useful life of one year or less that were part of the property distributed in liquidation. These supplies were either partially or completely unused. The entire cost of the supplies, purchased in the year prior to its liquidation, had been properly deducted by X in that year as "incidental" supplies for which no physical inventories were taken under section 1.162-3 of the Income Tax Regulations and for which X received a full tax benefit. Although no record of consumption was maintained, it was determined that the 75x dollars allocated to the supplies was not in excess of their cost. X purchased no such supplies in the year it liquidated.

The question presented is whether the 75x dollars allocated to these supplies under section 334(b)(2) of the Code must be taken into the income of X at the time of liquidation even though section 336 provides that no gain or loss shall be recognized to a corporation on the distribution of property in partial or complete liquidation.

In Anders v. Commissioner, 414 F.2d 1283 (10th Cir. 1969), the court, following Rev. Rul. 61-214, 1961-2 C.B. 60, held that the tax-benefit rule applied when a corporation sold expensed linen supplies pursuant to the non-recognition of gain provision of section 337 of the Code. The purpose of enacting section 337 was to make tax considerations a neutral factor in the determination of whether a liquidating corporation would itself sell its assets and distribute the proceeds, or, alternatively, distribute the assets to its shareholders for sale at that level. See S. Rep. No. 1622, 83d Cong., 2d Sess. 48 (1954). Applying the tax-benefit rule to liquidations to which section 336 applies insures that tax considerations will remain a neutral factor in this determination.

Accordingly, in the instant case, since X received a full tax benefit in prior tax years, it must include in its gross income under section 61 of the Code for the year in which it was liquidated the 75x dollars allocated to the supplies under section 334(b)(2).

In view of this position, the Internal Revenue Service considers the interpretation of "recovery" in Commissioner v. South Lake Farms, Inc., 324 F.2d 837 (9th Cir. 1963), aff'g 36 T.C. 1027 (1961) to be erroneous. In that case the court concluded that the tax-benefit rule did not apply to liquidations in which no gain or loss is recognized to the liquidating corporation by virtue of section 336. The court reasoned that since the liquidating corporation did not receive or become entitled to receive money or property equal to the amount previously spent and deducted, there could be no "recovery."

Recovery, for purposes of the tax-benefit rule, however, does not require that the taxpayer actually receive or become entitled to receive money or property. In William H. Block, 39 B.T.A. 338 (1939), aff'd sub nom. 111 F. 2d 60 (7th Cir. 1940), cert. denied 311 U.S. 658 (1940), the Board in discussing what constitutes a "recovery" stated, in part, as follows:

Income tax liability must be determined for annual periods on the basis of facts as they existed in each period. When recovery or some other event which is inconsistent with what has been done in the past occurs (Emphasis added), adjustment must be made in reporting income for the year in which the change occurs. No other system would be practical in view of the statute of limitations, the obvious administrative difficulties involved, and the lack of finality in income tax liability which would result. * * *

Accord, e.g. Mayfair Minerals, Inc., 56 T.C. 82 (1971), and Rev. Rul. 68-223, 1968-1 C.B. 154; Anders v. United States, 462 F. 2d 1147 (Ct. Cl. 1972).

In the instant case, X's deductions in its prior taxable year for the cost of incidental supplies were allowed under section 1.162-3 of the regulations on the assumption that the supplies would be used although not necessarily entirely in the year of purchase. However, because of the distribution of the supplies in the liquidation, X was foreclosed from using all of the supplies, a situation inconsistent with the reason for the prior deductions within the meaning of the decision in William H. Block, above. As such, the prior deductions to the extent of 75x dollars allocated to the supplies distributed in the liquidation are "recovered" for the purpose of the tax benefit rule.

This ruling applies equally to distributions governed by sections 331, 333, and 346 of the Code but does not apply to acquisitions of assets that are within the scope of section 381(a)(1) inasmuch as under section 381(c)(12), the acquiring corporation includes in its income such amounts as would have been includible by the distributor corporation in accordance with section 111 and the regulations thereunder.