Rev. Rul. 75-515

The Internal Revenue Service will not follow the decision in Meyer v. Commissioner, 383 F.2d 883 (8th Cir. 1967), rev'g and rem'g 46 T.C. 65 (1966), involving the question of the extent to which a deficit in earnings and profits survives an arrangement under Chapter XI of the Bankruptcy Act, 11 U.S.C. Ch. 11 (1970). The United States Court of Appeals held that earnings and profits may not be adjusted by reason of the cancellation of debt under such an arrangement.

In the Meyer case, the taxpayer owned 50 percent of the outstanding stock of the Meyer Jewelry Co. at the time the corporation was organized in 1946. By 1956, the corporation was involved in financial difficulty with the result that on July 3, 1956, an arrangement under Chapter XI of the Bankruptcy Act was approved by the Federal District Court. The corporation emerged from the proceeding with the same shareholders and the same charter. Among other things, the arrangement called for the payment by the corporation of certain debts only to the extent of 30 percent thereof. The remaining 70 percent of the debts that were cancelled served, in part, to reduce the corporation's basis in its retained assets as required by section 396 of the Bankruptcy Act. For its fiscal year ended June 30, 1956, the corporation had an accumulated deficit in earnings and profits.

During its fiscal year ending June 30, 1960, a distribution was made by the company to the taxpayer. The distribution was in excess of the earnings and profits of the corporation for that year.

The specific issue is whether there were sufficient accumulated earnings and profits as of July 1, 1959, so that the excess distribution would be taxed as a dividend. This, in turn, depends upon whether the cancellation of indebtedness in the arrangement (approved in 1956) under Chapter XI of the Bankruptcy Act, to the extent the cancellation was in excess of the reduction of basis of the assets under the Bankruptcy Act, was properly added to the corporation's accumulated earnings and profits.

The Tax Court of the United States reasoned that, to the extent of the basis adjustment, there is a deferral of profit until such time as the assets are sold. At that time any gain would be realized and recognized and would be added to the earnings and profits. Bangor and Aroostook Railroad Co., 16 T.C. 578 (1951), aff'd, 193 F.2d 827 (1st Cir. 1952), cert. denied, 343 U.S. 934 (1952). However, to the extent the cancellation of the debt exceeds the basis adjustment, failure to include the amount in earnings and profits immediately would mean that these amounts never would increase the earnings and profits. Therefore, the Tax Court held that the earnings and profits of the corporation were increased by the amount of its debts forgiven in the bankruptcy proceedings in excess of the amount available for reduction of the basis of its assets.

The United States Court of Appeals reversed the Tax Court on the earnings and profits issue. It concluded that section 395 of the Bankruptcy Act means that no income is "realized" when debt is adjusted in a bankruptcy proceeding. Similarly, see section 1.61-12(b) of the Income Tax Regulations. Although both section 395 of the Bankruptcy Act and section 1.61-12(b) of the regulations are concerned with the question of taxable income, the Court of Appeals decision in the Meyer case holds that these sections preclude any change in the amount of pre-bankruptcy deficit in earnings and profits as a result of cancellation of debt in an arrangement under Chapter XI of the Bankruptcy Act.

Section 395 of the Bankruptcy Act provides:

Taxes; income or profit from modification of indebtedness.

Except as provided in section 796 of this title, no income or profit, taxable under any law of the United States or of any State now in force or which may hereafter be enacted, shall, in respect to the adjustment of the indebtedness of a debtor in a proceeding under this chapter, be deemed to have accrued to or to have been realized by a debtor or a corporation organized or made use of for effectuating an arrangement under this chapter by reason of modification in or cancellation in whole or in part of any such indebtedness in a proceeding under this chapter: Provided, however, that if it shall be made to appear that the arrangement had for one of its principal purposes the evasion of any income tax, the exemption provided by this section shall be disallowed. (Emphasis added.)

Section 1.61-12(b)(1) of the regulations provides, in part, as follows:

(b) Proceedings Under Bankruptcy Act. (1) Income is not realized by a taxpayer by virtue of the discharge, under section 14 of the Bankruptcy Act (11 U.S.C. 32), of his indebtedness as the result of an adjudication in bankruptcy, or by virtue of an agreement among his creditors not consummated under any provision of the Bankruptcy Act, if immediately thereafter the taxpayer's liabilities exceed the value of his assets. Furthermore, unless one of the principal purposes of seeking a confirmation under the Bankruptcy Act is the avoidance of income tax, income is not realized by the taxpayer in the case of a cancellation or reduction of his indebtedness under--

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(ii) An "arrangement" or a "real property arrangement" confirmed under Chapter XI or XII, respectively, of the Bankruptcy Act (11 U.S.C. ch. 11, 12); * * *.

In general, the computation of earnings and profits of a corporation for dividend purposes is based upon reasonable accounting concepts that take into account the economic realities of corporate transactions as well as those resulting from the application of tax law. Thus, losses and expenses that are disallowed as a deduction for Federal income tax purposes, charitable contributions in excess of the limitations provided therefore, and other items that have actually depleted the assets of the corporation, even though nor reflected in the income computation, are allowed as deductions in computing earnings and profits. For the same reason, accretions to the wealth of a corporation, such as nontaxable income and exempt income, increase the corporate earnings and profits that are available for payment of dividends to shareholders. See section 1.312-6 of the regulations.

Under the facts of the Meyer case, income was not realized by the corporation for Federal income tax purposes as the result of a debt cancellation. However, the corporation derived an economic benefit to the extent of the debt cancelled. To properly reflect the economic benefit of the transaction on its books, the corporation must write off the debt cancelled and decrease the deficit in earnings and profits. Thus, where a debt cancellation occurs under a Chapter XI arrangement the amount to be added to the earnings and profits is that amount by which the cancellation of the debt exceeds the reduction of the basis in the retained assets. The amount so computed would reduce any deficit that may exist in the earnings and profits and, where such amount exceeds a deficit, create positive earnings and profits.

Accordingly, under the facts of the Meyer case, earnings and profits are to be increased by the gain resulting from the cancellation of the corporation's indebtedness, to the extent that such cancellation exceeds the amount by which the basis of the corporation's assets is reduced, even though such gain is not taxable to the corporation.

The above holding reflects the economic realities resulting from the arrangement under Chapter XI of the Bankruptcy Act as well as the appropriate application of section 1.61-12(b) of the regulations and will be applied by the Service where the facts are substantially the same as those in the Meyer case.