Rev. Rul. 76-347

Advice has been requested whether cash equal to a shareholder's net share of previously taxed income is distributable without recognition of gain upon liquidation of an electing small business corporation pursuant to section 333 of the Internal Revenue Code of 1954.

X, an electing small business corporation that files its Federal income tax return on a calendar year basis, has for several years had one shareholder, A. As of January 1, 1975, all shares of X stock owned by A had the same basis, and holding periods in excess of six months. A's basis for all the X stock was 30x dollars, and A's share of previously taxed income was 12x dollars. X had accumulated earnings and profits of 5x dollars.

On November 3, 1975, a plan of liquidation was adopted and A filed a valid election to postpone recognition of gain under section 333 of the Code. On November 5, 1975, pursuant to the plan of liquidation, X distributed all its cash, 13x dollars, to A. On November 19, 1975, in a final liquidating distribution, the remainder of X's assets having a fair market value of 37x dollars was distributed to A. As of November 19, 1975, without regard to the liquidating distributions, X had 1975 taxable income and current earnings and profits of 4x dollars. X made no other distributions during 1975.

Section 1.1373-1(a) of the Income Tax Regulations provides that each person who is a shareholder of an electing small business corporation on the last day of the corporation's taxable year must include in gross income the amount the shareholder would have received as a dividend if on such last day the corporation distributed pro rata to its shareholders an amount of money equal to its undistributed taxable income for the corporation's taxable year. The amount of this constructive distribution is determined in accordance with section 316 of the Code, and increases the shareholders' basis for their stock under section 1376(a). These rules apply also in respect of the short taxable year in which the corporation is liquidated. See Example (6) in section 1.1373-1(g).

Section 1.1375-4(b) of the regulations provides that actual distributions of money by an electing small business corporation that are in exchange for stock cannot be considered distributions of a shareholder's net share of previously taxed income.

Under section 1.333-4 of the regulations amounts received by a qualified electing shareholder of a corporation liquidated pursuant to section 333 of the Code are treated as received in exchange for stock as provided in section 331, and gain recognized from the receipt of such amounts is determined under section 1001. Gain or loss must be computed separately on each share of stock owned by a qualified electing shareholder. If certain stock and securities are not distributed in the liquidation, the gain recognized by a qualified electing shareholder is the greater of the money received or the shareholder's ratable share of accumulated earnings and profits as of the last day of the month of liquidation without diminution by distributions during such month. If the qualified electing shareholder is not a corporation, to the extent of such ratable share of accumulated earnings and profits, the gain is taxable as a dividend and the gain in excess of such ratable share is treated as short-term or long-term capital gain, as the case may be.

Accordingly, under section 1.1373-1(a) of the regulations, X's 1975 taxable income of 4x dollars must be included in A's gross income for 1975 as a constructive distribution of undistributed taxable income. Also, under the rules contained in section 1.373-1(e), the earnings and profits of the taxable year, 4x dollars, are allocated to this constructive distribution, and do not become part of the accumulated earnings and profits of X. As a result of such constructive distribution A's basis for the stock in X is increased from 30x dollars to 34x dollars. Since, as provided by section 1.333-4 of the regulations, the cash and property distributed in the liquidation are treated as received in exchange for stock, pursuant to section 1.1375-4(b) no portion of the cash distribution of 13x dollars is a distribution of A's net share of previously taxed income.

Thus, on the liquidation A realized gain of 16x dollars, this is, the excess of the cash and fair market value of the other assets received, 50x dollars, over A's basis for the X stock, 34x dollars. Under section 333(e) of the Code, since the amount of cash distributed, 13x dollars, exceeds A's ratable share of X's accumulated earnings and profits of 5x dollars, A has a recognized gain of 13x dollars. The gain of 5x dollars, which is the amount of A's ratable share of X's accumulated earnings and profits, is treated as a dividend, and 8x dollars, the remainder of the gain, is treated as long-term capital gain. Under section 334(c), A's basis for the other property received in the liquidation is 34x dollars, that is, A's basis for the X stock, 34x dollars, decreased by the amount of money received, 13x dollars, and increased by the gain recognized, 13x dollars.

If the facts were the same except that, instead of distributing the 13x dollars of cash to A pursuant to the plan of liquidation, X distributed the cash to A in 1975 prior to the adoption of the plan of liquidation, the consequences of the transaction would be as follows. Under section 1.1373-1(d) of the regulations the 4x dollars of earnings and profits for 1975 would be allocated to the distribution and included in A's gross income for 1975 as a dividend from current earnings and profits. Under section 1.1375-4 the remaining 9x dollars distributed would be considered a distribution of previously taxed income and would reduce A's basis for the stock in X from 30x dollars to 21x dollars; the earnings and profits of X would not be reduced on account of this distribution of previously taxed income. On the liquidation A would realize a gain of 16x dollars, that is, the excess of the fair market value of the assets received as a liquidation distribution, 37x dollars, over A's basis for the X stock, 21x dollars. Under section 333(e) of the Code, since no cash would be distributed in the liquidation, A's recognized gain would be limited to 5x dollars, the amount of A's ratable share of X's accumulated earnings and profits, and this gain would be treated as a dividend. Under section 334(c), A's basis for the property received in the liquidation would be 26x dollars, that is, A's basis for the X stock, 21x dollars, increased by the gain recognized, 5x dollars.