Rev. Rul. 78-89

Advice has been requested concerning the Federal income tax consequences under sections 1373, 1375, and 1378 of the Internal Revenue Code of 1954 of the sale of assets and subsequent complete liquidation of a corporation, under the circumstances described below.

The corporation, which was in existence for three years, elected after its first year to be treated as a small business corporation. The board of directors and the shareholders of the corporation, which was not a collapsible corporation pursuant to section 341 of the Code and the regulations thereunder, and which was primarily engaged in the holding of land for investment purposes and the ownership and management of a hotel, adopted a plan of complete liquidation under the provisions of section 337. Pursuant to the plan of liquidation, the corporation sold the land and hotel and distributed to its shareholders all its assets (less a nominal amount of assets retained to meet claims) within the 12-month period beginning on the date the plan of complete liquidation was adopted.

Except as otherwise provided in the Code, such as section 1245, section 337 provides that if, within the 12-month period beginning on the date on which a corporation adopts a plan of complete liquidation, all of the assets of the corporation are distributed in complete liquidation, less assets retained to meet claims, then no gain or loss shall be recognized by the corporation from the sale or exchange by it of property within the 12-month period.

Section 1373(a) of the Code provides, in general, that the undistributed taxable income of an electing small business corporation for any taxable year shall be included in the gross income of the shareholders of the corporation in the manner and to the extent set forth in section 1373. Under section 1373(b), each person who is a shareholder of an electing small business corporation on the last day of the taxable year of the corporation shall include in gross income, for the taxable year in which or with which the taxable year of the corporation ends, the amount the shareholder would have received as a dividend, if on the last day there had been distributed pro rata to its shareholders by the corporation an amount equal to the corporation's undistributed taxable income for the corporation's taxable year.

For purposes of section 1373(c) of the Code, the term "undistributed taxable income" means taxable income (computed as provided in section 1373(d)) minus the sum of (1) the taxes imposed by sections 56 and 1378(a) and (2) the amount of money distributed as dividends during the taxable year, to the extent that any such amount is a distribution out of earnings and profits of the taxable year as specified in section 316(a)(2).

Section 1375(a)(1) of the Code provides that the amount includible in the gross income of a shareholder as dividends (including amounts treated as dividends under section 1373(b)) from an electing small business corporation during any taxable year of the corporation, to the extent that the amount is a distribution of property out of earnings and profits of the taxable year as specified in section 316(a)(2), shall be treated as a long-term capital gain to the extent of the shareholder's pro rata share of the corporation's net capital gain for the taxable year.

Section 1378(c)(1) of the Code provides that an electing small business corporation is subject to the tax imposed by section 1378(a) if the election has not been in effect for the three immediately preceding taxable years.

Pursuant to section 1378(a) of the Code, if for a taxable year of an electing small business corporation the net capital gain of the corporation exceeds $25,000, and exceeds 50 percent of its taxable income for the year, and the taxable income of the corporation for the year exceeds $25,000, there is imposed a tax on the income of the corporation.

Section 1378 of the Code was enacted imposing a tax upon the capital gains of a corporation that has elected the "passthrough" treatment under certain limited conditions. Congress did not intend the "passthrough" election to allow a corporation that has a large amount of capital gains realized in one year, to elect the "passthrough" treatment for that year, to distribute the realized capital gains, and then to deliberately cause its "passthrough" status to be terminated. That avoids a capital gains tax at the corporate level and substitutes capital gains tax for an ordinary (dividend) income tax at the shareholder level. The "passthrough" treatment was basically intended for an operating business that for business reasons desired the corporate structure yet preferred tax treatment similar to that accorded a partnership. It was intended for an organization desiring this tax treatment at least for a number of years and not for a single year as a device to avoid capital gains tax to the corporation.

Section 1.1372-1(c) of the Income Tax Regulations in general provides that to the extent other provisions of chapter 1 of the Code are not inconsistent with those under subchapter S of that chapter, the provisions will apply with respect to both the electing small business corporation and its shareholders in the same manner that they would apply had no election been made.

Section 1.1373-1(c) of the regulations provides in general that for purposes of section 1373 of the Code, with certain exceptions not here pertinent, taxable income is computed in the same manner as it would be computed if no election had been made.

In the instant case, because all of the assets of the corporation less assets retained to meet claims were distributed in complete liquidation, pursuant to the provisions of section 337 of the Code, the gain realized upon the sale of the land and hotel is not recognized by the corporation, except as otherwise provided in the Code, such as section 1245. This is not inconsistent with the provisions of section 1378.

Accordingly, under section 1373 of the Code and the regulations thereunder, the gain realized but not recognized by the corporation is not includible in the taxable income of the corporation and therefore is not included in the undistributed taxable income of the corporation. Because the gain from the sale of the land and the hotel is not included in the corporation's taxable income or undistributed taxable income, no part of the gain is includible in the gross income of the shareholders under sections 1373 and 1375, and the corporation is not subject to the tax imposed by section 1378 on the gain from the sale. Gain required to be recognized by the corporation, for example under section 1245, is ordinary income and, therefore, is also not subject to the tax imposed by section 1378. However, under section 1001, the shareholders will realize gain on the liquidation to the extent that amounts distributed to them in liquidation (including any amounts attributable to sales proceeds, exceed the adjusted basis of their stock.