Citations: Rev. Rul. 79-10; 1979-1 C.B. 140
Rev. Rul. 79-10
Whether a non pro rata liquidating distribution to shareholders of a corporation having only one class of stock outstanding will be treated for federal income tax purposes as having been made pro rata to each of the shareholders.
Individual A formed corporation X to engage in a business enterprise. X issued 70,000 shares of no par value common stock to A at a price of 1x dollars per share. Shortly thereafter X, through a public offering, sold an additional 30,000 shares of the same class to approximately 1,000 shareholders (minority shareholders) at a price of 5x dollars per share.
Several years later, A, possessing the requisite voting power under state law, decided that X should be liquidated.
Under the circumstances at the time, if X had made a pro rata liquidation distribution, the minority shareholders would have suffered losses on their investments while A would have realized a substantial gain as a result of the relatively lower purchase price paid by A for the X stock. For various reasons, A decided to avoid this result by accepting less than the pro rata share of the liquidating distribution to which A was entitled so that the minority shareholders would receive more than the pro rata share of the distribution to which they were entitled, ensuring to the minority shareholders a profit from their investment.
Accordingly, on December 10, 1977, X adopted a plan of complete liquidation and distributed its property to its shareholders, in such non pro rata amounts, in exchange for their stock. In each case, the amount received by the shareholder exceeded the adjusted basis of the X stock surrendered in liquidation. The X stock was a capital asset, as defined in section 1221 of the Internal Revenue Code of 1954, in the hands of each shareholder. X was not a collapsible corporation as defined in section 341(b). X had no other stock outstanding.
LAW AND ANALYSIS
Section 331(a)(1) of the Code provides that amounts distributed in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock.
The legislative background of section 331(a)(1) of the Code indicates that Congress intended to have liquidating distributions treated as if they were proceeds of a sale of stock. S. Rep. No. 398, 68th Cong., 1st Sess. 11 (1924), 1939-1 (Part 2) C.B. 266, 274. In other words, a liquidating distribution is viewed as the proceeds of a purchase of the shareholder's interest by the corporation. Langstaff v. Lucas, 13 F.2d 1022, cert. denied, 273 U.S. 721 (1926). Since section 331(a)(1) confers "exchange" status upon the liquidating proceeds, they will generally qualify for capital gain or loss treatment provided the stock of the liquidating corporation is a capital asset in the hands of the shareholder and the corporation is not a collapsible corporation subjecting the shareholder to treatment under section 341(a).
The amount realized by the shareholder on the surrender of his stock should be measured by his pro rata share of the assets. If a shareholder receives an amount that is less than his pro rata share, he will be treated for federal income tax purposes as if he had received his pro rata share, and the difference will be treated as if it had been used in a separate transaction to make gifts, to pay compensation, to satisfy obligations of the transferor of any kind, or otherwise depending upon the particular facts and circumstances. Compare section 1.351-1(b)(1) of the Income Tax Regulations which states that the entire transaction will be given tax effect in accordance with its true nature when property is transferred to a corporation by two or more persons and the stock and securities received by each is received in disproportion to the interests transferred to the corporation. See also Rev. Rul. 76-454, 1976-2 C.B. 102, and Rev. Rul. 73-233, 1973-1 C.B. 179, both of which adopt and illustrate the approach described in section 1.351-1(b)(1) in the context of a section 351 transfer and a statutory merger, respectively.
The non pro rata liquidating distribution to the shareholders of X is treated for federal income tax purposes as if there had been a pro rata distribution to each shareholder by X in full payment in exchange for each shareholder's X stock, together with a transfer by A to the minority shareholders of an amount equal to the excess of the amount received by the minority over the minority's pro rata share of the liquidating distribution. In substance, the amounts received by the minority shareholders of X represented the total of two separate transactions: the first being the receipt of their pro rata share of the liquidating proceeds, and the second being a payment attributable to A in an amount equal to the excess over their pro rata share. A is deemed to have received his entire pro rata share of the liquidating distribution. The difference between A's pro rata share and the amount actually received by A is treated as having been paid over by A to the minority shareholders in a separate transaction. The federal tax consequences of that transaction will depend upon the underlying nature of the payments which in turn depends upon all of the relevant facts and circumstances, which must be determined from all of the extrinsic and intrinsic evidence surrounding the transaction.