Minimizing the consequences of a partial liquidation.

• Author: Ellentuck, Albert B.
• Position: Case study

Facts: Lawrence is the sole shareholder of Lacorp, which has a fair market value (FMV) of $1.5 million. Lawrence's basis in his stock is $900,000.

* Lacorp sells industrial chemicals at both retail and wholesale. Seven years ago, Lacorp began manufacturing some of the chemicals it sells, with the intent of increasing its gross profit margin and reducing prices in order to gain a bigger market share.

* However, recent changes in liability and municipal restrictions associated with the manufacturing operations have resulted in a sharp decrease in profit. Therefore, Lacorp plans to discontinue its manufacturing operations and dispose of the equipment, which has an FMV and basis of $500,000. Lawrence would like to distribute the proceeds from this disposition.

Issue: How can the disposition of the manufacturing operations be structured to minimize Lawrence taxes on the distribution from the corporation?

Analysis

A redemption of stock in partial liquidation of a corporation is treated as an exchange or sale of stock by a noncorporate shareholder under Sec. 302(b)(4); as an exchange, a redemption qualifies for capital gain treatment. A distribution is considered a partial liquidation under Sec. 302(e)(1) if it is:

1. not essentially equivalent to a dividend,

2. pursuant to a plan of partial liquidation, and

3. made in the year the plan is adopted or the subsequent year.

   All assets used in the terminated business or the proceeds from the sale of the assets must be distributed to the shareholder. Other assets of comparable value cannot be substituted.

   When determining whether a distribution is a partial liquidation, the term "not essentially equivalent to a dividend" refers to the distribution's effect at the corporate level instead of at the shareholder level. According to Regs. Sec. 1.346-1 (a) (under former Sec. 346), an example of a distribution not essentially equivalent to a dividend is one that results from a genuine contraction of the corporation's business. Although there is no statutory definition of "genuine contraction," the IRS has ruled that, unless the contraction results in a significant reduction of the corporation's size, it is not considered a partial liquidation. Generally, the size of the corporation's business before the contraction is compared to the size afterward. Size refers to such factors as the number of stores, number of employees, types of services and assets.

   The courts and the Service have provided guidance in this...