Recent private letter rulings prove partial liquidations are alive and well.

• Author: Bloom, Gilbert D.
• Position: IRS rulings

Background

Before the repeal of the General Utilities doctrine, partial liquidation treatment was highly prized. The distribution of assets in kind avoided corporate gain, shareholders recovered an allocable part of their basis on the receipt of the distributions, and capital gain rates -- significantly lower man ordinary income rates -- made the transaction attractive to shareholders. In addition, during the early 1980s, partial liquidations within the context of a consolidated return avoided the recapture rules of old section 334(b)(2) of the Internal Revenue Code, without jeopardizing a step-up in asset basis from a recent stock purchase.

The demise of the General Utilities doctrine, the narrowing of the ordinary income/capital gain rate differential, and the introduction of section 338 reduced the efficacy of partial liquidations. Ultimately, partial liquidations suffered the ignominy of the repeal of section 346 and the enactment of a subsection in the redemption rules (section 302(b)(4)). As evidenced by two recently released private letter rulings (Letter Ruling No. 9836027 (June 9, 1998) and Letter Ruling No. 199902001 (Oct. 30, 1998)), however, partial liquidations are alive and well.

Partial Liquidations

Section 302(b)(4) of the Code permits a redemption to be treated as "a distribution in part or full payment in exchange for the stock" (i.e., as a capital transaction rather than as a dividend) if both (1) it is a redemption from a noncorporate shareholder, and (2) it is a redemption in partial liquidation of the distributing corporation.

Section 302(e)(1) provides that a distribution will be treated as a partial liquidation if (1) the distribution is "not essentially equivalent to a dividend" and (2) the distribution is pursuant to a plan and occurs no later than the end of the tax year following the tax year in which the plan is adopted. The second of these requirements permits a maximum of eight quarterly "dividend" payments within a two-tax-year period to be under the umbrella of the partial liquidation.

The first requirement can be complicated. The term "not essentially equivalent to a dividend" for purposes of section 301(e)(1) does not have the same meaning that term has for purposes of section 302(b)(1). The former focuses on the effect of the transaction on the distributing corporation and the latter on the distributee shareholders. For purposes of section 301(e)(1), the phrase articulates the corporate contraction doctrine. The history of that doctrine is littered with contradictory results, and the entire genuine contraction approach to partial liquidation treatment has been roundly criticized. Moreover, the IRS will not ordinarily issue a ruling on the "genuine contraction" requirement unless there has been at least a 20-percent reduction in gross revenue, net fair market value of assets, and number of employees. Rev. Proc. 98-3, 1998-1 I.R.B. 100, [sections] 4.01(22). In many cases, it is difficult to achieve a partial liquidation using the "contraction" theory, because the 20-percent rule requires a significant reduction in the size of the distributing corporation.

Fortunately, the entire morass can be avoided if the distribution satisfies the safe harbor conditions of section 302(e)(2)'s "termination/retention" test. This safe harbor route to partial liquidation treatment not only sidesteps many thorny issues accompanying a genuine contraction analysis, but...