Partial liquidations: The forgotten section 302(b) redemption category

ARTICLE | November 01, 2022

Authored by RSM US LLP

Corporations that sell all or part of a business to third parties often look for ways to transfer the net sales proceeds to shareholders in a tax-efficient manner. Companies may structure such transfers so that their shareholders are taxed at (lower) capital gains rates and can offset the redemption amount by their stock basis rather than recovering earnings. As indicated above, many companies and their shareholders assume some version of the following choice:

• Distributions of cash or stock buybacks that do not significantly reduce a shareholder’s stock interest in the corporation are dividends to the extent made out of E&P. Dividends may be taxed at higher ordinary tax rates or, if a qualified dividend, taxed at capital gain rates. In either case, no stock basis reduction is permitted.
• Stock buybacks that reduce a shareholder’s interest by a significant amount—i.e., the buyback falls within section 302(b)(1), (2), or (3)—are treated as the sale or exchange of a capital asset.¹

However, companies that sell a business and transfer the net sales proceeds to shareholders must consider whether they have undergone a partial liquidation. As discussed below, this often-overlooked category of capital redemptions—found in section 302(b)(4)—does not fit neatly into the binary described above.

Overview of partial liquidations

Under other section 302(b) redemption categories, the effect of the distribution on shareholder level ownership is determinative. In determining whether a distribution qualifies as a partial liquidation, by contrast, the focus is on the effect of the distribution on the corporation rather than its shareholders. This differentiates section 302(b)(4) from other section 302(b) categories, which are based upon reductions in a shareholder’s ownership of a corporation. For this reason, a pro rata distribution of cash or other property to shareholders may qualify as a redemption in partial liquidation of a corporation.²

To be specific, there are two main requirements under section 302(b)(4). First, the distribution must be made in partial liquidation of the corporation, which occurs if the distribution is not essentially equivalent to a dividend. For our purposes, the phrase “not essentially equivalent to a dividend” is distinct from the standard, commonly known definition in section 302(b)(1). Rather, it is defined as follows:³

• Safe Harbor: A distribution attributable to the corporation ceasing to conduct one qualifying trade or business falls within a safe harbor definition of a partial liquidation if the corporation continues conducting another qualifying trade or business.⁴
• Corporate Contraction: A distribution resulting from a “genuine contraction” of the corporate business—including a full or partial sale of the business—is also a partial liquidation.⁵ Determining whether a corporate contraction has occurred involves myriad factors, including (a) the presence of a business purpose, (b) the motivation for the distribution, (c) the amount of reduction in corporate business activity, and (d) the past dividend policy.⁶

In order to be classified as a partial liquidation, the distribution must occur pursuant to a plan of liquidation and occur either within the taxable year of the plan or within the next taxable year.⁷

In addition, there must be a “redemption” of stock held by a non-corporate shareholder. In the case of a pro rata distribution, however, shareholders are not required to actually surrender shares of stock, meaning in form it does not have to be structured as a redemption or repurchase. The IRS and courts have deemed such a formal redemption as a “meaningless gesture.”⁸ On a practical level, therefore, a corporation that sells a business and distributes the net proceeds pro rata to its shareholders may have effected a “sale or exchange” redemption rather than a section 301 distribution.

The tax consequences of a partial liquidation to shareholders

Shareholders may welcome partial liquidation treatment or, conversely, find it undesirable, depending upon the situation. Consider a situation where a C corporation with a high amount of E&P wants to effect a distribution to shareholders out of the net proceeds from the sale of a business.

Example 1. X, a C corporation, is closely held by individual shareholders and has actively operated two equally valued businesses for over 5 years: A and B. In Year 1, X sells business A for net proceeds of $100. Thereafter, X continues to operate business B. X wishes to effect a distribution of the proceeds to all of its shareholders without altering their percentage ownership interests (i.e., pro rata). X’s E&P is in excess of the $100 net proceeds.

Because X’s E&P exceeds its net proceeds from the sale of business A, the shareholders may prefer that the distribution be taxed as a capital redemption rather than a dividend. Even if a dividend were taxed at capital gains rates (as a “qualified dividend”), a capital redemption allows shareholders the benefit of basis recovery.⁹ Thus, X should carry out a distribution of the $100 pro rata to its shareholders pursuant to a formal plan of partial liquidation. The distribution must be made in Year 1 or Year 2.

Notably, X’s distribution is made in partial liquidation only to the extent of net proceeds from the sale of business A. Any proceeds X uses to pay off liabilities or for investment in another active business reduces the net proceeds available for a distribution in partial liquidation. Further, had X received (and retained) rollover equity in the buyer, the value of that rollover equity likely could not be counted as part of the net sales proceeds available for distribution.¹⁰

Alternatively, consider a similar situation, but with an S corporation that has a high AAA. In this case, the shareholders may find partial liquidation treatment undesirable (i.e., they may prefer a dividend out of AAA to a redemption).

Example 2. S, an S corporation since its formation, is closely held and has actively operated the equally valued businesses for over 5 years: E and F. In Year 1, S sells business E for net proceeds of $50. Thereafter, S continues to operate business F. S’s AAA is in excess of the $50 net proceeds. S wishes to effect a distribution of the $50 net proceeds to its shareholders in the most tax efficient manner.

If S’s $50 distribution were treated as a section 301 distribution, it would be completely tax-free to the shareholders due to S’s high AAA. If we assume that the distribution is tied to proceeds from the sale of business E, however, it may be difficult to avoid characterization of the distribution as a partial liquidation. Rather than receiving a nontaxable distribution, therefore, S’s shareholders may be taxed at capital gains rates on the $50 distribution. If practical, however, S could avoid this outcome (i.e., section 302(b)(4) treatment) by waiting until Year 3 to make the $50 distribution.¹¹

Conclusion

Companies that want to transfer net proceeds from an asset sale to shareholders in a tax efficient manner need to be aware of the rules for partial liquidations, an often-overlooked section 302(b) redemption category (particularly, for S corporations). Because partial liquidations focus mainly on corporate level activity, companies should be aware of their obligation to report accurately any distribution in partial liquidation to its shareholders. For corporations with significant E&P that want to transfer to shareholders their net sales proceeds from the sale of a business, the partial liquidation category can be beneficial. For S corporations with significant AAA that anticipate distributing their net proceeds tax-free, however, the partial liquidation category can be a trap for the unwary. Taxpayers should consult a tax adviser regarding any application of the items discussed in this article.

¹ Unless otherwise stated or clear from the context, all references to “section” or “§” in this memorandum are to the Internal Revenue Code of 1986 (the “Code” or “IRC”), as amended, and all references to “regulation section” or “Reg. §” are to the regulations promulgated under the Code.

² Section 302(e)(4)(A).

³ Section 302(e)(1).

⁴ Section 302(e)(2). A “qualified trade or business” is a business that was actively conducted for the 5-year period ending on the redemption date and that was not acquired by the distributing corporation during that 5-year period in a gain or loss transaction. See section 302(e)(3).

⁵ See Reg. § 1.346-1(a).

⁶ See e.g., Imler v. Commissioner, 11 T.C. 836 (1948); Rev. Rul. 74-296, 1974-1 C.B. 80. (discontinuation of business activities resulted in genuine corporate contraction).

⁷ Section 302(e)(4)(B). An informal plan of liquidation may exist based upon the facts and circumstances surrounding the distribution. Naturally, companies that desire partial liquidation treatment should create formal, written plan to distribute any proceeds from the full or partial sale of a business.

⁸ See Rev. Rul. 70-240, 1970-1 C.B. 81 (where there is identical ownership of target and acquiring corporation, the requirement that the acquiring corporation in a D reorganization exchange stock is a meaningless gesture where). See also Flower Hosier Co. v. Commissioner, 36 T.C. 201 (1961), aff’d 301 F.2d 394 (7th Cir. 1962) (pro rata distribution to shareholders pursuant to a partial liquidation did not require surrender of stock); Rev. Rul. 81-3, 1981-1 C.B. 125, obsoleted by Rev. Rul. 90-13, 1991-1 C.B. 65 (same); and PLR 9619050 (Feb. 8, 1996) (same).

⁹ While a dividend from X may be treated as a qualified dividend (i.e., taxed at long-term capital gains rates), shareholders can partially offset the distribution from X against their stock basis if it is treated as a capital redemption instead of a dividend. See Rev. Rul. 90-13, 1990-1 C.B. 65 (constructive redemption of stock deemed to occur in a distribution in partial liquidation of a corporation).

¹⁰ It is possible for a corporation to temporarily invest its net proceeds in passive investments during any interim period between the sale of the business and the distribution. However, only the principal amount of the investment, and not the appreciation or return on investment, constitutes net proceeds. See Rev. Rul. 71-250, 1971-1 C.B. 112.

¹¹ Rev. Rul. 77-468, 1977-2 C.B. 109 (permissible delay of distribution avoided former section 346). Note that failing to adopt a plan of partial liquidation may be a problematic solution, as an informal plan can be found if no formal plan exists. See e.g., Eustice, Kuntz & Bodanski, ¶13.03[1], Federal Income Taxation of S Corporations (WG&L).