Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 78-25

1978-1 C.B. 270

Sec. 1341

IRS Headnote

Restoration of amount previously included in income. A shareholder who realized a capital gain of more than $3,000 in 1976 as the result of the sale of all of the assets of a liquidated corporation, which amount was included in income in that year, and who in 1977 paid the purchaser of the assets more than $3,000 as a result of failure to fulfill conditions of the purchase agreement is entitled to a capital loss deduction in 1977 for the amount paid and is entitled to compute tax liability for 1977 under section 1341 of the Code.

Full Text

Rev. Rul. 78-25

Advice has been requested whether, under the circumstances described below, the taxpayer is entitled to compute tax liability under section 1341 of the Internal Revenue Code of 1954 for the restoration of an amount that was previously included in gross income.

A, an individual, owned 75 percent of the outstanding stock of X corporation. X was the common parent and owned all the stock of three domestic corporations that were engaged in the sale of real estate, the publication of periodicals pertaining to real estate, and in other related activities.

In 1976, X adopted a plan of liquidation and pursuant thereto sold for $1,000x all of its assets, consisting primarily of the stock of its subsidiaries, to Y, an unrelated corporation. Under the terms of the purchase agreement, X placed $150x in escrow to indemnify Y against liabilities, damages and costs incurred as the result of the failure of A or X to fulfill the conditions specified in the agreement.

In 1976, X distributed all of its assets, except the $150x escrowed amount, to its shareholders. The liquidation of X was completed in 1976 and met the requirements of section 337 of the Code.

The amount received by A in liquidation of X resulted in a capital gain of more than $3,000 that A included in gross income for 1976 because it appeared that A had an unrestricted right to such amount. In 1977, a judgment was rendered against a former subsidiary of X, with respect to a transaction that occurred in 1975. As a result of this judgment, Y took legal action against X under the agreement. Later in 1977, as a result of this action, A paid Y more than $3,000, in addition to the 150x dollars paid from the escrow account.

Section 1341 of the Code provides rules for the computation of tax where a taxpayer is entitled to a deduction in excess of $3,000 as a result of restoring an amount included in gross income for a prior taxable year because it appeared that the taxpayer had an unrestricted right to such amount in that year.

Under section 1341(a) of the Code the tax imposed for the taxable year is the lesser of the amounts computed with such deduction, or the amount computed without such deduction but reduced by the decrease in tax for the prior taxable year attributable to the exclusion of such item.

In discussing section 1341 of the Code, the report of the Committee on Finance, S. Rep. No. 1622, 83rd Cong., 2d. Sess. 452 (1954), states:

The section will apply to cases of transferee liability such as Arrowsmith v. Commissioner, 344 U.S. 6 (1952). Thus, while the deduction in the current year is capital in nature, the taxpayer is not deprived of all relief because his tax is reduced at least to the extent of the tax attributable to the prior inclusion.

A similar statement concerning the applicability of section 1341 of the Code is contained in H. Rep. No. 1337, 83rd Cong., 2d Sess. A294 (1954).

In Arrowsmith v. Commissioner, 344 U.S. 6 (1952), 1952-2 C.B. 136, two stockholders who had equal ownership in a corporation, liquidated the corporation and divided the proceeds. The stockholders reported the profits realized from the transaction as capital gains. In a subsequent year, a judgment was rendered against the former corporation. The two former stockholders were required to and did pay the judgment for the former corporation because they were transferees of the former corporation's assets. The Supreme Court of the United States held that the losses resulting from the payment of the judgment were incurred because of a legal obligation arising out of a prior liquidation. Therefore, because the transaction in the prior year resulted in capital gains, the loss in the subsequent year is a capital loss.

Accordingly, in view of Arrowsmith, the amount paid by A to Y is allowed as a capital loss deduction in 1977. Further, to the extent such amount was included in A's gross income for 1976, A is entitled to compute Federal income tax liability for 1977 under section 1341 of the Code.