Internal Revenue Service
Revenue Ruling

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 Rev. Rul. 78-55

1978-1 C.B. 88

Sec. 346

IRS Headnote

Partial liquidation; distribution of unneeded cash reserve. A mass transit corporation's distribution of a cash reserve for bus replacement in redemption of a portion of its shareholders' stock under a plan of partial liquidation, after entering into an agreement to continue operating the transit service under a subsidy arrangement with a regional transit authority that would make all future bus purchases, did not represent a genuine contraction of the corporate business; and the distribution does not qualify as a distribution in partial liquidation within the meaning of section 346(a)(2) of the Code.

Full Text

Rev. Rul. 78-55

Advice has been requested whether, under the circumstances described below, amounts distributed by a corporation qualify as amounts distributed in partial liquidation within the meaning of section 346(a)(2) of the Internal Revenue Code of 1954 or as amounts distributed in redemption of stock pursuant to section 302.

A corporation, which was engaged for many years in the business of providing mass transit services, entered into an agreement with a regional transit authority (Authority) under which the corporation would operate, maintain, and service mass transit vehicles and equipment, and perform all other work necessary for the efficient running of the mass transit operation. In exchange for these services to be performed by the corporation the Authority agreed to pay the corporation a sum equal to the total of (a) gross cost (reasonable and necessary expenses) less gross revenue (revenues derived from the operation of the mass transit services), plus (b) a rate of return of 9 percent per annum on the corporation's capital investment less income taxes. Further, the Authority agreed to make all future bus purchases. As a result of this agreement the corporation adopted a plan of partial liquidation and within the same taxable year distributed to its shareholders in redemption of a portion of their stock its cash reserve set aside to replace buses. There was no significant reduction of the corporation's level of business activities. For example, the change in the corporation's business operations did not result in any significant reduction of the corporation's employees, services, income, or assets (other than the cash distributed).

The question presented is whether the distribution effected a "genuine contraction of the corporate business" so as to qualify the distribution as in partial liquidation within the meaning of section 346(a)(2) of the Code.

Section 346(a)(2) of the Code provides, in part, that a distribution by a corporation will qualify as in partial liquidation if it is not essentially equivalent to a dividend, is in redemption of part of the stock of the corporation pursuant to a plan and occurs within the taxable year in which the plan is adopted or within the succeeding taxable year.

Section 1.346-1(a) of the Income Tax Regulations provides that if a distribution results from a genuine contraction of the distributing corporation's business, such distribution will qualify as in partial liquidation within the meaning of section 346(a)(2) of the Code. These regulations further provide that the distribution must result in a cessation of a part of the distributing corporation's business activities, and that the distribution of funds attributable to a reserve for an expansion program that has been abandoned does not qualify as a partial liquidation within the meaning of section 346(a).

Section 302(a) of the Code provides, in part, that if a corporation redeems its stock and if section 302(b)(1), (2), or (3) applies such redemption shall be treated as a distribution in part or full payment in exchange for the stock. If section 302(a) does not apply to the redemption, under section 302(d) the redemption shall be treated as a distribution of property to which section 301 applies.

Rev. Rul. 67-16, 1967-1 C.B. 77, holds that where certain amounts representing proceeds from the condemnation of property are distributed in redemption of stock of a corporation, such distribution does not qualify as a partial liquidation within the meaning of section 346(a)(2) of the Code, where the condemnation did not result in a current decrease in the corporate business and the corporation can continue its operations to the same extent maintained prior to the condemnation. Compare Rev. Rul. 75-3, 1975-1 C.B. 108, which holds that the termination of a contract representing 95 percent of the gross income of a corporation resulted in a genuine contraction of the corporation's business and the distribution of cash in redemption of a portion of the corporation's stock qualified as a distribution in partial liquidation under section 346(a)(2) where the cash is made available by the release of funds from a restricted account established under a credit agreement with a bank and represents the working capital attributable to the terminated contract.

In the present case, the cash distributed by the corporation represented reserves that were no longer needed because of the change in the corporation's business operations. However, there was no genuine contraction of the corporation's business for purposes of section 346(a)(2) of the Code because there was no significant reduction in the corporation's level of business activities.

Accordingly, the cash distributed is treated as received by the shareholders as distributions in redemption of their stock surrendered subject to the provisions and limitations of section 302 of the Code.