Rev. Rul. 79-68: Liquidation Treated as a Reorganization
Explore how the IRS can look past the form of a corporate liquidation to find a reorganization, altering the tax treatment of shareholder distributions.
Revenue Ruling 79-68 serves as an example of the Internal Revenue Service’s application of the liquidation-reincorporation doctrine. This doctrine allows the IRS to look past the formal structure of a series of transactions to determine their true economic substance. When a business owner liquidates a corporation and then promptly transfers the operating assets, or the proceeds from the sale of those assets, into a new corporate entity they also control, the IRS may disregard the liquidation. Instead, it can recharacterize the entire sequence as a single, unified reorganization. This prevents shareholders from withdrawing corporate earnings at more favorable capital gains tax rates under the guise of a complete liquidation.
The Transaction Scenario in Revenue Ruling 79-68
The facts presented in Revenue Ruling 79-68 illustrate a liquidation-reincorporation pattern. The scenario involved a corporation, referred to as the “original corporation,” which was wholly owned by a single individual and conducted a specific type of business for many years. The first step in the transaction was the sale of all its operating assets to an unrelated third-party corporation for cash.
Following the sale, the original corporation was left holding only cash. The next step was a complete liquidation under Internal Revenue Code Section 331. In this liquidation, the corporation distributed all of its cash to its sole shareholder in exchange for all of the shareholder’s stock.
The final step involved the shareholder taking a significant portion of the cash received from the liquidation and using it to capitalize a brand-new corporation. This new entity then engaged in a business similar to the one previously operated by the original corporation.
IRS Analysis and Recharacterization
The IRS disregarded the taxpayer’s characterization of the events as a sale, liquidation, and new incorporation. It invoked the step transaction doctrine, a judicial concept that permits the government to integrate a series of formally separate steps into a single transaction to determine the true tax consequences. Under this doctrine, if the steps are prearranged and interdependent, they are collapsed and viewed as a single, unified plan.
The Service reclassified the entire sequence as a Type D reorganization. Under Internal Revenue Code Section 368, a transaction can qualify as a “D” reorganization if one corporation transfers all or part of its assets to another corporation, and immediately after the transfer, its shareholders are in control of the corporation receiving the assets. The IRS viewed the original corporation as having effectively transferred its assets to the new corporation, with the shareholder acting as a conduit.
Even though the specific operating assets were sold to an unrelated party, the reorganization requirements were met. The “control” requirement was satisfied because the sole shareholder of the old corporation owned all the stock of the new corporation. The substance of the transaction was a continuation of the business enterprise in a new corporate shell, not a termination of the business.
Tax Consequences of the Reorganization
The recharacterization of the transaction to a Type D reorganization had unfavorable tax consequences for the shareholder. The shareholder had anticipated that the cash distribution from the original corporation would be treated as a payment in exchange for stock, resulting in a capital gain taxed at preferential rates under Section 331. This treatment would have allowed the shareholder to offset the gain with their basis in the stock and benefit from lower long-term capital gains rates.
Under the reorganization framework, the cash distributed to the shareholder that was not reinvested in the new corporation was classified as “boot.” Boot is the term for non-stock property received in a transaction that otherwise qualifies as a tax-deferred reorganization. According to Section 356, when boot is received in a reorganization and has the effect of a dividend, it is taxed as such.
The cash received by the shareholder was treated as a dividend distribution to the extent of the original corporation’s accumulated earnings and profits. Dividend income is taxed at ordinary income tax rates, which are higher than capital gains rates, resulting in a substantially higher tax liability. Furthermore, the reorganization treatment meant that the tax attributes of the old corporation, such as its earnings and profits, carried over to the new corporation under Section 381.