Rev. Rul. 82-39: The Tax Benefit Rule in Liquidations

Revenue Ruling 82-39 is guidance from the Internal Revenue Service that clarifies how the tax benefit rule applies during a corporate liquidation. For business owners or shareholders involved in winding down a company, this ruling helps explain the tax consequences of final distributions. The ruling provides a framework for when a corporation must recognize income, even during a transaction that is afforded nonrecognition treatment under the Internal Revenue Code.

The Tax Benefit Rule Explained

The tax benefit rule is a judicial doctrine designed to correct inaccuracies in tax reporting that arise from events spanning multiple accounting periods. Its purpose is to create fairness by preventing a taxpayer from receiving a windfall. The rule operates when a company takes a deduction for an expense in one year, and a subsequent event in a later year makes that original deduction inappropriate. This later event is considered “fundamentally inconsistent” with the premise for the initial deduction.

The inclusionary component requires the taxpayer to include an amount in gross income in the year the inconsistent event occurs, effectively reversing the prior deduction. The exclusionary component, codified in Section 111 of the Internal Revenue Code, limits the amount of income that must be recognized to the extent the original deduction actually produced a tax benefit.

The modern understanding of this rule was shaped by the U.S. Supreme Court case Hillsboro National Bank, Inc. v. Commissioner. This case established the “fundamentally inconsistent” event test, moving beyond a requirement that an asset be physically “recovered.” The Court reasoned that the rule should apply whenever a later event occurs that would have foreclosed the deduction had it occurred in the same year. This standard provides the legal foundation for applying the rule to corporate liquidations.

Core Holding of Revenue Ruling 82-39

Revenue Ruling 82-39 presents a factual scenario to illustrate the tax benefit rule’s application. The ruling describes a corporation in the business of cattle feeding. In a prior tax year, the corporation purchased a significant amount of cattle feed and deducted the full cost as an ordinary and necessary business expense under Section 162. This deduction was premised on the assumption that the feed would be consumed by the cattle in its business operations.

Subsequently, the corporation adopted a plan of complete liquidation. As part of this plan, it distributed its remaining assets, including the previously expensed but unused cattle feed, to its shareholders. Under liquidation rules in Section 336, a corporation does not recognize gain or loss on the distribution of property in a complete liquidation.

The conclusion of Revenue Ruling 82-39 is that the tax benefit rule overrides the nonrecognition provision of Section 336. The IRS reasoned that distributing the unused feed to shareholders was a fundamentally inconsistent event. The original deduction was justified by its use in generating corporate income, and distributing it to shareholders is at odds with that premise. Therefore, the corporation was required to recognize income equal to the value of the distributed feed, to the extent it received a tax benefit from the prior deduction.

Application and Calculation

The principle in Revenue Ruling 82-39 extends beyond cattle feed and applies to any asset a corporation previously expensed and then distributes during liquidation. Common examples of these assets include:

• Inventories of supplies, such as office or cleaning materials
• Manufacturing consumables and other items deducted upon purchase
• Small tools and spare parts
• Certain prepaid expenses where the benefit has not been fully realized, such as prepaid advertising or insurance

The amount to be included in the corporation’s final income tax return is the lesser of two figures: the fair market value of the asset at the moment it is distributed, or the amount of the original cost that the corporation deducted and for which it received a tax benefit.

To illustrate, consider a corporation that purchased $10,000 worth of specialized spare parts and deducted the full cost. During its liquidation a year later, the fair market value of these unused parts has increased to $12,000. The corporation must recognize $10,000 of ordinary income, as this is the lesser of the $12,000 fair market value and the $10,000 tax benefit received.

If the fair market value of the same parts had decreased to $7,000 at the time of liquidation, the corporation would recognize only $7,000 of ordinary income. This is because the fair market value is lower than the $10,000 prior deduction. This calculation must be performed for each previously expensed asset distributed during liquidation.