certain limited circumstances a distribution in partial liquidation may still qualify for nonrecognition at the corporate level. Finally, Congress in the 1954 Act provided that a corporation does not recognize gain or loss on a sale of property if it adopts a plan of complete liquidation and distributes all of its assets to its shareholders within 12 months of the date of adoption of the plan (sec. 337). Thus, the distinction drawn in Court Holding Co. and Cumberland Public Service Co., between a sale of assets followed by a liquidating distribution of the proceeds and a liquidating distribution in kind followed by a shareholder sale, was in large part eliminated. Regulations subsequently issued under section 311 acknowledged that a distribution in redemption of stock constituted a "distribution with respect to ... stock" within the meaning of the statute.57 The 1954 Code in its original form, therefore, generally exempted all forms of nonliquidating as well as liquidating distributions to shareholders from the corporate-level tax.

Nonliquidating distributions: section 311

Three exceptions to the rule that gain was not recognized on nonliquidating distributions were provided under section 311. The purpose of these exceptions was to eliminate what were perceived to be opportunities for tax avoidance presented by the general rule. First, nonrecognition was not available for distributions of installment obligations to shareholders. Under the predecessor of section 453B, a corporation recognized gain to the extent of the excess of the face value of the obligation over the corporation's adjusted basis in the obligation.58 Second, upon distribution of LIFO inventory,59 a corporation recognized gain to the extent the basis of inventory determined under a FIFO method exceeded its LIFO value.60 Third, a corporation recognized gain on the distribution of encumbered property to the extent the liabilities exceeded the basis of the property in the distributing corporation's hands.61 These three statutory exceptions to section 311 have remained essentially unchanged since their enactment.

1969 amendments.-On three separate occasions since the enactment of section 311, Congress has reacted to perceived abuse of the provision by further restricting its scope. In 1969, Congress became aware of instances of large corporations making tender offers for their own stock and using appreciated portfolio stock to effectuate the redemption. These transactions were viewed as having the same economic effect as if the distributing corporations had sold the portfolio stock and redeemed their own stock with the proceeds. Congress "[did] not believe that a corporation should be permitted

57 Treas. Reg. sec. 1.311-1(a).

58 Under both the original statute and present law, installment obligations received by a corporation in a sale or exchange qualifying for nonrecognition under section 337 may be distributed to shareholders without recognition at the corporate level. Sec. 453B(d)(2).

59 Under the last-in, first-out or "LIFO" method of accounting, goods purchased or produced most recently are deemed to be the first goods sold. During periods of rising costs, LIFO inventory accounting tends to increase cost of goods sold and reduce gross income from sales.

60 Sec. 311(b). "FIFO" (first-in, first-out) accounting assumes that the first goods purchased or produced are the first goods sold.

61 Sec. 311(c). This rule would prevent, for example, a corporation's borrowing against appreciated corporate assets and immediately transferring the mortgaged assets to its shareholdersthus achieving the same economic position as if it had sold assets.

to avoid tax on any appreciated property (investments, inventory, or business property) by disposing of property in this manner."62 Congress addressed this problem by amending section 311 to require recognition of gain by a corporation on distributions in redemption of its stock. (For purposes of section 311, a redemption included a distribution in exchange for stock that was treated as a dividend subject to section 301, e.g., because it was "essentially equivalent to a dividend.") Certain types of redemptions were excepted, including distributions in complete termination of a 10 percent shareholder's interest, certain distributions of the stock or ob- . ligations of a 50 percent-or-more subsidiary, distributions to pay death taxes, distributions to private foundations, distributions by regulated investment companies upon the demand of a shareholder, distributions pursuant to certain antitrust decrees, and distributions constituting divestitures by bank holding companies.

TEFRA amendments.-In 1982, Congress, again responding to highly publicized tax avoidance transactions involving distributions of appreciated assets, further narrowed the applicability of the General Utilities rule. The transactions involved arrangements between a corporation and a prospective purchaser of a subsidiary of the corporation whereby the purchaser made a tender offer for shares of the parent's stock equal in value to the subsidiary's stock. The parent would then, pursuant to a prearranged plan, redeem the stock held by the purchaser using the stock of the subsidiary. Although it was unclear whether these transactions qualified for nonrecognition treatment under then-existing law,63 Congress believed it was desirable to clarify that they did not. Moreover, it determined that whether or not the stock ownership was transitory, as in the publicized cases, a distribution of property in a stock redemption was economically equivalent to a direct sale of the distributed property and should generally be treated as such for tax purposes. Congress felt that as a general rule, property should not be allowed to leave corporate solution in a redemption and take a stepped-up basis in the hands of a transferee without a corporate level tax being paid on the appreciation.

Under amendments made in the Tax Equity and Fiscal Responsibility Act of 1982 (TEFRA), the general rule in the case of distributions to corporate shareholders in redemption of their stock was that the distributing corporation recognized gain. Thus, for example, the exceptions to recognition for distributions in complete redemption of the stock of 10 percent shareholders and for distributions of stock or obligations of a 50 percent subsidiary were repealed in the case of corporate distributees. In a liberalization of prior law, however, nonrecognition treatment was accorded to redemption distributions to corporate shareholders constituting a dividend. In such a case, the distributed property would generally take

62 S. Rep. No. 552, 91st Cong., 1st Sess. 279 (1969).

63 Section 311(a) applies only if a distribution is to a shareholder in its capacity as a shareholder, and not in some other capacity such as vendee. Rev. Rul. 83-38, 1983-1 C.B. 76. See also Rev. Rul. 80-221, 1980-2 C.B. 170 (transaction that was in form a redemption of stock with corporate property treated as direct sale of assets to distributee where stock ownership was transitory).

a carryover rather than a fair market value basis in the hands of the distributee.64

Distributions in redemption of the stock of noncorporate shareholders (including S corporations) generally resulted in recognition of gain to the distributing corporation under the TEFRA amendments unless the distribution was to certain substantial, long-term shareholders and consisted of stock or obligations of a subsidiary.65 As discussed below, an exception was also provided for certain redemptions of stock held by noncorporate shareholders constituting partial liquidations.

The TEFRA amendments did not disturb the exceptions for distributions to pay death taxes, to private foundations, and regulated investment companies.

1984 amendments.-The applicability of the General Utilities rule to nonliquidating distributions was eroded still further by amendments in the Deficit Reduction Act of 1984.66 Prior to the 1984 Act, the gain recognition rule of section 311(d)(1) applied only to distributions of property in redemption of a shareholder's stock. The 1984 Act extended the gain recognition rule to most dividend distributions of appreciated property, including carryover basis distributions to corporate shareholders (whether or not in redemption of stock). In general, dividend distributions to noncorporate shareholders are also subject to the gain recognition rule. However, the 1984 Act preserved nonrecognition at the corporate level for distributions of "qualified dividends," defined as dividends to noncorporate shareholders of property (other than inventory or receivables) used in the active conduct of certain "qualified businesses."67 The Act also retained nonrecognition treatment for certain redemption distributions with respect to qualified stock held by noncorporate shareholders. Unlike prior law, the 1984 Act required the application of the LIFO recapture and installment obligation rules before the application of the recognition rules of section 311(d)(1).

Liquidating distributions and sales: sections 336 and 337 The rules regarding nonrecognition of gain on distributions in liquidation of a corporation are more liberal than those applicable to nonliquidating distributions. Section 336 as enacted in 1954 Code provided for nonrecognition of gain or loss by a corporation on the distribution of property in complete or partial liquidation of the corporation. An exception was provided (that is, gain was recognized) for a distribution of an installment obligation acquired other than in a liquidating sale that would be tax-free under section 337,68

64 Sec. 301(d)(2). The distributee's basis would be the fair market value of the property if that were lower than the distributor's basis.

65 More specifically, the distribution had to be with respect to "qualified stock," more than 50 percent in value of the subsidiary's stock had to be distributed, and certain active business requirements had to be satisfied. "Qualified stock" was defined as stock held by noncorporate shareholders owning 10 percent or more in value of the distributing corporation's outstanding stock for at least five years (or the period the corporation had been in existence, if shorter). 66 Pub. L. 98-369, sec. 54.

67 Sec. 311(a)(3). A "qualified business" is any trade or business that has been actively conducted for five years and was not acquired in a transaction in which gain or loss was recognized during such period. Sec. 311(e)2XB)(i).

68 Sec. 453(d), the predecessor of sec. 453B(d). Section 453(d) also provided (and sec. 453B(d) now provides) that no gain or loss is recognized by a corporation on distribution of an installContinued

Section 336, unlike section 311, has survived with relatively few modifications since its enactment. TEFRA amended this provision to make it inapplicable to partial liquidations, but granted nonrecognition treatment elsewhere in the Code for certain partially liquidating distributions made with respect to qualified stock. Qualified stock is defined in the same manner as for nonliquidating distributions. Nonrecognition is therefore limited to distributions to long-term, 10 percent shareholders other than corporations. 69 TEFRA also required recognition of the LIFO recapture amount in liquidating distributions.

Section 337 has likewise remained essentially in its original form. It provides that if a corporation adopts a plan of complete liquidation and within 12 months distributes all of its assets in complete liquidation, gain or loss on any sales by the corporation during that period is generally not recognized.70 Section 337 does not apply, and recognition is required, on sales of inventory (other than inventory sold in bulk), stock in trade, or property held primarily for sale to customers in the ordinary course of business. If the corporation accounts for inventory on a LIFO basis, section 337 requires that the LIFO recapture amount be included in income.

Special rules for distributions by S corporations

The Code allows a closely-held business operating in corporate form to elect to have business gains and losses taxed directly to or deducted directly by its individual shareholders. This election is available under subchapter S of the Code (secs. 1361-1379). The principal advantage of a subchapter S election to the owners of a business is the ability to retain the advantages of operating in corporate form while avoiding double taxation of corporate earnings. Prior to 1983, shareholders of corporations making a subchapter S election were taxed on actual cash dividend distributions of current earnings and profits of the corporation, and on undistributed taxable income as a deemed dividend. Accordingly, all of the taxable income of a corporation taxable under subchapter S generally passed through to its shareholders as dividends. A shareholder increased his basis in his stock by the amount of his pro rata share of undistributed taxable income.

The Subchapter S Revision Act of 1982 substantially modified these rules. The dividends-earnings and profits system was abandoned in favor of a pass-through approach based more closely on the system under which partnership income is taxed. Under these new rules, gain must be recognized by an S corporation (which gain is passed through to its shareholders) on a nonliquidating distribution of appreciated property as if it had sold the property for its fair market value (sec. 1363(d)). The purpose of this rule is to

ment obligation if the obligation is distributed in a section 332 liquidation of a controlled subsidiary into its parent and the parent takes a carryover basis under section 334(b)(1).

69 See secs. 311(d)2)A), 302(b)(4), (e). TEFRA added a provision that grants regulatory authority to prevent circumvention of the repeal of special tax treatment for partial liquidations through the use of section 355, 351, or 337, or other provisions of the Code or the regulations. Sec. 346(b).

70 As previously noted, the original motivation for the relief was apparently to avoid the necessity of making the often difficut factual determination of who (the shareholders or the corporation) actually effectuated the sale, and to avoid the perceived unfairness of having tax consequences turn on such formalistic distinctions.

assure that the appreciation does not escape tax entirely. A shareholder in an S corporation generally does not recognize gain on receipt of property from the corporation, but simply reduces his basis in his stock by the fair market value of the property, taking a basis in the property equal to that value. The shareholder can then sell the property without recognizing any gain. Thus, unless the distribution triggered gain at the corporate level, no current tax would be paid on the appreciation in the distributed property.

Liquidating distributions by an S corporation are taxed in the same manner as liquidating distributions of C corporations. Thus, no gain is recognized by the corporation (sec. 1363(e)). Although the General Utilities rule in this context is not responsible for the imposition of only a single, shareholder-level tax on appreciation in corporate property,71 it may allow a portion of the gain that would otherwise be ordinary to receive capital gains treatment.

Statutory law and judicial doctrines affecting application of General Utilities rule

Recapture rules

The nonrecognition provisions of sections 311, 336, and 337 are subject to several additional limitations beyond those expressly set forth in those sections. These limitations include the statutory "recapture" rules for depreciation deductions, investment tax credits, and certain other items that may have produced a tax benefit for the transferor-taxpayer in prior years.72

The depreciation recapture rules (sec. 1245) were enacted as part of the Revenue Act of 1962. They require inclusion, as ordinary income, of any gain attributable to depreciation deductions previously claimed by the taxpayer with respect to "section 1245 property" essentially, depreciable personal property-disposed of during the year,73 to the extent the depreciation claimed exceeds the property's actual decline in value. The 1962 Act also added a provision requiring recapture of amounts claimed as investment credits on premature dispositions of property for which a credit was claimed (sec. 47).

Congress has applied a more limited depreciation recapture rule to certain real estate. Under section 1250, gain on disposition of residential real property held for more than one year is recaptured as ordinary income to the extent prior depreciation deductions exceed depreciation computed on the straight-line method (sec. 1250). Gain on disposition of nonresidential real property held for more than one year, however, is generally subject to recapture of all depreciation unless a straight line method has been elected, in which case there is no recapture.74

71 A shareholder would under the subchapter S rules be entitled to a basis increase equal to the amount of gain recognized by the corporation.

72 These rules apply not just to corporate distributions but to sales and other dispositions of property, other than in tax-free reorganizations.

73 In the case of sales or exchanges of property in taxable transactions, the recapture rules convert a portion of what would otherwise be capital gain into ordinary income. In the case of nonrecognition transactions, the recapture rules require recognition of gain that would otherwise go unrecognized.

74 Sec. 1245(a)5).