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In 1938 Congress accompanied the enactment of the present stringent personal holding company provisions with a special provision to encourage liquidation of such companies. This provision, which has several times been extended or reenacted, limits the taxable income or gain to the larger of the corporation's accumulated earnings and profits or the cash distributed (now Internal Revenue Code, sec. 333).

In combination, the General Utilities principle that a corporation is not taxed upon the distribution of property to its shareholders and the availability of capital gain treatment to shareholders upon sale of stock or liquidation permitted the most elementary tax avoidance. Corporations were formed for single projects—e.g., the production of a motion picture or the construction of an apartment house by stockholders who were frequently dealers in the kind of property involved. Upon completion, when the value of the property could be established, often by reference to contracts for its exploitation, but before the actual receipt of income, the corporation would be liquidated, or its stock would be sold and the purchaser would liquidate it. In either case, there was no corporate tax, the shareholders paid a capital gains tax, and the resulting increased basis of the property could be written off against ordinary income from its exploitation. Congress enacted the collapsible corporation provision in 1950 to forestall this practice (now Internal Revenue Code, sec. 341). This statute, despite repeated amendment, is still one of the most unsatisfactory provisions of its income tax law, almost unreadable, erratic and uncertain in its impact, and insufficiently provided with guides for administration.

When we consider the haphazard growth of liquidation provisions, we should perhaps be surprised that they are not worse. Congress has never undertaken the hard task of analyzing them as a whole to see whether a simpler, fairer, and more coherent liquidation statute might be fashioned. The Advisory Group on Subchapter C and the American Law Institute project would make only limited and piecemeal changes which would further complicate the statute. No one has undertaken the difficult search for a possible unifying principle.

The root of the complexity lies in two features of the present system: (1) The forgiveness of the corporate tax upon liquidations and other distributions in kind, and upon sales in liquidation; and (2) the imposition of a shareholder tax upon liquidations in kind. The following system might be substituted under a broader base, lower rate income tax:

(1) Recognition to the corporation of (a) all gains and losses accrued on property distributed in kind to its shareholders, in liquidation or otherwise; and (6) all gains and losses realized on sales or exchanges of property, in liquidation or otherwise.

(2) Nonrecognition of gain or loss to shareholders upon corporate liquidations in kind. Cash received in liquidation would be first applied in recoupment of the shareholder's basis for his stock; any excess of cash over basis would be taxed as capital gain.

(3) The shareholder's basis for his stock would become the basis of the assets received by him in kind in the liquidation. Such basis would be increased by any gain taxed on liquidation and decreased by the amount of cash received. The basis, as thus adjusted, would be allocated among the assets in proportion to their fair market values.

(4) Distributions in kind to shareholders which are corporations

would not be subject to the above rules. Such distributions, whether in liquidation or otherwise, would be tax free to both the distributor and the distributee; the distributee would inherit the distributor's basis (even though the stock of the distributor was recently purchased).

Several criticisms of this set of proposals may be anticipated and answered.

Criticism: The shareholder may escape with a single capital-gains tax by selling stock; therefore, the proposal would be so easily avoided that it would be largely ineffective. Answer: The purchaser of corporate stock would be unable under the proposal to obtain a new basis for the corporation's assets without payment of tax by the corporation. Liquidation by an individual purchaser would result in a corporate tax upon gain accrued to the corporation; liquidation by a corporate purchaser would not step up the basis of the assets. Purchasers could be expected to take the prospective corporate tax or lack of new basis into account in negotiating the purchase price.

Criticism: The double tax is inherently objectionable, and, therefore, should not be strengthened. Answer: The present system singles out for favored treatment one kind of income (accrued gains on certain kinds of property) for relief against the double tax, and then only in two types of transactions (distributions in kind to shareholders and sales during liquidation). As to other types of income, and as to realized gains in other circumstances, the double tax system operates. Students of taxation are not in agreement as to the impact of the corporate tax upon shareholders, consumers, suppliers, or wage earners. Under any theory as to the impact of the corporate tax, the reasons for relief restricted to one kind of income in two situations have not been articulated.

Criticism: The provisions under discussion are utilized mostly by small business, which the tax laws should be designed to encourage. Most small corporations do not pay dividends and thus are not subject to the double tax prior to their liquidation; therefore, it is logical to relieve them from double tax at liquidation. Answer: These provisions have frequently been utilized by large and publicly held corporations to escape the corporate tax on sales of assets during liquidation. As regards small corporations, not all of them are able to avoid paying dividends. Those which do not pay dividends are postponing rather than eliminating the shareholder tax.? Postponement of the shareholder tax during the corporation's life does not justify elimination of the corporate tax at its death. If the tax laws are to foster small business, they should foster its formation and growth, not its liquidation and sale.

Criticism: The double tax could easily discourage the liquidation or sale of corporate business enterprises because such transactions are usually voluntary. Moreover, its timing is severer upon gain from liquidation or sale than upon operating profits, which can be at least partially retained by the corporation. Answer: Under the proposal,

1 The shareholder tax is ultimately eliminated to the extent that stock receives a new and higher basis at the death of its holder, provided the stock is thereafter sold or the corporation liquidated. However, the stock is subject in that event to the estate tax. Whether or not provision for a new basis on death is appropriate, in any event its existence should not militate against an appropriate structure for the corporate income tax.

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a liquidation in kind would not incur a simultaneous double tax; the shareholder tax would be postponed until he disposes of the assets received. Nor would a sale by the corporation of its assets incur a simultaneous double tax if, instead of liquidating, it invests the proceeds in another business or operates as an investment company; the second tax is postponed until the proceeds are ultimately distributed to the shareholders. If sale and liquidation both take place, the tax will usually be a double capital gains tax having a combined effective rate of 4334 percent. This is, of course, a lower effective rate than that of the combined tax upon corporate operating profits. It is questionable whether the tax laws should go further than this in favoring liquidations and sales over continuing business ownership and operation.

Criticism: The proposals would tax, and therefore require the valuation of, business good will in liquidations in kind. Answer: The present statute does the same in taxing shareholders on gain upon such liquidations. Moreover, this is necessary to equate the tax at the corporate level on sales and liquidations.

A further criticism of the proposal might be its taxation of gains accrued prior to incorporation. If an individual incorporates property which cost him $50,000 and is worth $500,000, the accrued gain of $450,000 is not taxed upon incorporation. If the value of the property remains at $500,000, it may be urged that the tax law should permit a liquidation in kind without a corporate tax; and if the property increases further in value after incorporation, that the corporate tax should fall only upon that further increase. If this right is granted, then it would be realistic also to permit the corporation to sell the property during liquidation without being taxed on the gain accrued prior to incorporation. Such rules, combined with the proposed deferment of the shareholder tax until the property was sold to outsiders, would give persons who incorporate appreciated property rashly and without an understanding of the tax laws an opportunity to repent. Present law does not completely offer that opportunity; however, the proposal, in closing the escape hatch from the double tax, may accentuate the need for such relief. Shielding of the preincorporation accrued gain from tax would interfere to some extent with the statutory simplification outlined below. Nevertheless, and although no tax system can completely protect those who act ignorantly, the better course might be to grant some limited protection of preincorporation accruals from corporate tax upon distribution in kind or sale during liquidation. Possibly the protection should be limited to the original shareholders who incorporated the property, and possibly it should also be available for only a limited time following incorporation of the appreciated property.

The proposals would result in substantial statutory simplification, as the following review of Internal Revenue Code provisions shows:

Section 311.- Present law: Gain or loss is not recognized to the corporation upon a nonliquidating distribution of property in kind as à dividend or in redemption of stock (subsec. (a)). There are three exceptions: The corporation recognizes gain upon distribution of LIFO inventories (subsec. (b)), property subject to liabilities in excess of its basis (subsec. (c)), or installment obligations (sec. 453 (d)). Proposal: The corporation would recognize gain or loss on such distributions. No exceptions.

Section 312.—Present law: Accrued but unrealized gains and losses on corporate property are not reflected in the corporation's earnings and profits either as they accrue or when the property is distributed in kind; upon distribution of the property, earnings and profits are reduced by its adjusted basis (subsec. (a)). As an exception, unrealized gain on "inventory assets" and "unrealized receivables and fees" are added to earnings and profits when such assets are distributed (subsec. (b)). Proposal: Accrued gains and losses, being recognized to the corporation upon distribution of the property in kind, would be reflected in its earnings and profits. No exceptions.

Section 331.-Present law: Amounts distributed in corporate liquidations are treated by the shareholder as in payment in exchange for the stock. Proposal : Same, except that the shareholder's gain or loss would not be recognized as to distributions in kind.

Section 332(a).-Present law: No gain or loss is recognized to a corporate parent on the liquidation of a controlled-i.e., 80 percent or more owned subsidiary. Proposal: Nonrecognition for all shareholders, individuals or corporate, regardless of level of stock ownership, except for distributions of cash to individuals.

Section 332(c).—Present law: No gain or loss recognized to corporate subsidiary upon transfer of property in satisfaction of indebtedness to controlling—i.e., 80 percent or more owning-parent. Proposal: Same with percentage limitation on stock ownership removed; but gain or loss upon distributions in kind in satisfaction of indebtededness to individual shareholders would be taxed.

Section 333.—Present law: Limited recognition of gain (and partial taxation as a dividend) in certain 1-month liquidations. Proposal: Repeal.

Section 334(a):-Present law: Basis of property received in ordinary liquidation is fair market value at time of receipt. Proposal: As to individual distributees, such property would succeed to the basis of the distributee's stock, with appropriate adjustment for any gain taxed on liquidation and any cash received. As to distributees which are corporations, see the next two paragraphs.

Section 334(6)(1):-Present law: Basis of property received in liquidation by controlling--i.e., 80 percent or more owning-parent is inherited from subsidiary unless subsidiary's stock was purchased within 2 years before liquidation. Proposal : Same to any distributee which is a corporation, regardless of level of stock ownership and regardless of when subsidiary's stock was purchased.

Section 334(b)(2).-Present law: Property received in liquidation by controlling parent from subsidiary the stock of which was purchased within 2 years before liquidation succeeds to basis of subsidiary's stock with adjustments. Proposal: Repeal.

Section 334(c).-Present law: Prescribes basis of property received in 1-month liquidations under section 333. Proposal: Repeal.

Section 336.-Present law: Prevents recognition of gain or loss to the corporation upon a liquidating distribution in kind. Exception for installment obligations (sec. 453(d)). Proposal: Recognize such gain or loss to the corporation. No exceptions.

Section 337.—Present law: Prevents recognition of gain or loss to the corporation upon sales or exchanges of property during 12-month liquidating period. Exceptions for inventory not sold in bulk, installment obligations, collapsible corporations, and controlled subsidiaries. Proposal: Repeal.

Section 341.-Present law: Treats as ordinary income gain from sale or exchange of stock of a collapsible corporation, liquidating distributions from such a corporation, and certain nonliquidating distributions from such a corporation. Several complex exceptions relating to size of shareholding, source of gain, holding period and nature of porperty, and business history of stockholders. Proposal: Repeal.

The varied and cumulatively numerous exceptions under sections 311, 312, 336, and 337 reflect congressional concern over abuse of the present system. The elimination of those exceptions would be one of the chief simplifications inherent in the proposal. The other, and more important, principal simplification would be the elimination of the fantastically complicated and uncertain collapsible corporation provision. The two features of the present system which made such a provision necessary—the nontaxability to the corporation of accrued gains on property distributed to shareholders and the obtaining by the shareholders of a new and higher basis for the property on liquidation-would both be eliminated under the proposal. As explained earlier, sale of corporate stock would not be a vehicle for abuse because the corporate tax would ultimately be payable and the purchaser of the stock could be expected to take this into account in negotiating the purchase price.

Under the proposal, dealers in various kinds of property might, by incorporating projects involving such kinds of property, still obtain too great a tax advantage in the form of a double capital-gains tax. This problem could be dealt with by provisions far simpler than the present collapsible corporation section. The shareholder-dealer's business history would simply be taken into account in determining whether ordinary income or capital gain should result to the corporation from its sale of the property or distribution of the property in kind or to the shareholder from his sale of stock.

The proposed revision of section 331 to provide nonrecognition of gain to shareholders upon liquidations in kind differs from the revision of that section proposed by the Advisory Group on Subchapter C. The Advisory Group would provide for recognition of gain to the extent that the corporation's basis for the property distributed in kind exceeded the shareholder's basis for his stock, and for recognition of loss in all cases. The present proposal is simpler, more uniform, and easier to administer.

The proposed repeal of section 333 is based on two grounds. The general postponement of gain to shareholders on liquidations in kind would make any such special provision unnecessary. Moreover, the lapse of more than 20 years since the enactment of the personal holding company provisions that gave rise to this section should now permit its elimination.

With the proposed repeal of the basis provisions of section 334(b), it should be made clear that a purchaser of stock cannot shift his basis for the stock to the assets upon liquidation, even if he bought

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