Section 302(b)(4): Partial Liquidations of Closely-Held Corporations

Partial Liquidations Under Section 302(b)(4)

  1. Section 302(b)(4) provides sale or exchange treatment on a “partial liquidation” for a non-corporate shareholder
  2. Section 302(e) defines a partial liquidation
    1. Not essentially equivalent to a dividend- this is tested at the corporate level rather than at the individual shareholder level)
    2. Distribution is part of a plan that occurs during the current or succeeding taxable year

Section 302(e)(2) provides a ‘safe harbor’. The requirements of this safe harbor are:

  1. Distribution is attributable to the corporation ceasing to conduct a trade or business- this must meet the 5 year test
  2. Immediately after the distribution, the corporation is actively engaged in the conduct of a qualified trade or business- this also must meed the 5 year test

Other Issues:

  1. The distribution can be pro-rata among the shareholders but it doesn’t have to be so
  2. For a corporate shareholder, a partial liquidation is always treated as a dividend- this can take advantage of the dividend received deduction

The Imler vs Commissioner Case:

  1. Prior to 12/01/41, Imler Supply Co. was engaged in the business of retinning and soldering metals as well as renting excess space in building owned by the company
  2. In its main building, Imler leased its top two floors to another company
  3. On 12/01/41, a fire destroyed these two upper floors
  4. The fire was insured and in 1942, Imler received insurance proceeds in the amount of $28K as a result of the fire
  5. The cost to rebuild the two floors was estimated to be $40k-$50k
  6. Alternatively, a roof could be put on the remaining top floor for about $15k
  7. They decided to put a roof on the top floor and to distribue the $15k of excess cash to the shareholders
  8. If it weren’t for the insurance money, the corp couldn’t have paid the $15k distribution to shareholders
  9. The corp ceased to engage in the business of retinning and soldering metals due to lack of storage space. Likewise, the war made it difficult to make a profit in this business

The Issue: Did the $15k distribution constitute a dividend taxable at ordinary rates or a partial liquidation taxable at capital gains rates?

The Judgement: The distribution constituted a partial liquidation

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