a collapsible corporation will be treated as gain from the sale of property which is not a capital asset. For example, in the case of a sale of stock of a collapsible corporation to a person other than an issuing corporation, section 343 (a) (1) (A) provides in general that so much of the shareholder's gain on the sale or exchange of stock as is equal to such stock's ratable share of the unrealized appreciation on section 343 assets (i. e., those assets which if sold would produce ordinary income) will be treated as gain from the sale of property which is not a capital asset.

Thus assume that A organizes a corporation and acquires its stock for $10,000. The corporation uses the funds to purchase inventory which appreciates in value to $25,000. A then sells all of his stock to X for $25,000. A's gain of $15,000 will be treated as ordinary income because it represents unrealized appreciation in inventory. (See proposed sec. 343 (a) (1).) If X, the purchaser of the stock, liquidates the corporation, he will have no gain or loss on the liquidation. Under section 334 the purchaser will take over the inventory upon the liquidation at a cost of $25,000.

This rule is to be contrasted with that contained in H. R. 8300 in the form in which it passed the House of Representatives. In that bill A's $15,000 profit on the sale would have constituted capital gain to him, but upon liquidation of the corporation X would have had to take over the inventory at the corporate cost of $10,000 despite the fact that he had actually paid $25,000 to acquire it. This obvious loss of basis to the purchaser, which was one of the principal objections to these provisions in the 1954 House bill, has been eliminated in the present proposals.

As a further illustration, assume that the corporation's inventory, having a cost of $10,000 had appreciated only to $20,000. Assume further that the corporation had cash of $5,000, representing taxable profits derived by it from its operation. If A sells all the stock to X for $25,000, A's $15,000 gain on the sale of his stock would be treated as ordinary income only to the extent of the $10,000 appreciation in inventory. (See proposed sec. 343 (a) (1).) The remaining $5,000 of his gain, representing realized corporate profits, would be treated as capital gain to him.

If in the latter illustration A sold only one-half of his stock to X for $12,500, realizing a gain on the sale of $7,500, $5,000 of the gain (attributable to inventory appreciation) would be ordinary income and the balance of $2,500 would be capital gain.

Distributions in excess of earnings and stock basis.-This rule of socalled fragmentation of gain is applied not only to sales of stock of collapsible corporations, but also to certain distributions from a collapsible corporation to its shareholders. For example, if a cor poration makes a distribution to shareholders, not in redemption of its stock, in an amount exceeding its earnings, section 301 (c) (2) re quires that the amount in excess of earnings be applied against and reduce the adjusted basis of the stock owned by the shareholder, and section 301 (c) (3) (A) provides that any further excess be treated a gain from the sale or exchange of the stock. In the proposed revision section 343 (a) (1) (B) provides that so much of that gain as represent the shareholder's ratable share of the unrealized appreciation in th corporation's section 343 assets will be taxed to him as ordinary income.

For this latter purpose section 343 (a) (1) provides that the unrealized appreciation is calculated immediately after the distribution, although in all other cases it is calculated immediately before the distribution. While ordinarily any appreciation in the distributed assets should be taken into account in determining the amount of shareholder's gain to be treated as ordinary income, this is not true with respect to a distribution to which section 301 applies. In a section 301 case, the appreciation on the distributed section 343 assets will, under section 312 (b), serve to increase the earnings and profits of the corporation for the purpose of determining the amount of the distribution taxable as an ordinary dividend. In order to prevent any subsequent duplication of ordinary income tax to the shareholder, section 343 (a) (3) provides that upon any subsequent sale or exchange of the stock on which a distribution under 301 (c) (3) (A) is received, any amount taxable as ordinary income upon the subsequent sale or exchange of the stock will be reduced by the amount of the gain on the distribution treated as ordinary income to the shareholders.

Nonaliquot distributions in complete liquidation.-Section 343 (a) (1) (C) also provides for fragmentation of gain to the shareholder if there occurs a nonaliquot distribution in complete liquidation of the corporation (including any distribution under 346 (a) (1) which is technically treated as a partial liquidation under 346 (a) (1) but is a part of a series of distributions in complete liquidation). The term "nonaliquot" distribution is defined in section 343 (e) (3), in effect, as one in which the shareholder receives section 343 assets which have an unrealized appreciation less than 90 percent or more than 110 percent of the shareholder's ratable share of all the unrealized appreciation on all the section 343 assets of the corporation. Thus if in the complete liquidation each shareholder receives substantially the same proportion of each of the section 343 assets of the corporation, or the division of corporate assets is made in such a way that each receives section 343 assets having unrealized appreciation substantially proportionate to his share of the total unrealized appreciation on all the section 343 assets, the rules of section 331 will be applicable and the shareholder will have only capital gain or loss on the liquidation. If there is a gain, the gain will be limited under section 331 (b) to the difference between his stock basis and the corporate asset basis of the assets distributed to him.

This treatment cannot be permitted, however, if the section 343 assets are distributed on a disproportionate basis since those assets might then be distributed to those shareholders who have a high basis for their stock and much of the unrealized appreciation would then escape taxation as ordinary income. Hence if the shareholders voluntarily distribute the assets on a "nonaliquot" basis in complete liquidation, then under section 331 (b) (2) and 343 (a) (1) (C) each shareholder will realize gain or loss in the amount of the excess of the fair market value of the assets distributed to him over his stock basis; and that part of the gain representing his ratable share of the corporation's unrealized appreciation on its section 343 assets will be treated as ordinary income to him.

Distributions under section 337 plans.-Finally, in section 343 (a) (1) (D) the fragmentation rule is made applicable to distributions, whether aliquot or nonaliquot, in complete liquidation of a corporation pursuant to section 337 if by reason of the application of section

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337 gain was not recognized to the corporation on sales of section 343 assets occurring pursuant to the plan. This rule is necessary to insure ordinary income tax treatment with respect to the gain on section 343 assets if all such assets are sold by the corporation tax free under section 337 and the proceeds of sale are distributed to the shareholders in an aliquot complete liquidation of the corporation. In such case, unlike existing law which denies the benefits of section 337 to a collapsible corporation, section 337 will apply to relieve the corporation from tax but the shareholder's liquidation gain will be fragmented even though the distribution is aliquot.

In conjunction with this rule regarding section 337 transactions, section 343 (a) (5) provides that in determining that part of the liquidation gain which is treated as ordinary income, the section 343 assets sold by the corporation without recognition of gain because of the application of section 337 will be treated as still being owned by the corporation immediately prior to the distribution to the shareholders; but in determining the unrealized appreciation on such assets, their fair market value and adjusted basis will be determined as of the time immediately prior to their actual sale or exchange by the corporation. In this manner the actual gain realized but not recognized to the corporation on its sale of the assets will be taken into account in determining the part of the liquidation gain taxable as ordinary income.

Furthermore, in the definition of the term "collapsible corporation" in section 343 (e) (2), any corporation which satisfies the requirements of section 337 (a) and is a collapsible corporation at any time on or after the adoption of a plan of complete liquidation, will be treated as a collapsible corporation at all times thereafter even though by reason of the sale of section 343 assets pursuant to the plan it might otherwise be removed from this category.

Stock purchased from other stockholders.--Section 343 (a) (2) provides a limitation on the amount of gain to be treated as ordinary income of a shareholder if the collapsible corporation stock sold or exchanged by him was acquired by him from another shareholder who realized ordinary income on its sale by virtue of the application of section 343. In such case the amount of gain to be treated as ordinary income on the subsequent sale or exchange will be based upon the unrealized appreciation in section 343 assets of the corporation occurring after the acquisition of the stock by the selling shareholder.

For example, assume that A acquires all the stock of a corporation for $10,000 on its organization. The corporation invests the $10,000 in inventory assets which appreciate to $25,000 in value. A thereupon sells the stock of the corporation to X for $25,000. A's gain of $15,000 will be treated as ordinary income under section 343 (a) (1). Assume further that after the acquisition of the stock by X, the inventory appreciates to $35,000 in value and the corporation earns $5,000 in cash from operations. X thereupon sells the stock to Y for $40,000. Under section 343 (a) (2), X's gain of $15,000 will be treated as ordinary income only to the extent of the $10,000 unrealized appreciation which has occurred in the section 343 assets since the date of his acquisition of the stock

Stockholders owning less than 5 percent of stock. An exception to the operation of the rules for fragmentation of gain is made in section

343 (a) (4). This exception is designed to exclude from the operation of the rules shareholders owning less than 5 percent of the stock of the corporation (sec. 343 (a) (4)). As in the case of a comparable rule in present section 341, this exception will remove from the ambit of the collapsible corporation provision persons owning relatively small interests in the corporation. As in existing law, the percent is measured by value of the outstanding stock, but unlike existing law there is excluded stock which is limited and preferred as to dividends. The shareholder must not own 5 percent or more at any time during the period of 3 years ending with the date of the sale or exchange of the stock. In determining the 5-percent ownership, the attribution rules of section 318 are made applicable. In existing law the attribution rules of the personal holding company provisions are used with certain extensions to include certain in-law relatives. The advisory group believes that the attribution rules of proposed section 318 (a) provide, in general, sufficient protection to the revenue and will prove. less difficult in determining their application.

Erception for small amounts of ordinary income.-In the proposed revision consideration was given to a further exception for cases in which the amounts treated as ordinary income to the shareholders under section 343 would not, in the aggregate, exceed, say, $2,500 during the taxable year of the shareholder. This would prevent the necessity of applying section 343 in cases which cannot produce a material change in the tax of the shareholder. The first report of the advisory group on subchapter K has recommended an exemption for gain of $1,000 recognized by any partner in any transaction under section 751. A dollar figure applied to each transaction might be difficult to police in the corporate field because of the possibility of piecemeal sales of stock during the year. An exception based upon an aggregate amount for each taxpayer in each year might make it possible for substantial amounts of ordinary income to escape taxation via the scattering of ownership of stock among various members of a family and trusts, together with the spreading of sales of stock over two or more taxable years. Accordingly, no exception for small amounts is provided for in the proposed section 343.

As noted at the beginning of the comments concerning collapsible corporations, the proposed section 343 would operate entirely by objective tests and would not depend upon the intention of the shareholders. Nor would it depend upon the existence of a purpose to avoid Federal income tax. Instead it would operate in the main to fragment the gain of a shareholder between ordinary income and capital gain where the circumstances are such as to indicate that the use of a corporation would otherwise cause a conversion of significant amounts of ordinary income into capital gain. While the advisory group believes that further consideration might be given to introducing some further limitation upon the operation of section 343 based upon lack of tax avoidance purpose, it has not recommended such a provision in the proposed amendments.

Nonaliquot partial liquidations and stock redemptions.—Section 343 (b) of the proposed revision would tax to a collapsible corporation, as ordinary income, gain on section 343 assets distributed in a nonaliquot distribution in partial liquidation under section 346 (a) (2) or in redemption of stock under section 302 (a). The normal rule of fragmentation of gain to the shareholder will not suffice in such a

case. If, for example, all the appreciated inventory of the corporation is distributed to one shareholder in redemption of his stock, taxing that shareholder on his ratable share of the unrealized appreciation of the section 343 assets of the corporation will permit the appreciation in excess of his ratable share to go free of ordinary income tax. It would not appear feasible to tax that balance of unrealized appreciation to the remaining shareholders when no assets are distributed to them. In the partnership field, section 751 provides that in the case of such a nonaliquot distribution the remaining partners are deemed to sell to the withdrawing partner their pro rata interest in the distributed inventory assets and the withdrawing partner is deemed to sell to the remaining partners his pro rata interest in the other assets left with the partnership. This latter rule is believed to be too complex to introduce in the corporate field.

Accordingly, the advisory group recommends that if a collapsible corporation makes a nonaliquot distribution of section 343 assets in partial liquidation or in redemption of stock, the corporation will be treated as having sold such assets to the withdrawing shareholder and gain will be recognized to the corporation as ordinary income. This result can be avoided by the corporation if the distribution is made on an aliquot basis. If the distribution is nonaliquot, with the result that the gain is taxed as ordinary income to the corporation, there will be no fragmentation of gain in the hands of the shareholder; he will derive capital gain on the liquidation or redemption exchange, measured by the difference between his stock basis and the fair market value of the assets distributed to him.

It will be noted that if a collapsible corporation redeems stock under section 302 (a) but does not distribute section 343 assets to the redeeming shareholder, the distribution will not be regarded as a nonaliquot distribution. Section 343 (b) will not tax the corporation on gain on non-section 343 assets which are so distributed. Section 343 (a) will not convert any part of the gain realized by the shareholder in such a case into ordinary income, for the reason that all the section 343 assets will remain in the corporation and affect the tax status of subsequent transactions in which such assets are disposed of by the corporation or stock of the corporation is sold by the remaining shareholders. Further consideration might be given to applying section 343 (a) to such redemptions by withdrawing shareholders with appropriate adjustments for the benefit of the remaining shareholders to prevent duplication of ordinary income treatment. Moreover, further consideration might be given to the definition of nonaliquot distributions as applied to redemptions under section 302 (a). Carryover of character of section 343 assets on certain distributions.— Under section 334 (a) (2) and (3), the basis to a shareholder of property received by him in connection with partial or complete liquidations and certain redemptions is determined by reference to the basis of the property in the hands of the distributing corporation or to the shareholder's basis for his stock in the corporation. This carryover-of-basis provision applies to distributions of section 343 assets by collapsible corporations unless the distribution is a nonaliquot one. The advisory group recommends that where section 343 assets are distributed by a collapsible corporation and the basis of the property in the hands of the distributee is determined under these provisions, any gain on the sale of the property by the shareholder within 5 years