of the stock or liquidation of the corporation, except to the extent such income is offset by any depreciation in value of the corporate assets. Unrealized appreciation in the corporate assets would not be taken into account in determining the liquidation gain of the shareholder.

This approach of the 1954 bill as it passed the House of Representatives was not adopted in the final version of the 1954 Code. Instead, the final Code returned to the prior law with a number of modifications in the area of "collapsible corporations." After considerable deliberation, the advisory group has concluded that the approach of the House bill in 1954 is fundamentally sound and should be adopted, but with a number of important changes which, it believes, remove the principal objections made to the House bill at that time.

B. PROPOSED REVISION OF SECTION 331

Section 12 (a) of the proposed amendments revises section 331 of the Code. In the proposed revision, section 331 (a) would continue the rules of existing law that amounts distributed in complete liquidation of the corporation shall be treated as in full payment in exchange for the stock, and amounts distributed in partial liquidation shall be treated as in part or full payment in exchange for the stock. Thus the amount of gain or loss realized in the transaction would continue to be computed, as in existing law, by the difference between (1) the value of the assets received and (2) the basis to the shareholder of the stock plus the corporate liabilities assumed by the shareholder and liabilities to which the distributed property is subject.

However, in the proposed revision there would be inserted a new section 331 (b) dealing with the extent to which the realized gain will be recognized to the shareholder. Sections 331 (b) (1) and (2) in the revision deal with cases in which gain is realized by the shareholders. Section 331 (b) (1) (A) provides, in general, that if the adjusted basis to the corporation for the assets distributed in liquidation (increased by any gain recognized to the corporation upon the distribution-which might occur by virtue of secs. 311 or 453 (d)) exceeds the sum of the basis to the shareholder for his stock plus the corporate liabilities assumed by him in the liquidation and the liabilities to which the property is subject, then gain will be recognized only to the extent of such excess. Section 331 (b) (1) (B) provides, in general, that if there is no such excess no gain will be recognized on the liquidation. While these two rules could be combined in a single paragraph, they have been stated in separate subparagraphs in order to facilitate the statement in section 334 of the rules applicable in determining the basis to the shareholder of the assets distributed to him.

In section 331 (b) (3) it is provided that any loss realized by the shareholder will be recognized to him as under existing law. The following examples illustrate the operation of these rules:

(1) Assume the shareholder has a basis for his stock of $10,000 and the property distributed in complete liquidation has a value of $30,000. The adjusted basis to the corporation for the distributed property is $25,000. The gain realized on the liquidation is $20,000 (value of $30,000 minus stock basis of $10,000), but the amount of gain recognized to the shareholder will be only $15,000 (corporate asset basis of $25,000 minus stock basis of $10,000). (See sec. 331 (b) (1) (A).)

(2) Assume the same facts as to stock basis and value of assets distributed, but assume that the basis to the corporation of the assets distributed is $9,000. Again the amount realized is $20,000 (value of $30,000 less stock basis of $10,000), but no gain will be recognized to the shareholder because the corporate asset basis ($9,000) is not in excess of the stock basis ($10,000). (See sec. 331 (b) (1) (B).)

(3) Assume again that the stock basis is $10,000, but that the value of the assets distributed is only $7,000. There is, therefore, a loss of $3,000 realized on the liquidation ($10,000 stock basis minus $7,000 value of assets distributed). In that event, regardless of the basis to the corporation for the assets distributed, the entire realized loss of $3,000 would be recognized to the shareholder. In such event it would be immaterial whether the corporate asset basis was greater than, or less than, the stock basis. (See sec. 331 (b) (3).)

These rules would apply also where property is distributed in redemption of stock under section 302 (a).

Under section 331 (b) (2) of the proposed revision gain would be recognized in the case of certain distributions in liquidation or in redemption of stock of collapsible corporations. Such distributions would be dealt with in a new section 343 designed to forestall any significant conversion of ordinary income into capital-gains tax by the device of liquidating a corporation, selling its stock, or selling the corporate assets without corporate tax under section 337. See the comments, infra, under D. Collapsible Corporations. The present provisions of section 341 dealing with collapsible corporations would be repealed. Also, the present provisions of section 333 dealing with liquidations within one calendar month would be repealed.

The American Law Institute, in whose studies the outlines of this approach were originally developed, suggested that, except in the case of collapsible corporations, the limitation on the recognition of gain in corporate liquidations be made elective with each shareholder. The advisory group recommends, however, that the system described herein not be made elective but be made applicable in all cases. The advisory group believes that an elective system would create unnecessary administrative complexities and would interfere with the uniform application of the Internal Revenue Code.

The American Law Institute had also suggested that the limitation on recognition of gain be made inapplicable in the case of certain publicly held corporations. The advisory group believes that a distinction between publicly held and closely held is not necessary and recommends that the rule have uniform application.

The American Law Institute studies proposed that the recognition of gain to the shareholder be measured by reference to his ratable share of the entire basis to the corporation of all its assets distributed in the liquidation instead of by reference to the basis of the particular assets distributed to the taxpayer. While the use of the shareholder's ratable share of the entire corporate asset basis would be feasible, the advisory group concluded on balance that the operation of the system would be simplified if the shareholder were required to compute his recognized gain by reference to the basis of the particular assets distributed to him. While this might produce different results for different shareholders if each does not receive his ratable share of the

corporate asset basis in the distribution, it is believed that this is a matter which can be satisfactorily adjusted by the shareholders between themselves in working out the plan of liquidation. Comparable problems of basis have existed for many years in the area of distributions in kind by partnerships, estates, and trusts and have caused no particular difficulty. No serious opportunities for tax avoidance would exist, for if any substantial amount of noncapital assets are distributed in the liquidation and each shareholder does not receive his ratable share of the noncapital assets, the special rules of section 343 will be applicable to protect the revenue.

C. PROPOSED REVISION OF SECTION 334 (a)

Section 14 (a) of the proposed amendments revises section 334 of the code. In the proposed revision section 334 (a), which now deals with the basis of property received by a shareholder in partial or complete liquidations, would be extended to property received in redemption of stock entitled to capital gain treatment under section 302 (a). Section 334 (a) (1) would provide as a general rule that the basis of property received in the liquidation or redemption is the fair market value at the time of distribution. This provision would apply, for example, wherever the value of the assets distributed is less than the basis to the shareholder for his stock in the corporation. It would apply also where there is a gain realized on the liquidation if the value of the assets distributed is less than their basis in the hands of the corporation.

Two exceptions would be made, however, to cover cases in which there is a gain realized on the distribution but the basis to the corporation for the assets distributed is less than their fair market value at the time of the distribution:

(1) If there is a gain realized on the liquidation and the corporate asset basis is greater than the stock basis but less than the value of the assets, then the basis to the shareholder of the property distributed to him will be the same as the basis which the property had in the hands of the corporation immediately before the distribution. For example, if stock basis is $10,000, corporate asset basis is $25,000 and corporate asset value is $30,000, then the basis of the corporate asset to the shareholder after liquidation will be $25,000-the same basis it had in the hands of the corporation. See section 334 (a) (2). (Under sec. 331 (b) (1) (A), the gain recognized to the shareholder will be $15,000.)

(2) If there is a gain realized on the distribution, but the corporate asset basis is less than the stock basis, then the basis of the property to the shareholder will be the same as the basis to him for his stock in the corporation. For example, if stock basis is $10,000, corporate asset basis is $9,000 and corporate asset value is $30,000, the basis of the asset to the shareholder following the liquidation will be $10,000. See section 334 (a) (3). (Under sec. 331 (b) (1) (B) no gain will be recognized on the liquidation.) If several properties are distributed to the shareholder in the liquidation, the aggregate basis of such properties in the hands of the shareholders will be allocated among the several properties under

regulations to be prescribed by the Secretary or his delegate. The advisory group concluded that it is advisable to leave this matter of detail to regulations. A similar situation has existed in section 333 for many years, as well as in section 358, without specific rules being set forth in the statute. The advisory group assumes that the regulations under section 334 (a) (3) will contain provisions comparable to those in present section 333 under which any adjustment required by reason of the assumption by the shareholder of a corporate liability constituting a specific lien on property distributed will be made in the basis of the particular property on which the lien exists. Moreover, the advisory group believes that appropriate regulations under section 334 (a) (3) should allocate first to each asset received an amount equal to the adjusted basis which that asset has in the hands of the corporation; then the excess of the shareholder's stock basis over the aggregate basis to the corporation of the assets distributed to him should generally be allocated among the properties received in proportion to the unrealized appreciation on those assets in the hands of the corporation.

D. COLLAPSIBLE CORPORATIONS

Section 16 of the proposed amendments would add a new section 343 to the code. Section 343 is designed to replace section 341 of existing law, which would be repealed.

The proposed new section 343 differs from section 341 of existing law in three principal respects:

(1) It would operate entirely by objective tests and would not depend for its application upon the intention of the shareholders. Present section 341 applies only if a corporation is "formed or availed of principally" for certain proscribed purposes "with a view to" a sale or exchange of the stock by the shareholders at a gain before realization by the corporation of a substantial part of the taxable income to be derived from its property. Proposed section 343 would not depend for its operation upon the intention of the parties-a matter obviously difficult to determine.

(2) Under present law if section 341 applies, the entire gain from the sale or exchange of the stock of the corporation is treated as ordinary income taxable at surtax rates. Proposed new section 343 would tax to the shareholders at ordinary rates only the gain attributable to property which, if sold by the corporation (or by the individuals if there had been no corporation), would have produced ordinary income.

(3) Present section 341, while originally adopted in order to prevent use of a corporation to convert ordinary income into capital gain, may operate in many cases to convert into ordinary income what might be capital gain to the shareholders if no corporation were used. However, in general, section 343 would not tax to shareholders as ordinary income items which would be capital gain to them if no corporation were used by them. Sales of stock to persons other than the issuing corporation. In order to prevent the use of a corporation to convert ordinary income into capital gain, proposed section 343 (a) provides that in certain cases part or all of the gain realized on the sale or exchange of the stock of

GENERAL REVENUE REVISION

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 corporation makes a distribution to shareholders, not in redemption of its stock, in an amount exceeding its earnings, section 301 (c) (2) requires 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 as 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 represents the shareholder's ratable share of the unrealized appreciation in the corporation's section 343 assets will be taxed to him as ordinary

income.