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FEDERAL INCOME, ESTATE & GIFT TAX PROJECT 1 (PRELIMINARY DRAFT 201, July 9, 1956)

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P.D. 201 7/9/56
CDRPDRATE CONTRACTIONS: CRITICAL COMPARISON OF NET WORTH
AND GROSS ASSETS TESTS.
This memorandum raises certain questions about the 50% grosi--issets
test of corporate contraction voted for by the Committee at its last meeting.
The test was voted in lieu of the 80% nct worth test proposed in subsection
(a)(4) of the draft statute in Preliminary Draft 198A.
The net worth test of P. D. 198A embodied the mathematical criteria
required to be satisfied before a redemption distribution incident to a liquidation
of operating assets could qualify for contraction treatment. Its essential
requirement was that the distribution of the operating assets reduce the net
worth of the corporation (i.e., sharcholder equity) by 80%. The test did not
require that the gross assets of the corporation also be reduced by some
minimum percentage as a result of the contraction.
The gross assets test voted by the Committee would require the con-
traction to involve the liquidation of at least 50% in value of the gross assets of
the corporation. It would not, however, require all the liqyidated assets to be
distributed. Part of them would be permitted to be applied in reduction of the
corporation's liabilities, either by direct application of the assets to pay off
liabilities or by distribution of the assets subject to the liabilities attaching
to them. The test would, however, limit the extent to which the liquidated
assets could be used to reduce liabilities rather than distributed, by prescribing
a pro rata rule operating as follows. In the case where the liquidated assets
represent 50% of the gross corporate assets before liquidation, the ratio of
the amount applied against liabilities to the amount distributed must not exceed
the ratio of total corporate liabilities to net worth before the liquidation. This
establishes the minimum amount that must be distributed for capital gains
treatment to apply. If more than 50% of the assets are liquidated, the
minimum amount that must be distributed remains the same as for the 50%

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