Corporate Finance

A Dirty Word?

"Partial liquidation" doesn't sound so bad to shareholders who have enjoyed the tax benefits.
Linda CormanJuly 1, 1997

Here’s a club your company doesn’t want to join, unless membership is secret: companies whose noncorporate shareholders are probably forking over at least $200 million a year in income tax they needn’t pay, because management is failing to exploit a 50-year-old tax break.

That estimate comes from Robert Willens, a tax and accounting expert at Lehman Brothers Inc. It’s based on his observation that about 12 companies a year could designate distributions from proceeds of the sales of businesses as “partial liquidations” but fail to do so. Since the designation would allow shareholders that aren’t corporations to pay taxes on the money they receive at the capital gains rate of 28 percent instead of the ordinary income rate, which can run as high as 39.6 percent, and since companies distribute roughly $2.4 billion a year in dividends, that 12 percentage point gap in tax rates creates a difference of $200 million. That’s just for federal taxes. But there’s another reason that estimate is conservative. Designating distributions as partial liquidations also reduces the size of taxable gains.

So why don’t more companies take advantage of partial liquidations? “It’s not the best term,” says Willens. “People associate liquidation with going out of business. It’s a very provocative phrase.” Other companies are evidently laboring in ignorance.

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The tax break arises from a federal court case involving Joseph W. Imler, a midwestern textile company, in 1948. The court decided that shareholders who received the proceeds of an insurance claim after an Imler factory burned down were entitled to pay tax on the money at capital gains rates rather than ordinary income rates, because the distribution wasn’t a dividend.

Since then, any firm that has used the proceeds of the sale of a portion of its business that resulted in a 20 percent reduction in net assets, gross revenues, and employees, to buy back stock or make a special pro rata distribution, has been able to designate the disposition of those proceeds as a partial liquidation. A sale can qualify even if it doesn’t reduce the firm’s overall business by 20 percent, so long as the business sold is “self-contained,” says Willens.

With this designation, shareholders are not only taxed at the capital gains rate rather than the dividend rate, but also can treat distributions as if they result from a stock sale even though no stock is exchanged. Say a shareholder owns 100 shares of Acme Semiconductor Corp., with a cost basis of $40 per share, and the stock is trading at $75 a share. In a distribution of $10 per share that’s designated a partial liquidation, the shareholder is considered to have surrendered 13.3 percent of his stock ($10 divided by $75).

As a result, he realizes a capital gain of $467, which represents the difference between the $1,000 he received from Acme and $533, the cost basis of the surrendered shares ($4,000 times .133). So instead of paying 39.6 percent of a $1,000 dividend, or $396, to the IRS, leaving him with $604 after taxes, the shareholder is coughing up 28 percent of a $467 capital gain, or $131, netting $869.


Yet investment bankers can count on one hand the number of companies that have used the device in recent years. And Willens says there certainly have been other companies that qualified for a partial liquidation but failed to obtain it, although he is unable to name any offhand.

Among those about to join the list is Chubb Corp. While Chubb sold its life insurance subsidiary and used a large portion of the proceeds for a stock buyback, the company will not designate the distribution a partial liquidation, although Willens contends the transaction qualifies. Says Gail Devlin, senior vice president of Chubb: “The concept of partial liquidation is not applicable, because we are purchasing shares from time to time on the open market, and there is no reason why anyone should have other than capital gains treatment.”

Ah, but there may be. Willens notes that any Chubb shareholder who does not tender enough shares to decrease his percentage of stock ownership will be taxed at the ordinary income rate rather than the capital gains rate. But, he says, if the company obtained partial liquidation status for the buyback, even shareholders whose percentage ownership share increased because others tendered more would be assured of capital gains treatment.

One reason Chubb and other companies aren’t taking advantage of partial distributions may be that shareholders themselves seem oblivious to the advantages. A spokesperson for the Dreyfus Fund, which owned $925,000 in Chubb shares, or about half of one percent, as of last December 31, declines to discuss Chubb’s approach to the stock buyback, saying the money-management company is unfamiliar with partial liquidations.

Of course, some companies that opt against partial liquidation have a better alternative for disposing of businesses, the so-called Morris Trust transaction, which is entirely tax free. But this technique, in which a company spins off to shareholders the business it wants to keep and then sells off a portion of its business for stock, would be curtailed by a bill in Congress that is given a good chance of passage (see New Deals, May). Still other companies prefer to use the proceeds of a sale to pay off debt or reinvest.

Yet companies with little or no debt and unpromising reinvestment prospects may find the case for a partial liquidation compelling, especially when a big chunk of their shares is owned by one or two large investors that want to cash at least partly out but prefer not to sell shares.


Consider St. Joe Corp., a $431 million (in revenues) land development company based in Jacksonville, Florida. In March 1996, St. Joe opted to distribute the $336 million of net proceeds that it received in the sale of its communications, container, and forest products businesses in the form of a special dividend to share- holders that was designated a partial liquidation. The company had no debt to repay and the new management team wasn’t ready to pursue any investment opportunities.

Partial liquidation status was also the right move with a $970 million dividend paid by Schuller Corp. (now Johns Manville Corp.) in 1996 after it sold off Riverwood International Corp., its forest products business. Its largest investor, with 80 percent of the shares, is a trust that the company set up as part of its reorganization plan to pay off asbestos litigants and so emerge from bankruptcy in November 1988.

“With a large owner who needs cash, we weren’t about to reinvest,” says Kenneth Jensen, senior vice president and CFO of Johns Manville.

The company could have spun off Riverwood to shareholders instead, but the board of directors, almost one-quarter of whom also sat on the board of the trust, decided it would not make as much sense as a partial liquidation. For one thing, the tax benefits of a Morris Trust­ style spin-off would not have been worth anything, because the company had operating loss carryovers that offset the gain on the sale, and the proceeds paid into the trust to cover liability claims were tax deductible.

Also, cash was worth more than stock to the trust. “The trust wanted cash for the asbestos claimants, not something it could turn around and sell,” says Jensen.

Of course, the price was also right. If the offers for the company had been lower than the minimum sought by the board, it might have chosen to spin off Riverwood anyway, says Jensen.

General Dynamics Corp. also used a partial liquidation in selling off three of its defense-related businesses in the early 1990s. With defense budgets shrinking and competitors making “disastrous” diversification forays, the company lacked confidence that its businesses could stand alone if spun off. It also had no promising opportunities to reinvest the proceeds of a sale, says Michael Mancuso, senior vice president and CFO.

But General Dynamics may not have gone as far as it could have for shareholders. Of the $3 billion in proceeds from the sales, $600 million was used to pay down debt, $900 million was used to buy back stock, and $1.5 billion was used for a special distribution that received partial liquidation treatment. However, Mancuso says he did not know if the company had obtained partial liquidation status for the stock buyback and did not want to take the time to find out. Maybe prospective shareholders will have better luck getting him to do so.

Several other companies that analysts have identified as likely candidates for partial liquidations, including Campbell Soup, Dow Jones, Kellogg’s, MacAndrews & Forbes, and the Limited, either declined or failed to respond to requests for interviews. But if their shareholders wake up, they could come under increasing pressure to use the tactic, especially if the capital gains tax rate is reduced and Morris Trust transactions are curtailed.