Question

Under what circumstances must a corporate shareholder recognize gains in a complete liquidation?

Answer 1

Corporate shareholders owning 80 percent or more of the stock (voting power and value) of the liquidating corporation do not recognize gain or loss on the receipt of liquidating distributions. Shareholders recognize gain or loss upon receiving liquidating distributions in exchange for their stock.The amount of the shareholder's gain or loss will, therefore, be the difference between the net fair market value of the property distributed to him in liquidation and the basis of his stock. The nature of the gain or loss will be capital if the stock is a capital asset in the shareholder's hands, which will usually be the case.

So, on the one hand, §331(a)(1) does not treat amounts distributed in complete liquidation as a dividend to the extent of the corporation's earnings and profits. Rather it treats the transaction as a sale of stock by the shareholder. On the other hand, where the corporation's assets are distributed in kind to the shareholder he has not yet really terminated his interest in those assets, but because the transaction is treated a a sale or exchange of stock, he may be required to pay a tax on receipt of these assets if their value exceeds his stock basis. Unless a sale of the assets for cash follows shortly thereafter, this could cause difficulties.

There are two statutory provisions which we will discuss shortly, § §332 and 333, under which the shareholder may be able to avoid the recognition of gain on liquidation and postpone that gain until he sells the assets. As we will see, these sections are applicable only in limited circumstances.

Where the liquidation is goverened by the general rule of § 331, the basis of the assets in the hands of the shareholders will be the fair market value of the assets at the time of liquidation. This ability to obtain a stepped up basis for assets at the cost of a capital gains tax is one incentive for the use of the liquidation-reincorporation device to be discussed later in the program.

Upon a subsequent disposition of those assets the nature of the income or loss, if any, will depend on the nature of those assets in the shareholders' hands and whether the disposition was in the form of a "sale or exchange." If the assets are sold at their fair market value shortly after their taxable receipt in liquidation, there should be little further gain or loss since the basis of the assets will be their fair market value on the date of distribution.