Question

What exactly is a liquidating distribution? Does its tax treatment differ from that of a non liquidating distribution? If so, how? Is there a justification for the difference? If so, what is it?

Answer 1

A liquidating distribution is a non dividend distribution made by corporations or partnerships to its shareholders during its partial or complete liquidation. Liquidation basically means the dissolution or the winding up of a company.

In liquidating distribution what we distribute is the entire amount of shareholder's equity and not solely profits. When the company has negative equity i.e. Liabilities > Assets, then no liquidating distribution takes place. We can view liquidating distribution as return of capital, This means what ever the amount the shareholders have invested is returned to them rather than only the earnings.

Non liquidating distribution on the other hand is distributions of cash or property by a continuing corporation to its shareholders. For example A,B and C each own 3000 shares of D Ltd. A has a problem with other shareholders and eants his share to be redeemed. The other shareholders agree to to give a land of D Ltd to A and balance settle in cash. This is a non liquidating distribution.

Tax treatment of liquidating distribution

The gain or loss recognised by shareholder= Fair Market value of assets recieved(cash, property or both) - Adjusted value of stock surrendered.

If the stock is a capital asset for the shareholder it will result in capital gain or loss to shareholder

If the company itself sells its assets and distributes cash to shareholder , then the shareholder will recognise gain or loss when the proceeds are recieved by him

Here there is double taxation i,e corporate also pays tax and shareholder also pays tax, as the corporation is treated as selling the distributed assets for FMV to its shareholders, with the resulting corporate-level tax consequences. Then, the shareholders are treated as exchanging their stock for the FMV of the assets distributed in complete liquidation, with the resulting gains or losses at the shareholder level.

Tax treatment of Non liquidating distribution

At the shareholder level, a nonliquidating corporate distribution can produce a variety of tax consequences, including taxable dividend treatment, capital gain or loss, or a reduction in stock adjusted value.

At the corporate level, a nonliquidating corporate distribution can also have varying tax consequences. The distribution may have no tax effect, or it may trigger corporate-level capital gain and/or ordinary income. The corporate-level tax consequences of a nonliquidating corporate distribution depend on whether the distribution consists of cash or property (other than cash). The corporation does not recognize gain or loss when it distributes cash to shareholders or when it redeems stock in exchange for cash payments (Sec. 311(a)).

The major difference in the tax treatment of liquidating and non liquidating distribution is in recognising corporate level loss. In case of a non liquidating distribution a corporation cannot recognize a tax loss on a nonliquidating distribution of depreciated property (i.e., where the property’s FMV is less than the adjusted basis) however a corporation is generally allowed to recognize tax losses when depreciated property is distributed to shareholders in liquidating distribution of the corporation (Sec. 311(a))