Question

The company for which you work is contemplating either non-liquidating or liquidating distributions to its shareholders. As the tax accountant, you have been asked for your advice.

1. Which type of distribution would you advise the company to execute?

2. Provide your reasons for this advice and discuss the tax implications

Answer 1

Solution:

Liquidating Distribution:

Under Sec. 331, a liquidating distribution is considered to be full payment in exchange for the shareholder’s stock, rather than a dividend distribution, to the extent of the corporation’s earnings and profits (E&P). The shareholders generally recognize gain (or loss) in an amount equal to the difference between the fair market value (FMV) of the assets received (whether they are cash, other property, or both) and the adjusted basis of the stock surrendered. If the stock is a capital asset in the shareholder’s hands, the transaction qualifies for capital gain or loss treatment.

If the corporation sells its assets and distributes the sales proceeds, shareholders recognize gain or loss under Sec. 331 when they receive the liquidation proceeds in exchange for their stock. If the corporation distributes its assets for later sale by the shareholders, the assets generally “come out” of the corporation with a basis equal to FMV (and with the related recognition of gain or loss under Sec. 331 for the difference between the FMV and the shareholder’s basis in the stock). As a result, the tax consequences of a subsequent sale of the assets by the shareholder should be minimal.

Non Liquidating Distribution:

Nonliquidating corporate distributions are distributions of cash and/or property by a continuing corporation to its shareholders. 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 basis.

At the corporate level, a non liquidating 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))

When a corporation makes a nonliquidating distribution of corporate property other than cash (including a distribution to redeem stock), the corporation recognizes gain if the property’s fair market value (FMV) exceeds its adjusted tax basis in the corporation’s hands (Sec. 311(b)(1)). Specifically, the corporation recognizes gain as if it had sold the appreciated property for FMV to the recipient shareholder. When multiple properties are distributed, the corporation computes gain on an asset-by-asset basis (Rev. Rul. 80-283). The portion of the corporation’s gain attributable to recapture items (e.g., depreciation recapture) is ordinary income, as is gain attributable to the distribution of inventory and unrealized receivables. Gain attributable to capital assets and certain property used in a trade or business (Sec. 1231 property) is capital gain.

In view of above, i will advise to go for liquidating distribution as it will have tax consequences in the hands of shareholders while non liquidating distribution will have tax consequences in hands of company as well as in shareholder.