Question

Under IRC Section 311(b)(2), when a corporation distributes a property, subject to a liability, or the shareholder assumes the obligation of the distributing corporation, the fair market value (FMV) of the property is at least equal to the amount of the liability.

• Assume your client made a nonliquidating distribution with FMV exceeding its adjusted basis.
• What are the potential tax effects to the distributing company (client) and the receivers (shareholders)?
• Propose a plan in which you mitigate the potential tax impact on your client and the shareholders.

Answer 1

Internal Revenue Code, Section 311(b) stands for Taxability of Corporation on Distribution.

Subsection (2) stands for Distribution of Appreciated Property and sub-cluase (b) stands for FMV (fair market value consideration).

Fact 1: Client has made a nonliquidating distribution with FMV exceeding its adjusted basis.

Fact 2: (FMV) of the property is at least equal to the amount of the liability. Thus, no losses can generate. There can be gain (profit) on distribution of appreciated property.

Issues: What are its tax implications on both parties?

Answer: For this purpose, section 336(b) shall apply in same capacity of IRC.

In the case, When a corporation makes a nonliquidating distribution of corporate property and if the property’s fair market value (FMV) exceeds its adjusted tax basis in the corporation’s hands, the corporation recognizes gain. This is because, it is assumed that, corporation is selling the appreciated asset for FMV. When more properties are sold this way, gain multiplies and thus taxes. The gain portion can be calculated by reducing the depreciable value of asset, if the asset is depreciable such as building, car, machinery etc. In the Section mentioned above, cash transfers are not considered. Rules of Section 336(b) is apllicable.

Conclusion: Recognise the Corporate Level Gain and re-consider if there are any depreciable assets pending. Pay taxes on the Adjusted Capital Gain.

The Plan:

For Client: Company:

Taxble Capital Gain: 100% - (Portion of depreciable asset)

For Shareholder:

Not taxable in the hands of Shareholder (if the company pay taxes beforehand) to avoid Double Taxation.

Further Explanation:

Let us understand the Section 311(b) in detail.

Section 311(a)states that, no gain or loss will be recognised to a corporation in its distribution of its stock or of property except as it is given in Section 311(b).

Section 311(b) states that when a corporation distributes appreciated property to shareholder, it will be recognised as if the corporation has sold it for FMV at gain. (Please note that - There can only be gain in this case and not loss).

Example for understanding the case above: Let's say there is a machinery in corporation whose depreciated value is not fully utilised. But, we know its Book Value = $40,000 on the date of liquidation of corporation. Book Value = Adjusted Basis (assuming no further adjustments are made).

On same day, Same machinery has higher value in the market (FMV), say, $65,000. The market value is said to be appreciated in this case up to $25,000 (difference between FMV and adjusted basis). If the corporation sells this machinery to a shareholder at FMV, it is obviously understood that it is sold for appreciated value.

Therefore, according to Section 311(b)(2) corporation will be considered as the gainer and hence corporation will be taxed.

Tax Effects on both Parties:

For Client: Client (Corporation) will be taxed on the gain (to the extent of FMV).

For Shareholder: Shareholder will not pay tax as there is no gain.

Full Plan:

In the example above, ordinary income is $25,000.

Assume there are no Earnings and Profits, so no question of distributing dividends as per Section 301(c). Then, as a shareholder, reduce basis in corporation stock. ( let's assume that there are stock of $20,000 (basis/ Book Value)).

Now, first reduce the basis in stock from income. i.e., $25,000 - $20,000 = $5,000.

This will make stock basis for shareholders = Zero. (Because amount is paid from ordinary income).

The balance will be considered as a Capital Gain in the hands of corporation. This is taxable as per Section 301(c)(3).

Summary:

First of all, calculate ordinary income of corporation. Reduce the basis in stock by paying shareholders. This will give you reduced balance on which corporation will pay taxes.

Hope this answer helps.

All the best!