Question

Determine the tax consequences of complete liquidations for both corporation and its shareholder.

Answer 1

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.

The result of these rules is double taxation. 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.

Recognizing Capital Gains Rather Than Dividends:-

When determining whether a closely held corporation should be liquidated, the tax consequences to the shareholders should be considered. If the stock is a capital asset in the hands of the shareholder, the shareholder has a capital gain or loss on the exchange. The maximum tax rate for both long-term capital gains (realized after May 5, 2003, and before 2013) and dividends (for tax years beginning after 2002 and before 2013) is 15%. For taxpayers in the 10% or 15% ordinary tax brackets, there is no tax on most long-term capital gains and dividends realized after 2009 and before 2013.

Handling Corporate Liabilities:-

Shareholders that assume corporate liabilities or receive property subject to corporate liabilities take the liabilities into account in computing their gain or loss. They do not increase their basis in the property received on liquidation because doing so would give them a double tax benefit. Instead, the liability reduces the amount realized by the shareholder.

If the property distributed is worth less than the amount of the liability itself, the FMV of the property is treated as no less than the amount of the liability (Sec. 336(b)). The assumption of a contingent or unknown liability is disregarded in determining the property’s FMV. However, the IRS has stated that a shareholder that assumes such a liability will receive capital loss treatment when the liability is ultimately paid by the shareholder (Rev. Rul. 72-137).

Handling Unrealized Receivables:-

A corporation, whether it uses the cash or accrual basis, may have earned income that it has not collected before the liquidation takes place. The corporation recognizes gain or loss for the receivable when it distributes the receivable to the shareholder. The shareholder does not recognize and report additional income as it collects the receivable because the shareholder has already included this amount in its gain or loss computation when it received the liquidating distribution. But if the amount of the receivable that the shareholder ultimately collects differs from the amount that the corporation distributed, the shareholder recognizes gain or loss for the differences in the amounts reported and collected.

Receiving Liquidating Distributions in More Than One Year:-

A distribution is treated as one made in complete liquidation of a corporation if it is one in a series of distributions in redemption of all the stock of the corporation pursuant to a plan of liquidation (Sec. 346(a)). As a result, all the distributions necessary to effect a complete liquidation of a corporation do not have to take place on the same date or even in the same year.

Claiming a Loss on a Liquidation

A shareholder may claim a loss on a series of distributions only in the year the loss is definitely sustained. Generally, a loss cannot be recognized until the tax year in which the final distribution is received. However, there have been some exceptions to this rule (e.g., in the year the last substantial distribution was made because the amount of the final distribution was then determinable with reasonable certainty) (Rev. Ruls. 68-348 and 85-48).