Tax Consequences of De Facto Liquidations

By Robert C. Pedersen, CPA, J.D., LL.M., and Stephen C. Arber, CPA, J.D., LL.M., New York, NY

Corporations & Shareholders

As a result of the recent recession, many taxpayers have been evaluating their legal entities and structures. Generally, a corporation is respected as a distinct entity and not ignored unless it is used to defraud the law ( Moline Properties, Inc. , 131 F.2d 388 (5th Cir. 1942)). However, under specific facts, a corporation may be deemed to have liquidated for income tax purposes without an actual legal liquidation. This is referred to as a de facto liquidation. This principle can trigger income tax consequences for both the company and its shareholders.

Identifying a De Facto Liquidation

Whether a corporation has had a de facto liquidation is a subjective determination based on case law. Thus, it is sometimes difficult to determine precisely in which corporate tax year the de facto liquidation occurs, if at all, especially if the company has been slowly winding up its existence over a period of time. In Estate of Maguire , 50 T.C. 130 (1968), the Tax Court used a three-pronged test to determine whether a corporation had a de facto liquidation. Such a liquidation encompasses:

  • A “manifest intention to liquidate”;
  • A continuing purpose to terminate corporate affairs; and
  • Corporate activities directed toward termination of the corporation.

In analyzing these three prongs, the court cited certain factors, such as board resolutions, the adoption of a plan of liquidation, the sale of assets and cancellation of debt, termination of contracts, and the distribution of corporate assets in complete cancellation or redemption of all shareholders’ interests. Rev. Rul. 61-191 cited several similar factors in its determination that a de facto liquidation had occurred.

On the other hand, otherwise seemingly “shell” or “dormant” companies were respected as corporations for tax purposes where there were business and/or legal reasons to keep the corporation in existence. For example, in Rev. Rul. 74-462, the IRS deemed that no de facto liquidation had occurred, even though the corporation had terminated its “regular” business activities, because the corporation continued to retain counsel and actively defended and prosecuted legal actions brought against it and on its behalf, and it maintained a reserve against possible adverse judgments in pending lawsuits. The retention of a reserve against possible future liability was a valid business reason for continuation of the corporate charter.

The taxpayer’s intention with respect to liquidation is also relevant to concluding whether a de facto liquidation had occurred. In the facts of Rev. Rul. 74-462, management had decided to liquidate the corporation; however, it intended that a complete liquidation not occur until after substantial lawsuits that were pending against the company were resolved. Supporting this intent not to completely liquidate was the fact that the assets the corporation retained represented the best available estimate of maximum liability on the pending lawsuits and related legal fees and expenses. The plan of liquidation further supported management’s intent to completely liquidate within three years after the partial liquidation, rather than immediately.

Tax Consequences of a De Facto Liquidation

In general, if a de facto liquidation is deemed to occur, the tax consequences are substantially the same as if the company had formally liquidated. Notably, the consequences depend on whether the corporation was solvent at the time of the de facto liquidation.

In the context of a foreign-owned corporation, the following results would generally be deemed to occur in the year that a U.S. corporation is determined to be de facto liquidated (assume in this discussion that a wholly owned U.S. corporation has been de facto liquidated and its parent is a foreign corporation).

If the de facto liquidated corporation is solvent, it is subject to tax on any gain to the extent the fair market value of its property exceeds its tax basis (Secs. 367(a) and 367(e)). Note that in the case of de facto liquidations, there may be no materially appreciated assets (if there are any assets at all); however, this should be confirmed on a case-by-case basis. Absent the application of the Foreign Investment in Real Property Tax Act, P.L. 96-499 (FIRPTA), under which liquidation of a corporation that holds an interest in U.S. real property is generally taxable (see generally Sec. 897), the receipt of property (including cash) by a foreign corporate shareholder on a complete liquidation should not be taxable under Sec. 332. Sec. 367 has no effect on the tax treatment to the corporate shareholder.

The liquidating corporation’s tax attributes (including net operating losses, earnings and profits, and capital losses) carry over to the foreign corporate shareholder under Sec. 381. Interestingly, Sec. 367(a)(1) only disregards the corporate status of the foreign corporate transferee for purposes of determining the extent to which gain is recognized by the liquidating corporation; it otherwise does not preclude reorganization treatment. For example, although gain may be recognized under Sec. 367(a)(1), other provisions that apply to reorganizations, such as Secs. 358, 362, and 381, may still apply to the transaction. The foreign acquiring corporation takes the liquidating corporation’s adjusted basis in the assets received and tacks on the liquidated corporation’s holding period in the assets received (Secs. 334(b) and 1223(2)).

If the wholly owned U.S. corporation is insolvent and the shareholder of the de facto liquidated corporation is a foreign corporation, the liquidating corporation is subject to U.S. tax on the distribution of property as if such property had been sold to the distributee at fair market value under Sec. 336. The tax attributes of the liquidated corporation disappear in this scenario; consequently, the company’s net operating losses and other deferred tax items may need to be revised to account for the de facto liquidation. Absent the application of FIRPTA, the foreign corporation should not be subject to U.S. tax on the deemed liquidation because gains derived by foreign persons (including gains derived from the complete liquidation of corporations) are generally non-U.S.-sourced income (Secs. 871 and 881). The acquiring corporation’s basis in any acquired assets is the property’s fair market value at the time of the distribution, pursuant to Sec. 334(a).

Conclusion

As a result of the above tax consequences, tax advisers should remain diligent in analyzing whether any corporate subsidiaries have been or are at risk of de facto liquidation treatment in either the domestic or the foreign context, which may trigger various tax consequences, including the unintended disappearance of valuable tax attributes.

Editor: Kevin D. Anderson, CPA, J.D.

EditorNotes

Kevin Anderson is a partner, National Tax Services, with BDO Seidman, LLP, in Bethesda, MD.

For additional information about these items, contact Mr. Anderson at (301) 634-0222 or kdanderson@bdo.com.

Unless otherwise noted, contributors are members of or associated with BDO Seidman, LLP.

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