Understanding the Tax Consequences of Liquidation to an S Shareholder

Albert B. Ellentuck, Esq.

The shareholder consequences of a complete liquidation of an S corporation are governed by Secs. 331 and 1001. The dividend rules that otherwise apply to corporate distributions are not applicable to distributions in complete liquidation. Distributions received by the shareholder are treated as payment in full for the exchange of stock. The shareholder’s adjusted basis in the stock is subtracted from the cash and fair market value (FMV) of other property received from the corporation. If the shareholder assumes known corporate liabilities or receives corporate property subject to a liability (such as the distribution of mortgaged land), the amount realized is reduced by the amount of the liability (Ford, 311 F2d 951 (Ct. Cl. 1963)).

The general rule is that a shareholder’s stock basis is determined as of the end of the S corporation’s tax year. It appears that the adjusted basis of stock held in a liquidating corporation is adjusted for current-year passthrough items prior to determination of gain or loss from the receipt of the liquidating distributions (see Regs. Sec. 1.1367-1(d)(1) and Letter Ruling 200106009).

If the shareholder has different bases in different blocks of stock, the computation of gain or loss depends on whether there is a single distribution or a series of liquidating distributions (Rev. Ruls. 68-348 and 85-48). The shareholder recognizes gain when the adjusted basis of each block has been recovered, while loss is not recognized until the corporation has made its final distribution.

Example 1: T holds 30 shares of stock in an S corporation, represented by two blocks of stock. T has a basis of $10,000 in Block 1 (which represents 10 shares) and a basis of $40,000 in Block 2 (which represents 20 shares). The corporation distributes $45,000 cash to T in return for his stock.

The $45,000 is allocated pro rata to the two blocks, so $15,000 is allocated to Block 1 (10 ÷ 30 × $45,000) and $30,000 to Block 2 (20 ÷ 30 × $45,000). T recognizes a $5,000 gain on Block 1 ($15,000 – $10,000 basis) and a $10,000 loss on Block 2 ($30,000 – $40,000 basis).

If T receives $45,000 in 2007 and an additional $135,000 in 2008, each distribution is allocated ratably between the blocks based on the number of shares in each block. The 2007 distribution is allocated the same as before. T recognizes a $5,000 gain on Block 1 ($15,000 – $10,000 basis), which reduces his basis in that block to zero. T recognizes no gain or loss on Block 2 ($30,000 – $40,000 basis) and has a remaining basis of $10,000 in Block 2.

The 2008 distribution is allocated $45,000 to Block 1 (10 ÷ 30 × $135,000) and $90,000 to Block 2 (20 ÷ 30 × $135,000). T recognizes a $45,000 gain on Block 1 ($45,000 – $0 basis) and an $80,000 gain on Block 2 ($90,000 – $10,000 basis).

Determining the Character of Gain or Loss

The character of gain or loss recognized by the S shareholder depends on whether the stock is a capital asset in the shareholder’s hands and whether the transaction constitutes a complete or a partial liquidation of the corporation. Long-term or short-term classification of a liquidation that qualifies for capital gain treatment depends on the shareholder’s holding period, with long-term status having significant importance due to the 15% tax rate cap on long-term capital gains. Shareholders in the 35% tax bracket achieve a 57.1% ((35% – 15%) ÷ 35%) tax savings on capital gain versus ordinary income. For tax years beginning in 2008, 2009, and 2010, the savings is even greater for taxpayers in the 10% and 15% brackets because their net capital gain is taxed at 0% in those tax years.

Planning tip: If the stock surrendered in the liquidation qualifies as Sec. 1244 stock, the shareholder may be able to claim an ordinary loss rather than a capital loss.

Distributions in complete liquidation of an S corporation are treated as payments in exchange for the shareholder’s surrendered stock (Sec. 331(a)). The ordinary distribution rules of Sec. 1368 do not apply. Thus, accumulated earnings and profits (AE&P) or accumulated adjustments accounts (AAA) are not relevant to the characterization of the liquidating distribution. Since the existence of AE&P has no impact on the characterization of a liquidating distribution, an S corporation with AE&P should identify liquidating distributions as such (for example, in a board of directors resolution adopting the plan of complete liquidation).

In addition, during the liquidation of an S corporation, it may be difficult to predict the ending balance of AAA. This may in turn make it difficult to accurately determine the AAA available for ordinary distributions and makes inadvertent dividend distributions from AE&P more likely to occur. If the S corporation has AE&P, the shareholders may want to forgo distributions prior to commencement of the liquidating distributions, because once the AAA is exhausted, preliquidation distributions are treated as dividend income to the extent of AE&P.

Determining the Basis of Property Received

The shareholder’s basis in assets received is their FMV at the time of the distribution. Basis is not affected by the shareholder’s assuming corporate liabilities or receiving corporate property that is subject to a liability (Sec. 334(a); see also Ford).

Structuring a Partial Liquidation for Best Tax Results

A distribution in partial liquidation of the S corporation will also qualify for sale or exchange treatment under Sec. 302 if the distribution is pursuant to a plan and occurs within the tax year the plan is adopted or the following tax year and the “safe harbor” of Sec. 302(e)(2) is met. Under the safe harbor, the assets, or proceeds from the sale of the assets, of a trade or business conducted by the S corporation during the previous five-year period must be distributed to the terminating shareholder, and the S corporation must continue conducting a trade or business that it conducted during the same prior five-year period.

A distribution in partial liquidation that does not qualify for sale or exchange treatment will be governed by the usual S corporation distribution rules of Sec. 1368. In certain cases, this treatment is preferable to sale or exchange treatment. If the shareholder prefers Sec. 1368 treatment, the sale or exchange rules can be easily avoided, for example, by failing to adopt a plan of liquidation or delaying the distribution until two years after the tax year the plan is adopted.

If the S corporation has a large AE&P amount but a nominal AAA balance, a Sec. 1368 distribution will result in dividend income, while sale or exchange treatment allows a partial stock basis offset and capital gain treatment. Conversely, if the corporation has little or no AE&P or the distribution is less than the AAA balance, a Sec. 1368 distribution allows full stock basis offset at the shareholder level, while sale or exchange treatment allows only part of the shareholder’s stock basis to offset the distribution.

Handling Passthrough Items in the Year of Liquidation

The liquidation process itself does not terminate the company’s S election. Therefore, passthrough items in the year of liquidation are allocated under the normal per-share, per-day rule of Sec. 1377(a)(1). However, a bunching of income can occur in the year of liquidation of a fiscal-tax-year S corporation if the final liquidating distribution occurs on a date other than the last day of the fiscal year. This can result in the shareholders reporting more than 12 months of passthrough income in a single year.

For example, if an S corporation with an April 30 year end makes its final liquidating distribution on October 31, 2007, the shareholders will report 18 months of passthrough items on their 2007 returns. This bunching problem can be avoided if the corporation delays making its final distribution from October 31, 2007, to a date in 2008 (after the end of the shareholders’ calendar tax year).

An additional timing problem can arise from the S corporation’s selling appreciated assets and distributing the proceeds to the shareholders, rather than distributing the assets directly to the shareholders. The taxable gain from the sale passes through to the shareholders and increases their stock basis, which in turn reduces the gain (or increases the loss) the shareholders recognize from the distribution of the sale proceeds. If the sale and distribution do not occur in the same tax year, a shareholder may report capital gain from the sale of the asset but report a capital loss (which cannot be carried back) in a later year when the sale proceeds are distributed. If the sale and distribution occur in the same year but the sale of the asset results in ordinary income, the shareholder may report some or all of the asset sale as ordinary income, which cannot be offset against a capital loss recognized when the proceeds from the sale are distributed.

Example 2: As part of its complete liquidation, a calendar-year S corporation sells its assets in 2007 for $120,000 in cash but does not distribute the proceeds to I, its sole shareholder, until early 2008. The 2007 sale generates a $50,000 capital gain that passes through to I and increases her stock basis from $100,000 to $150,000. As a result of the distribution of the $120,000 sales proceeds in 2008, I realizes a capital loss of $30,000 ($120,000 distribution – $150,000 stock basis).

Thus, I reports a $50,000 capital gain in 2007, but in the absence of other offsetting capital gains in 2008, her $30,000 realized capital loss will be limited to a $3,000 capital loss deduction in 2008.

Deducting Suspended Passthrough Losses

In a complete liquidation, pass-through losses suspended because of basis limitations that remain after the basis of the redeemed stock has been reduced to zero do not reduce gain or increase loss resulting from the liquidation. Since suspended passthrough losses are lost, the shareholder should consider creating additional basis before the final distribution through additional capital contributions or loans. (See Regs. Sec. 1.1366-2(a)(5).) While there is no authority on point, it appears that the shareholder is not entitled to restore basis after the liquidation has been completed in a manner similar to the post-termination transition period rules of Sec. 1366(d)(3).

Losses limited by the at-risk rules are also eligible for indefinite carryover (Sec. 465(a)(2)). Unlike the basis limitation rules, at-risk basis is increased by gain recognized from disposition of the stock. Accordingly, it appears that suspended losses arising from the at-risk rules can be claimed by the shareholder to the extent of gain recognized. (Prop. Regs. Sec. 1.465-66(a) specifically states that this rule applies to the liquidation of a partner’s interest and the complete redemption of an S shareholder’s interest.)

Losses limited by the passive activity rules are also suspended at the shareholder level and carry forward indefinitely to offset future passive income. While a taxpayer who disposes of his or her entire interest in a passive activity can deduct suspended passive losses (and any loss from the disposition) against current passive and nonpassive income, an exception to this rule postpones the deduction if the passive activity is transferred to a related party (Secs. 267(b)(2) and 469(g)(1)(B)). While a corporation and a 50%-or-more shareholder are related for this purpose, it seems that this exception would not prevent a less-than-50% shareholder from recognizing suspended passive losses due to the liquidation of the corporation.

Recapturing Business Credits

General business credits can be subject to recapture as the result of the liquidation of an S corporation. For example, the low-income housing credit (LIHC) authorized by Sec. 42 is a business tax credit for residential rental property that qualifies as low-income housing under detailed statutory criteria. While claimed over a 10-year period, compliance with the statutory criteria must be met over a 15-year “compliance period” (Sec. 42(i)(1)).

The LIHC is subject to recapture if any interest in the building (including stock owned in an S corporation that owns the building) is disposed of during the compliance period. The liquidation of an S corporation that has passed through the LIHC to its shareholders, and the distribution of the low-income housing property (or proceeds from its sale) to the shareholders, appear to result in recapture. The shareholder can avoid recapture by furnishing a bond in an amount and for the period required by the IRS, as long as the property can reasonably be expected to be operated as a qualified low-income building during the remainder of the compliance period (Sec. 42(j)(6); Rev. Rul. 90-60). Alternatively, the shareholders can pledge Treasury securities in lieu of a surety bond (Rev. Proc. 99-11).

The Sec. 46 investment credit is also subject to recapture. Recapture is reduced 20% for each year the property is held, so recapture is zero once the S stock has been held for five years. A reduction in stock ownership triggers recapture when the shareholder’s interest falls below two-thirds, and then one-third, of what it was in the year the S corporation placed the investment credit property in service (Sec. 50(a); Regs. Sec. 1.47-4).

However, a “mere change in the form of conducting the business” will not cause investment credit recapture if certain conditions are met (Sec. 50(a)(4)). Former Sec. 47(b) (regarding dispositions of Sec. 38 property) contained a similar exception, but the underlying regulations added that for the exception to apply, the transferee’s basis in the property must be determined by reference to the transferor’s basis (Regs. Sec. 1.47-3(f)(1)(ii)). In a complete liquidation, the shareholder’s basis in the distributed property will be its FMV (rather than by reference to the transferor’s basis). Thus, liquidation within five years of placing the property in service will result in recapture even if the distributee shareholders continue to conduct the business of the liquidated corporation (Long, 652 F2d 675 (6th Cir. 1981)).

This case study has been adapted from PPC’s Tax Planning Guide—S Corporations, 21st Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot, and James A. Keller, published by Practitioners Publishing Company, Ft. Worth, TX, 2005 ((800) 323-8724; ppc.thomson.com).