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.
Caution: Shareholders may want to evaluate the sale or disposal of stock by the end of 2012 to take advantage of the 15% dividend tax rate, lower individual income tax rates, and lower capital gain tax rates set to expire on Dec. 31, 2012. Guidance on the tax treatment of these items in 2013 and subsequent tax years is uncertain, so practitioners should watch for future legislation.
Shareholders that do not have a strong preference on whether distributions in 2012 are taxed as dividends or capital gain/loss may prefer sale or exchange (capital) treatment in 2012 if they:
Have capital losses or capital loss carryforwards, since Sec. 301 dividend income cannot be used to offset capital losses;
Have basis in stock that can used to offset the distribution income (if the basis is higher than the amount of the distribution, the shareholder could potentially report a loss); or
Desire installment sale treatment—capital gain income can potentially be reported on an installment basis, while Sec. 301 dividend income cannot.
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.
Observation: Distributions in partial liquidation of a corporation must be made in the year the plan is adopted or in the subsequent year. No such requirement exists for distributions made in a complete liquidation of a corporation.
Unfortunately, no clear-cut guidance exists regarding the period over which liquidating distributions can be made. In fact, Sec. 346 does not address this issue. The IRS indicates it will normally not issue a ruling or determination letter on the tax effects of a corporate liquidation accomplished through a series of distributions made over a period in excess of three years from adoption of the plan of liquidation (Rev. Proc. 2012-3, §4.01(24)).
The liquidation should be completed as quickly as possible to ensure sale or exchange treatment (as opposed to possible dividend treatment if the corporation has E&P) for the liquidating distributions. Note also that Rev. Rul. 80-177 raises the issue of the constructive receipt of assets by shareholders when a corporation adopts a plan of liquidation and the shareholders are entitled to a liquidation distribution at any time after a certain date. Finally, it may be desirable to avoid a lengthy liquidation period to minimize exposure to double taxation and to avoid Sec. 541 personal holding corporation (PHC) status for the corporation after the assets are sold.
Shareholders should maintain documentation that multiple distributions are liquidating distributions whenever multiple distributions are necessary (especially if they will span several tax years and, therefore, result in tax deferral). For example, a plan of liquidation documented in the corporate minutes could state that multiple liquidating distributions will occur and explain the business reasons for this.
Recovering Stock Basis Before Recognizing Gain
Generally, shareholders are allowed to recover their entire basis before recognizing gain (Rev. Ruls. 68-348 and 85-48; and Quinn, 35 B.T.A. 412 (1937), acq. 1937-1 C.B. 21). The full amount (100%) of all distributions made after basis has been recovered are recognized as gain.
Observation: The current reduction of the maximum tax rate on capital gains and on qualifying dividends to 15% through 2012 somewhat mitigates the traditional preference for a sale or exchange transaction (e.g., a Sec. 331 liquidation payment) over a dividend. However, under current law, distributions made after 2012 will be taxed at higher capital gain and dividend rates. Therefore, taxpayers should consider making the final distribution before 2013.
When a shareholder holds several blocks of the same class of stock (acquired at different times and at different prices) and several distributions are made in complete liquidation, each distribution is allocated among the different blocks in proportion to the number of shares in each block (Rev. Rul. 85-48).
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).
Requesting a Prompt Assessment
The normal period for assessment of tax is three years from the date the return is filed. A corporation can accelerate the period in which the IRS can assess tax by requesting a prompt assessment of tax (Sec. 6501(d)). Form 4810, Request for Prompt Assessment Under Internal Revenue Code Section 6501(d), is used to request a prompt assessment. The request limits the time for assessing tax or beginning a court action to collect the tax to 18 months from the date the request is filed. It does not extend the time in which an assessment can be made beyond three years from the date the return was filed (Regs. Sec. 301.6501(d)-1(b)).
One example of a situation when a request for prompt assessment might be appropriate is the liquidation of a corporation because of shareholder differences. If the IRS assesses an additional tax liability after the assets have been divided among the shareholders, disagreements could arise regarding who is responsible for the deficiency. On the other hand, filing a request for prompt assessment when there is only one shareholder might not be warranted.
This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 25th Edition, by Albert L. Grasso, R. Barry Johnson, Lewis A. Siegel, Richard Burris, Mary C. Danylak, Kimberly Drechsel, James A. Keller, and Robert Popovitch, published by Thomson Tax & Accounting, Fort Worth, Texas, 2012 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP, in Arlington, Va.