Summary of tax rules for liquidating corporations

Editor: Mark Heroux, J.D.

Domestic corporations, either S corporations or C corporations, are liquidated by applying Secs. 331-346. This discussion provides a review of the rules that apply to liquidating corporations, but it does not address the exceptions set forth in Sec. 361 via a reorganization plan or the exceptions arising from having foreign liquidating corporations or foreign shareholders.

General liquidations

When a domestic corporation either partially or completely liquidates through a one-time event or through a series of distributions in redemption of part or all of the stock of the corporation pursuant to a plan, the cash and the fair market value (FMV) of the property received by a shareholder is generally treated as proceeds in exchange for the stock unless the shareholder is a qualifying corporation. If a complete distribution happens within one tax year starting with the date of the first distribution, the distribution will generally default to a liquidating distribution (Sec. 332(b)(2)).The liquidating corporation may also adopt a liquidation plan that would generally be made through either a single distribution or a series of distributions made over no greater than a three-year period starting with the first distribution (Sec. 332(b)(3)).

Generally, the shareholder’s basis in the property received equals its FMV at the time of distribution (Sec. 334). The shareholder will use the carrying period on its shares in order to determine whether the gain is long-term or short-term capital gain. The received assets will then start their carrying period anew as of the date of the liquidating distribution. The liquidating corporation is generally required to recognize gain or loss on the assets disposed of (Sec. 336). This amount is calculated as if the property were sold to the shareholder at the FMV of the assets.

Multiple distributions

If a liquidating plan includes multiple distributions over multiple years, the receiving shareholder will not recognize a gain until the FMV of the received property exceeds the aggregate shareholder’s basis in the stock (even if the shareholder surrenders a portion of its stock immediately). If the receiving shareholder is expecting to recognize a loss, the shareholder will not be able to recognize the loss until the last distribution is made.

Corporations liquidating to 80%-or-more corporate shareholder

When property is distributed in a complete liquidation of a corporation to another corporation with ownership qualifying under the consolidated group rules of Sec. 1504(a)(2), the receiving corporation is not able to recognize a gain or loss on the distributed property under Sec. 332. Instead, the received property will assume the basis that the liquidating corporation had in the assets when the assets are distributed (Sec. 334). The rules of Sec. 332 apply only when the receiving corporation was a shareholder on the date of the adoption of the plan of liquidation through the date the property was received.

Treatment of liabilities

If any distributed property is subject to a liability or the shareholder assumes a liability in connection with a liquidating distribution, the liability must be taken into account and will be used to reduce the amount the shareholder realized. Note this treatment is different from how the liquidating corporation treats liabilities. Under Sec. 336(b), if any property distributed in liquidation is subject to a liability or the shareholder assumes a liability of the liquidating corporation in connection with the distribution, then the FMV of the property shall not be less than the liability for the liquidating corporation. The General Explanation of the Tax Reform Act of 1986 (JCS-10-87) (at p. 339) prepared by the staff of the Joint Committee on Taxation indicates the rule of Sec. 336(b) does not apply to the distributee-shareholder as it does to the liquidating corporation. In instances where the liabilities assumed by the shareholder exceed the FMV of the assets, the shareholder should be deemed to contribute capital to the liquidating corporation in the amount of the excess. In instances where a liquidating corporation is a subsidiary of another corporation under Sec. 1504(a)(2) and the liquidating corporation owes debt to the corporate shareholder as of the adoption date of the plan of liquidation, then any property distributed to satisfy the debt will be treated as part of the liquidation, and the receiving shareholder will have a carryover basis under Sec. 332.

Exceptions

There are exceptions under Sec. 332(c) if the liquidating corporation is a regulated investment company or a real estate investment trust. Sec. 336(d) contains additional exceptions if any property is distributed to a related party under Sec. 267 or if property was acquired in a Sec. 351 transaction or as a contribution of capital and the intent of the contribution was for the liquidating corporation to recognize loss.

Filings

Once a corporation adopts a plan of liquidation and files the proper state paperwork (if required), it must send Form 966, Corporate Dissolution or Liquidation, with a copy of the plan to the IRS within 30 days after the date of the adoption. Once any distributions are made, Form 1099-DIV, Dividends and Distributions, must be filed for each shareholder who receives a distribution of $600 or more.

Shareholders who immediately before the first liquidating distribution own 1% or more (by vote or value) of a private corporation, or 5% or more (by vote or value) of a public corporation, must include a statement on or with their tax return. This statement is titled: “Statement pursuant to § 1.331-1(d) by [insert name and taxpayer identification number (if any) of taxpayer], a significant holder of the stock of [insert name and employer identification number (if any) of issuing corporation]” and must include the FMV and basis of the stock the shareholder transferred to the liquidating corporation and a description of the property the shareholder received from the liquidating corporation.

Converting to an LLC taxed as a partnership

If a corporation is terminating or intending to convert to a limited liability company (LLC) taxed as a partnership, the liquidation regulations will apply. These regulations generally apply the same way to an S corporation or a C corporation. When a corporation is converting to an LLC taxed as a partnership, the corporation is deemed to have liquidated and distributed the property to the shareholders. Then, the shareholders are deemed to contribute the property to the new entity at the step-up basis amounts. The primary difference between an S corporation or C corporation is that any gain recognized by the S corporationon liquidation increases the shareholders’ basis in their stock, thus reducing the amount of gain on which it is taxable.

Example 1. Computation of gain/loss: X Corp. has 100 shares of stock outstanding and has, as its only asset, $100,000 in cash. Shareholder C owns 30 shares of X stock, and Shareholder B owns 70 shares. C has an adjusted basis of $20,000 in his shares, the amount originally contributed to X on its organization. B has an adjusted basis of $90,000 in his shares, the amount paid to purchase shares from a prior shareholder. X completely liquidates, distributing $30,000 to C (30 shares ÷ 100 shares = 30% × $100,000 = $30,000) and $70,000 to B (70 shares ÷ 100 shares = 70% × $100,000 = $70,000). C realizes a gain of $10,000 on the distribution ($30,000 cash received − $20,000 tax basis), and B realizes a $20,000 loss ($70,000 cash received − $90,000 tax basis). If X Corp. was an S corporation, any gain or loss would be reported on the shareholders’ Schedules K-1 (Form 1120-S), Shareholder’s Share of Income, Deductions, Credits, etc. The shareholders’ basis in the stock of the business will fluctuate based on the income or loss recorded over the years, which will affect the gain/loss generated by the liquidation.

Example 2. Computation of gain/loss: Assume the same facts as in the above example except that, in addition to $100,000 cash, X has an accrued tax liability of $50,000. C’s share of the accrued liability is $15,000 (30% × $50,000). B’s share of the accrued liability is $35,000 (70% × $50,000). C realizes a loss of $5,000 on the distribution ([$30,000 − $15,000] amount realized − $20,000 tax basis), and B realizes a $55,000 loss ([$70,000 − $35,000] amount realized − $90,000 tax basis).

Example 3. Series of liquidating distributions: B owns 100 shares of X Corp., which he purchased several years ago for $20,000. Pursuant to a plan of liquidation, X Corp. makes a liquidating distribution of $15,000 to B on June 1, year 1, and a second liquidating distribution of $15,000 to B on June 1, year 2. In year 1, B recognizes no gain or loss. Instead, B recovers $15,000 of his basis in the stock. In year 2, B recognizes $10,000 of gain ($15,000 amount realized − $5,000 remaining basis in stock).

Example 4. Series of liquidating distributions: B owns 100 shares of X Corp. that he purchased several years ago for $20,000. Pursuant to a plan of liquidation, X Corp. makes a liquidating distribution of $5,000 to B on June 1, year 1, and a second liquidating distribution of $5,000 to B on June 1, year 2. In year 1, B recognizes no gain or loss. Instead, B recovers $5,000 of his basis in the stock. In year 2, B recognizes $10,000 of loss ($5,000 amount realized − $15,000 remaining basis in stock).

The rules that govern liquidating corporations are an integral part of the CPA’s toolbox. Knowing these rules can provide significant value to clients.

EditorNotes

Mark Heroux, J.D., is a tax principal and leader of the Tax Advocacy and Controversy Services practice at Baker Tilly US, LLP in Chicago.

For additional information about these items, contact Mr. Heroux at 312-729-8005 or mark.heroux@bakertilly.com.

Unless otherwise noted, contributors are members of or associated with Baker Tilly US, LLP.