Liquidating a controlled subsidiary tax-free

The liquidation of a corporation generally requires the liquidating corporation to recognize gain or loss on the distribution of its property in a complete liquidation as if the property were sold at its fair market value (FMV). However, a controlled subsidiary corporation liquidates without gain or loss to its parent, with implications for the parent’s succeeding to the subsidiary’s loss carryforwards and other tax benefits, as well as satisfaction of any indebtedness to the parent.

Avoiding recognition of gain or loss

Nonrecognition of gain or loss by a parent corporation and its subsidiary on the liquidation of the subsidiary is mandatory if the following requirements are met (Secs. 332 and 337):

• The parent owns at least 80% of the voting stock of the subsidiary and at least 80% of the total value of all the subsidiary’s stock (Secs. 332(b)(1), 337(c), and 1504(a)(2)). Sometimes, liquidating distributions are made over a number of years rather than at one point in time. In that instance, the parent corporation must own at least 80% of the subsidiary’s stock beginning on the date of adoption of the plan of liquidation; that ownership must continue until all property has been distributed. If the parent’s ownership falls below the required 80% at any time during this period, this requirement will not be met, and the nonrecognition provisions will not apply to any distribution (Regs. Sec. 1.332-2(a)). A resolution by the shareholders to distribute all the subsidiary’s assets in complete cancellation or redemption of all the subsidiary’s stock is an adoption of a plan of liquidation, even if the date to complete the property transfer is not identified (Sec. 332(b)(2)). However, when liquidating distributions are made in more than one tax year of the subsidiary, the plan must specify the period during which the property transfer to the parent will be completed (Regs. Sec. 1.332-4(a)(1)).
• The distribution must be in complete cancellation or redemption of all the subsidiary’s stock, and the transfer of property must occur within the tax year. Or the distribution must be one in a series of distributions in complete cancellation or redemption of the stock in accordance with a plan of liquidation under which the distributions of the property must occur within three years from the close of the tax year in which the first distribution occurred (Secs. 332(b)(2) and (3)).
• The subsidiary must be solvent (Regs. Sec. 1.332-2(b)). This means that the Sec. 332 rules do not apply when an insolvent subsidiary liquidates because there is nothing to distribute in cancellation or redemption of the subsidiary’s stock. If the parent receives nothing for the stock, the liquidation is not treated as a tax-free liquidation. Instead, the parent may be able to claim a worthless stock loss under Sec. 165(g).

Obtaining other tax benefits

When a subsidiary’s liquidation qualifies for nonrecognition of gain or loss, the parent corporation takes the subsidiary’s basis and holding period in all property received in the liquidation (Sec. 334(b)(1)). An exception to this rule exists for property that has an imported built-in loss (Sec. 334(b)(1)(B)).

Since gain is not recognized, the subsidiary does not recapture depreciation under Sec. 1245 or 1250 (Secs. 1245(b)(3) and 1250(d)(3)). The potential depreciation recapture is transferred to the parent. Other attributes that carry over to the parent are:

NOL carryovers: Net operating losses (NOLs) can only be carried forward beginning with the first year ending after the distribution. (NOLs cannot be carried back to the parent’s earlier year.) The NOL deduction in the first year is limited to a prorated amount of the parent’s taxable income based on the number of days in the tax year after the distribution divided by the total number of days in the tax year (Sec. 381(c)(1)(B)). Also, the parent cannot carry back an NOL of a year ending after the date of distribution to a previous tax year of the subsidiary (Sec. 381(b)(3)).

Capital loss carryovers: The same limitations that apply to NOL carryovers also apply to capital loss carryovers (Sec. 381(c)(3)).

Earnings and profits (E&P): The subsidiary’s E&P (positive or negative) is transferred to the parent as of the date of the distribution (Sec. 381(c)(2) (A)). However, the subsidiary’s deficit in E&P can only offset E&P accumulated after the date of distribution (Sec. 381(c)(2)(B)).

Business credit carryovers: Business credits and the minimum tax credit can be carried forward by the parent subject to limitations during the liquidation year (Secs. 381(c)(24), (25), and (26)).

Disallowed business interest: Business interest disallowed because of the business interest limitation is carried forward indefinitely (Sec. 381(c)(20)).

Example 1. Liquidating a subsidiary with no tax consequences: Parentco Inc. owns 100% of the stock of Subco Inc. Parentco’s stock is held by a small number of shareholders who want to liquidate Subco to lessen the administrative costs of operating the two companies. Because Subco holds appreciated assets, the shareholders are concerned about the tax cost of liquidating the subsidiary.

Parentco’s liquidation of Subco meets the criteria of Secs. 337 and 332. Therefore, Parentco can adopt a plan of liquidation and immediately distribute Subco’s assets in liquidation in a tax-free transaction. Parentco will take Subco’s basis and holding period for all assets received as a result of the liquidation (Sec. 334(b)(1)).

Satisfying indebtedness to the parent

A subsidiary does not recognize gain or loss when property is transferred to the parent (as part of a complete liquidation) to satisfy indebtedness to the parent (Sec. 337(b)(1)).

Example 2. Avoiding gain recognition upon satisfaction of parent debt: ABC Corp. owned 100% of the stock of XYZ Corp. ABC adopted a plan to distribute all the assets of XYZ in complete redemption of the XYZ stock. When the plan was adopted, XYZ owed $80,000 to ABC. XYZ distributed property with an FMV of $75,000 to ABC in satisfaction of the debt.

XYZ is not required to recognize the $5,000 gain on satisfaction of the debt. If the liquidation did not qualify under Sec. 332 (e.g., if ABC owned less than 80% of XYZ stock on the date the plan of liquidation was adopted), XYZ would have recognized a $5,000 gain.

Recognizing intercompany items from a subsidiary in liquidation

In Regs. Sec. 1.1502-80(g), the IRS determined that each member of the controlled group that receives intercompany items that are generated as a result of the controlled subsidiary’s complete liquidation will succeed to those intercompany items from the liquidating subsidiary. The intercompany items are taken into account by the receiving member to the extent that such items would be reflected in the investment basis of the liquidating subsidiary as if an outside party owned stock in the liquidating subsidiary and received cash or property as a part of the liquidation.

The regulations do not apply to intercompany items of the liquidating corporation. The IRS continues to study those rules and, therefore, has withdrawn that portion of the proposed regulations under Regs. Sec. 1.1502-13. For rules applicable to the treatment of those items, see Regs. Sec. 1.1502-13(j)(2)(ii).

In situations in which the intercompany items are not generated in conjunction with the liquidation, any member of the controlled group receiving assets succeeds to the intercompany items of the liquidating member and can use those items to offset income or tax liabilities of the controlled group or the individual member as long as the items would be reflected in the investment basis of the liquidating subsidiary stock as if an outside party owned the liquidating subsidiary’s stock and was redeemed in the liquidation.

Making liquidating distributions to minority shareholders

When a subsidiary makes liquidating distributions to minority shareholders in connection with a complete liquidation into the parent under Sec. 332, the subsidiary is required to recognize gain on those distributions (Sec. 336(a)). However, the subsidiary cannot recognize losses on the distributions to the minority shareholders (Sec. 336(d)(3)).

Example 3. Recognizing gains on distributions to minority shareholders: AB Corp. owned 80% of the stock of XY Corp. L, an individual, owned the remaining 20%. XY completely liquidated, and the assets were distributed to the shareholders as shown in the table “Distribution of Assets Upon Liquidation of XY Corp.,” below.

AB’s basis in XY stock was $40,000, and L’s basis in his XY stock was $10,000. The distribution is tax-free to AB under Sec. 332. XY’s cost basis and holding periods in the assets distributed carry over to AB.

L recognizes a capital gain of $23,750 on the distribution of the inventory and equipment in exchange for his stock. He has a basis of $33,750 in the assets received. Also, XY recognizes a $5,000 ordinary gain on the inventory distribution to L. However, XY cannot recognize the $1,250 loss on the equipment distribution.

Handling distributions involving tax-exempt entities

The nonrecognition rule provided in Sec. 337 for subsidiary corporations generally does not apply if the parent corporation is a tax-exempt organization (Sec. 337(b)(2)). Regulations under Sec. 337(d) explain the tax treatment of either transfers of assets to, or conversion of status to, a tax-exempt entity by a taxable corporation. The general rules are summarized below:

Asset-sale rule: A taxable corporation that transfers all or substantially all of its assets to one or more tax-exempt entities must recognize gain or loss as if the assets transferred were sold at their FMV (Regs. Sec. 1.337(d)-4(a)(1)).

Change-in-status rule: A taxable corporation that changes its status to a tax-exempt entity generally is treated as having transferred all of its assets to the tax-exempt entity immediately before its change in status becomes effective and is subject to the asset-sale rule (Regs. Sec. 1.337(d)-4(a)(2)).

UBTI rule: The asset-sale rule does not apply if the tax-exempt entity uses the transferred assets in an activity that produces unrelated business taxable income (UBTI). When the assets are disposed of or cease to produce UBTI, gain will be included in UBTI (Regs. Sec. 1.337(d)-4(b)(1)).

Three-year rule: The changein- status rule does not apply if the corporation formerly was tax-exempt and the change in status is within three years of the later of (1) the corporation’s first filing of a return as a taxable corporation or (2) a final determination that the corporation has become a taxable corporation (Regs. Sec. 1.337(d)- 4(a)(3)).

A taxable corporation must recognize the same percentage of gain or loss as the non–unrelated business use percentage bears to 100% (Regs. Sec. 1.337(d)-4(b)(1)(i)). The regulations give rules for allocating the use of an asset to unrelated business activities as well as rules to follow when the unrelated business usage declines (Regs. Secs. 1.337(d)-4(b)(1)(ii) and (iv)).

Contributor

Trenda B. Hackett, CPA, is a technical editor with Thomson Reuters Checkpoint. For more information about this column, contact thetaxadviser@aicpa.org.

This case study has been adapted from Checkpoint Tax Planning and Advisory Guide’s Closely Held C Corporations topic. Published by Thomson Reuters, Carrollton, Texas, 2022 (800-431-9025; tax.thomsonreuters.com).