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The Tax Consequences of Liquidating C Corporations

The Tax Consequences of Liquidating C Corporations

By Anthony Diosdi

The closing events of corporate lifetime invoke liquidation of the corporate enterprise. The Internal Revenue Code and regulations fail to provide a precise definition of the term liquidation. However, some guidance is provided by regulations providing that “[a] statute of liquidation exists when the corporation ceases to be a going concern and its activities are merely for the purpose of winding up its affairs, paying its debts, and distributing any remaining balance to its shareholders.” See Treas. Reg. Section 1.332-2(c). Thus, it is useful to think of liquidations as a process through which the corporation winds up its affairs and distributes remaining assets to its shareholders rather than a single event.

A corporation may liquidate in one of two ways. After paying off creditors, it may distribute the assets remaining directly to the shareholders in-kind. Alternatively, the corporation may sell off its assets for cash, first paying off creditors and ten distributing the remaining cash to its shareholders. In either case, since the liquidation distribution effectively terminates the shareholder’s interest in the corporation, distribution in liquidation, whether in-kind or cash, are treated as taxable events as if the shareholders sold their stock back to the corporation in return for corporate assets in-kind  or for cash. See IRC Section 331. This article will provide an overview of the tax considerations that should be considered in the liquidation of a C corporation. 
Consequences to Individual Shareholders: Section 331

The computation of a shareholder’s gain or loss on a complete liquidation is ordinarily a straightforward affair. The shareholder’s amount realized for tax purposes is the money and the fair market of all other property received from the liquidating corporation. If a shareholder assumes corporate liabilities or receives property subject to a liability in a liquidation of a corporation, the amount realized is limited to the value of the property received and the net of the liabilities.

Shareholders who hold several blocks of stock with different bases and acquisition dates must compute their gain or loss separately for each block rather than on an aggregate basis. See Treas. Reg. Section 1.331-1(e). The timing of a shareholder’s gain or loss on a corporate liquidation can raise difficult questions. Since stock from most shareholders is a capital asset, the resulting gain or loss will be capital gain or loss. The amount realized on liquidation will be allocated to blocks of shares at different times. So, for example, if the shareholder purchased two-thirds of his shares several years ago and one-third of his shares within the last two months, he will allocate two-thirds of the amount realized to the first block and the remaining one-third to the more recently purchased block of shares. Long-term capital gain treatment will only be available for the first block of shares. See Treas. Reg. Section 1.331-1(e). Moreover, the shareholder may have a gain on one block of shares and a loss on another. If the shareholder receives an in-kind distribution and reports gain or loss under Section 331, the basis of the property received will be the fair market value of the property at the time of distribution under Section 334(a). Since the receipt of the property was a taxable event, the shareholder essentially is credited with a cost basis.

Shareholders of a liquidating corporation may defer part of their gain if the corporation sells certain assets for installment notes and then distributes the notes in a complete liquidation. To qualify for this treatment, the obligations must have been acquired by the corporation in respect of a sale or exchange of property during the 12-month period beginning on the date a plan of complete liquidation is adopted and the liquidation must be completed within a 12 month period.

Tax Consequences to the Liquidating Corporation: Section 336

For purposes of computing gain or loss, the corporation is viewed as having sold the distributing property to the shareholders at fair market value. When the shareholders assume a liability or property is distributed subject to a liability, however, Section 336(b) of the Internal Revenue Code provides that the amount realized on the sale “shall be treated as not less than the amount of such liability.” Section 336(b) indicates that in the liquidation context the notion that amount realized on the sale or exchange of property subject to liabilities must include the full liability, even if the liability exceeds fair market value. Thus, Section 336(b) provides that a corporation recognizes gain or loss when it distributes property in complete liquidation as if it had sold the property to the distributee for its fair market value. Gain or loss is determined separately on each asset.

Loss Limitation Rules

Internal Revenue Code Section 336(d) provides two basic sets of loss limitations. First, the “related party” rules in Section 336(d)(1) disallow certain losses on distributions to related parties. Section 267 of the Internal Revenue code provides a definition of the term “related person.” An individual shareholder is related under Section 267(b)(2) if she directly or indirectly owns more than 50% in value of outstanding stock of the corporation- a controlling shareholder. Section 267(f) adopts the controlled group definition from Section 1563(a) with the exception that a 50% control test is substituted for the 80% control test whenever it appears in Section 1563(a). Controlled groups include parent-subsidiary chains, brother-sister corporations commonly owned by five or fewer persons and any combinations of two.

Second, Section 336(d)(2) prevents the doubling of precontribution built-in losses on certain distributions to minority shareholders. This limitation applies only if the distributing corporate acquiring property in a Section 351 transaction (Section 351 generally provides that no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in such corporation and immediately after the exchange such person or persons are in control (as defined in Section 368(c)) of the corporation) or as a contribution to capital as part of a plan of was to recognize loss by the corporation on a liquidating sale, exchange or distribution of property. In such a case, Section 336(d)(2) limits the corporation’s deductible loss to the amount of loss that accrued after the corporation acquired the property.

Liquidations of Subsidiaries

Unlike corporate liquidations discussed above, which typically are taxable events to both the liquidating corporation and to the shareholders that receive distributions in the liquidation, liquidations of subsidiary corporations generally are not taxable to either the liquidating subsidiary or the shareholder parent corporation.

Consequences to the Parent Corporation or Shareholder

Under Section 332(a) of the Internal Revenue Code, a parent corporation or shareholders of a subsidiary should not recognize taxable gain on the receipt of distributions in the complete liquidation of a subsidiary. In order to be eligible for Section 332(a) nonrecognition, the distribution must be in complete cancellation or redemption of all the liquidating corporation’s stock. In addition, the liquidating corporation must either transfer all of its property within the taxable year or make a series of distributions with a plan of liquidation under which all the property is distributed within three years. To be eligible for Section 332 nonrecognition, the parent corporation must meet the two-art 80% control test on the date of adoption of a plan of liquidation and at all times until receipt of the property in liquidation. If the subsidiary is indebted to the parent at the time of liquidation, payment in satisfaction of indebtedness will be taxable to the parent despite the nonrecognition rules discussed above.

Assuming that the corporate parent meets the control test and that the distribution in liquidation otherwise satisfies the requirements of Section 332, the parent corporation will recognize no taxable gain or loss upon the receipt of property in the liquidation of the subsidiary. A corporation acquiring the assets of a liquidating corporation is able to obtain a basis in assets equal to their fair market value. Nonrecognition under Section 332 is only available to the controlling parent corporation.  The nonrecognition rules are not available to minority shareholders. Minority shareholders must recognize gain or loss under the general rules discussed in Section 331(a) and take a fair market value basis in any distributed property.

Tax Consequences to Liquidating Subsidiary

A liquidating subsidiary does not recognize gain or loss on distributions of property to its parent in a complete liquidation to which Internal Revenue Code Section 332 applies. However, if a subsidiary owes a debt to its parent on the date of the adoption of a liquidation plan, any transfer of property by the subsidiary to satisfy the debt is treated as a distribution subject to the general nonrecognition rules. The nonrecognition rule discussed in the Internal Revenue Code is limited to distributions of property by a liquidating subsidiary of a parent corporation. Distributions to minority shareholders will only recognize gain but not loss.

Anthony Diosdi is one of several tax attorneys and international tax attorneys at Diosdi Ching & Liu, LLP. Anthony focuses his practice on providing tax planning domestic and international tax planning for multinational companies, closely held businesses, and individuals. In addition to providing tax planning advice, Anthony Diosdi frequently represents taxpayers nationally in controversies before the Internal Revenue Service, United States Tax Court, United States Court of Federal Claims, Federal District Courts, and the Circuit Courts of Appeal. In addition, Anthony Diosdi has written numerous articles on international tax planning and frequently provides continuing educational programs to tax professionals. Anthony Diosdi is a member of the California and Florida bars. He can be reached at 415-318-3990 or adiosdi@sftaxcounsel.com.