Tax Aspects of Liquidating a Corporation
| Publication year | 1982 |
| Pages | 2971 |
1982, December, Pg. 2971. Tax Aspects of Liquidating a Corporation
Most lawyers whose practice consists of some degree of business planning are familiar with the federal income tax provisions that apply upon the incorporation of a business.(fn1) This is generally true among the great majority of business lawyers who do not consider themselves experts in the field of taxation. The tax rules that apply to liquidation of a corporation are not as widely known by nonspecialists, which is unfortunate because, at this stage, lawyers have a greater opportunity to benefit (or burden) clients by their counsel and guidance.
This article explores the tax possibilities at the end of corporate existence and suggests ways to approach special problems that arise with predictable frequency. Certain changes have recently been made by the Tax Equity and Fiscal Responsibility Tax Act ("TEFRA"), and these new provisions are also to be considered.(fn2)
When a corporation is organized, it is the shareholders' tax position that is of paramount concern. That a corporation recognizes neither gain nor loss on issuing its stock was an accepted rule even before it was statutorily mandated.(fn3) When a corporation is liquidated, on the other hand, counsel must be aware that the corporation is a separate taxable entity and its tax consequences, as well as that of the shareholders, must be considered if the transfer of accumulated corporate wealth is to be maximized.
The liquidation of a corporation is treated as a sale or exchange of the shareholders' stock.(fn4) Shareholders recognize gain or loss on the liquidation measured by the difference between both the amount of money and the fair market value of property received and the adjusted basis in their stock.(fn5) Since corporate stock is ordinarily a capital asset, capital gain or loss will be realized in most instances. Any property distributed in liquidation will have a tax basis in the hands of the shareholders equal to its fair market value at the date of distribution.(fn6)
Subject to several exceptions, discussed in detail below, the distribution of property in complete liquidation is not an income-generating event to the corporation. Subject to most of the same exceptions, sales of property during the twelve-month period after adopting a plan of complete liquidation are tax-free to the corporation if it actually liquidates within the twelvemonth period.(fn7)
A corporation was formerly able to obtain non-recognition treatment upon the distribution of appreciated property in partial liquidation as well as in complete liquidation, but TEFRA changed that result.(fn8) Distributions of appreciated property in partial liquidation made after August 31, 1982, are now treated as taxable exchanges by the corporation.(fn9) Furthermore, exchange treatment applies at the shareholder level, as before, for noncorporate shareholders, but under TEFRA corporate shareholders will receive a non-liquidating distribution.(fn10) For corporate shareholders this means that a partial liquidation following an acquisition of stock no longer enables the acquiring corporation to receive a stepped-up basis for selected assets of the acquired corporation and at the same time enabling the latter to defer or avoid recapture on those assets by filing a consolidated return.(fn11)
Two existing statutory exceptions modify the general rule of shareholder recognition of gain or loss measured against stock basis upon the receipt of property in complete liquidation. These are for liquidation of any 80 percent-owned subsidiary corporation and elective "one-month" liquidations, both discussed below.
Liquidation has certain other consequences. Corporate "earnings and profits" and other corporate tax attributes such as net operating loss carryovers are extinguished upon liquidation of the corporation.(fn12) Since any distribution from a corporation to a shareholder is ordinarily taxed as a dividend to the extent of corporate earnings and profits, the availability of capital gain treatment to shareholders on the liquidation of a corporation having substantial earnings and profits is a significant tax advantage. By liquidating the corporation, the earnings and profits will never be taxed at ordinary income tax rates to anyone. If the shareholder sold his stock rather than liquidating the corporation, taxation of the earnings and profits would merely be delayed until the payment of dividends to the new shareholder.
Given that liquidation represents the Treasury's last opportunity to tax corporate earnings and profits to shareholders at ordinary income tax rates, it is to be expected that close scrutiny by the Internal Revenue Service ("IRS") may be given to the corporation's final return. If it is determined that the collapsible corporation or personal holding company provisions of the Internal Revenue Code ("Code") apply, the shareholders' gain will be taxed at ordinary income tax rates.(fn13) A major task of
the shareholders' tax advisor in liquidating a corporation is to light the path to capital gain treatment or no gain recognition at all and, along the way, carefully to avoid the ordinary income traps which the Code has laid for unwary taxpayers.
Having looked briefly at the tax basics of corporate liquidations, a corporate liquidation should be defined. Any distribution to shareholders made before the corporation is in "liquidation status" will not qualify for sale or exchange treatment as a liquidating distribution. Rather, such distributions generally are taxed as a dividend to the extent of current or accumulated earnings and profits and then as a return of capital to the extent of the shareholder's basis in his stock, with any remaining amount treated as capital gain.(fn14) The term "complete liquidation" is not defined in the Code. However, a liquidation is commonly thought to be a change in the activities of a corporation from business as usual to closing down. It is defined in the Treasury Regulations as follows:
A status 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. A liquidation may be completed prior to the actual dissolution of the liquidating corporation. However, legal dissolution of the corporation is not required. Nor will the mere retention of a nominal amount of assets for the sole purpose of preserving the corporation's legal existence disqualify the transaction.(fn15)
In Maguire Estate, the Tax Court held: (1) a manifest intention to liquidate; (2) a continuing purpose to terminate the affairs of the corporation; and (3) activities directed at the termination of the corporation were the conditions necessary to establish liquidation status.(fn16)
Continuance of normal business activity does not necessarily defeat liquidation status. For example, a corporation owning a chain of lumber yards sold off individual yards as buyers were found. It was held to have been in liquidation status even though it continued to operate the other yards until buyers could be found.(fn17) The corporation's activities are not important so long as the corporation's aim is to liquidate. However, it is prudent to forego such activity as soliciting new customers or acquiring new property, which gives the appearance of business as usual. Moreover, the adoption of a formal plan of liquidation is not necessary; it is desirable because without it one or more of the early distributions in a series may be excluded from liquidation treatment and be taxed as a dividend.
A corporation is required to file Form 966 with IRS and Form DR-539 with the Colorado Department of Revenue within thirty days after adopting a formal plan of liquidation and, if the plan is amended or supplemented, another Form 966 and DR-539 must be filed within thirty days after the amendment.(fn18) If the corporation simply dissolves voluntarily under state law without a liquidation plan, Forms 966 and DR-539 must be filed within thirty days after the execution of a certificate of dissolution. Liquidating distributions to stockholders in excess of $600 must be reported on Form 1096, and Form 1099L must be sent to the stockholders. The corporation's earnings and profits must be computed on Form 5452 and filed by February 28 of the year following liquidation under IRC § 333.
The corporation does not have to be dissolved under state law to have a valid liquidation for tax purposes. However, if the shareholders reactivate the corporation after liquidation, IRS may hold that the liquidation was a nullity. This would result in the denial of shareholder sale or exchange treatment for liquidating distributions and denial of corporate nonrecognition treatment for distributions of appreciated property or for the sale of corporate property where the corporation was liquidated within a twelve-month period. On the other hand, IRS has ruled that a corporation that had been dormant for eight years before being reactivated was a new taxpayer which must obtain a new employer identification number. If reactivation is delayed until the statute of limitations passes for the year of liquidation, then at least the liquidation will be impervious to attack from IRS.(fn19)
If the assets received upon the liquidation are then transferred to a new corporation, it is likely that IRS will attempt to treat the...
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