Determining tax consequences of corporate liquidation to the shareholders.

• Author: Ellentuck, Albert B.

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...