Avoiding the dangers of using liquidation-reincorporation as a planning technique.

• Author: Ellentuck, Albert B.
• Position: Tax planning case study

Facts: Sam Jones owns 100% of the stock of S Inc., with a $200,000 basis. S's basis in its depreciable assets is $100,000, with a $200,000 fair market value (FMV). The corporation has an unused $100,000 net operating loss (NOL) carryover expiring at the end of the current tax year.

Sam has informed his tax adviser that his goals for S are to:

1. Depreciate its assets using a basis equal to FMV, instead of adjusted basis; and

2. Use the $100,000 NOL before it expires.

Sam is somewhat familiar with the tax laws and has devised a plan to meet these goals. Under the plan, Sam would liquidate the corporation in the current year and have it distribute the depreciable assets to him. The corporation would use its $100,000 NOL carryover to offset the $100,000 gain ($200,000 FMV of assets--$100,000 basis) it would recognize on the liquidating distribution. Sam would not recognize any gain; his stock basis would equal the FMV of the assets distributed to him.

Sam would then transfer the assets to a new corporation for $200,000 of stock. Sam anticipates the new corporation would have a basis in the assets equal to the $200,000 FMV and would depreciate that higher basis. In effect, the transaction would be a liquidation-reincorporation. Issue: What advice should Sam's tax adviser give him as to the use of a liquidation-reincorporation to attain his objectives?

Analysis

Taxpayers contemplating the use of liquidation-reincorporation as a planning technique should he aware that Regs. Sec. 1.331-1(c) may cause problems. That rule collapses the two transactions (the liquidation of the old corporation and the formation of the new one) into one transaction. If a liquidation is followed or preceded by a transfer to another corporation of all or part of the liquidating corporation's assets, it may have the effect of a dividend distribution or a transaction in which gain recognition is limited (and no loss is recognized). Recharacterization as a dividend would trigger $200,000 ordinary income to Sam (limited by S's earnings and profits). Sam's $200,000 basis in his S stock would offset any dividend distribution not classified as ordinary income. Also, S's $100,000 NOL carryforward would offset the $100,000 capital gain realized on the distribution of the appreciated property to Sam.

If the IRS recharacterizes the transaction as a D reorganization, S would not realize taxable gain (and, thus, could not use the carryover); the new corporation would not step-up the...