This article discusses the tax consequences of liquidating an S corporation that owns certain assets and describes three plans of liquidation.
Pursuant to I.R.C. [section]1361(a)(1), (1) an S corporation is a small business corporation created through an I.R.C. tax election and is governed by subchapter S, unless contradicted by subchapter C or otherwise indicated. For purposes of subchapter S of the I.R.C., a "small business corporation" is a domestic corporation that meets certain statutory criteria. (2) S corporations are advantageous to small businesses because the business itself is not subject to federal taxation (although, some states subject S corporations to taxation); only the S corporation shareholders are subject to federal taxation.
In our hypothetical, we have an S corporation that owns a warehouse, a promissory note, and cash. The precise tax consequences to the corporation and its sole shareholder are not possible to know without knowing the fair market values and basis of the corporation's assets. This information is essential because the tax liability of corporation and shareholder is based on the gain recognized from the liquidating distributions. In a typical transaction, the gain recognized, if any, is the difference between the basis (the cost) and the fair market value of the asset being sold or distributed.
Generally, if the fair market value of the asset exceeds the basis of the asset, the difference is the gain recognized; if the basis exceeds the fair market value, you recognize a loss. Despite not knowing the fair mar ket value and basis of corporations' assets, we can describe the general tax consequences to corporation and shareholder when liquidating an S corporation. When a corporation distributes an asset to a shareholder, the shareholder's stock basis increases by the gain recognized in that distribution and decreases by the fair market value of the asset being distributed.
Liquidating Without Tax Planning
In general, pursuant to I.R.C. [section]336, unless the liquidation is part of a reorganization plan, gain or loss is recognized to a liquidating corporation upon the distribution of property in complete liquidation as if the property were being sold to the distributee at its fair market value. If the shareholder's stock basis is large enough, the corporation can liquidate and incur no tax liability because the shareholder's stock basis will not be depleted, only reduced, in the liquidating distributions.
After all assets have been distributed, if the shareholder's stock basis is more than $0, there will be a capital loss in the amount by which the stock basis exceeds $0, and that loss can be used to offset any capital gains incurred in other distributions. However, if the stock basis is depleted before the corporation distributes all of its assets, then any subsequent distributions will result in taxable gain to the extent there is gain recognized in those subsequent distributions.
Distribution of Cash
In either a liquidating or a non-liquidating distribution, a distribution of cash to the shareholder will only decrease the shareholder's stock basis by the amount of cash distributed. Accordingly, if the corporation has any outstanding debts, it should pay off those debts with cash to reduce the amount of cash to be distributed to the shareholder. When the cash is finally distributed to the shareholder, there will be less cash to reduce the shareholder's stock basis, leaving a larger stock basis to minimize the tax liability, if any, from the liquidating distribution of the other assets.
Distribution of Warehouse
If the corporation were to distribute the warehouse in a liquidating distribution, any gain recognized would be ordinary gain pursuant to I.R.C. [section]1239. I.R.C. [section]1239 applies when depreciable property is sold or exchanged, directly or indirectly, between related persons and treats any gain recognized in that sale or exchange as ordinary income. Pursuant to I.R.C. [section]167, a warehouse is depreciable property.
Pursuant to I.R.C. [section]336(a), a distribution in a complete liquidation of a corporation is treated as if the distributed property were sold to the distributee. Pursuant to I.R.C. [section]1239(b) (1) and [section]1239(c)(1)(A), a corporation and a person are related persons if the person owns more than 50 percent of the value of the outstanding stock of the corporation. If the corporation were to completely liquidate and distribute the warehouse to a shareholder, a "related person" because the shareholder owns more than 50 percent of corporation, that liquidating distribution would be treated as a sale, and I.R.C. [section]1239 would apply so that any gain recognized would be taxed as ordinary income.
When appreciated, depreciable real property is distributed, any gain recognized is allocated between the land and the property. Pursuant to I.R.C. [section]1239, any gain allocated to the land is taxed as capital gain, and any gain allocated to the property is taxed as ordinary income. An attempt to allocate more of the gain to the land to avoid I.R.C. [section]1239 ordinary income would come at a cost. Less gain would be allocated to the warehouse, which can depreciate the cost of the warehouse over 39 years, because...