Avoiding dividend treatment on distributions by liquidating.

• Author: Ellentuck, Albert B.

Facts: Peters, Inc. is a corporation that has been in the paving business since 1968. John Peters, the sole shareholder, has been in poor health for several years; he has slowly reduced the corporation's operations and sold most of its assets. At the end of the next tax year, the only remaining assets will be two pieces of unimproved land. Both were purchased by the corporation six years ago from an unrelated party for investment purposes.

Potential Basis FMV corporate gain (loss) Property A $100,000 $ 25,000 $(75,000) Properly B 50,000 125,000 75,000 Total $150,000 $150,000 $ 0 The corporation has $275,000 in earnings and profits (E&P). John's basis in the stock is $200,000. When John picks up his individual income tax return, he mentions to his tax adviser that he is planning to have the corporation execute a quitclaim deed next year (Year One) to transfer A to him. He plans to have the corporation transfer B to him the following year (Year Two) in the same manner. he also mentions that it will probably be several years before his health improves enough for him to work full-time again in the paving business. Issue: how should the tax adviser recommend that John and Peters, Inc. structure the transfer of the two properties?

Analysis

After reviewing the transaction, the tax adviser should tell John that the transaction, as John plans to structure it, will result in the worst possible tax scenario, with the property distributions treated as dividends.

The corporation will not be able to take a deduction for the distributions, but John will have to report them as ordinary income (because the amount of the distribution will not exceed the corporation's $275,000 of E&P). In Year One, when A is distributed, the corporation will not be able to recognize the $75,000 loss. However, when B is distributed in Year Two, the corporation will have to recognize gain on the distribution. If property that has depreciated in value is distributed as a dividend or in redemption of stock, the corporation will not receive any tax benefit from the potential loss, because losses on nonliquidating distributions are not recognized. Corporations must, however, recognize any gain on distributions of property that has appreciated in value.

To address this problem, the tax adviser could recommend that the corporation be liquidated. The two properties could then be distributed to John in complete liquidation of the corporation.

Corporations are allowed to recognize some...