Liquidations

• Pages: 211-234
• Author: Howard E. Abrams,Don A. Leatherman,Thomas J. Brennan

211

Chapter 8

LIQUIDATIONS

8.01 Introduction

When a corporation is formed, a shareholder typically recognizes

no gain or loss.

1

If the shareholder has realized but not recognized

gain, the corporation preserves the gain by taking a transferred basis

in the transferred assets and the shareholder also preserves the gain

by taking an exchanged basis in the corporation’s stock. § 362(a);

§ 358(a). For example, if B forms X Corp. by transferring an asset

with an $8,000 basis and $15,000 fair market value to the corporation

in exchange for all of its stock, B will not be taxed on the exchange.

§ 351. B will take an $8,000 basis in the stock, and X Corp. will take

an $8,000 basis in the property. § 358; § 362.

If B were to liquidate X Corp. when X Corp.’s basis in the asset

was $8,000, the asset had a $15,000 fair market value, and B’s stock

basis was $8,000, one might expect similar nonrecognition

treatment. That is, neither X Corp. nor B would recognize gain and

B would succeed to X Corp.’s basis in the assets of $8,000. But

nonrecognition typically is not the order of the day for liquidations.

Instead, a complete liquidation usually is a recognition event to both

the distributing corporation and its shareholders. The distributing

corporation recognizes gain (or generally loss) as if the distributed

property were sold to the distributee shareholder at fair market

value. The shareholders must recognize gain or loss on the difference

between the fair market val ue of the property received on the

distribution and the shareholder’s stock basis.

In the example, on its liquidation, X Corp. recognizes a $7,000

gain and incurs a $1,470 tax ($7,000 times 21%). § 11. Assume that

B will pay that tax liability.

2

To account for the liability, B’s amount

realized for her X stock is just $13,530 (the property’s value less the

liability), and B recognizes a $5,530 gain. § 331; § 1001. B’s tax on

the gain, assuming a 20% rate, is $1,106.

3

1

See § 351(a). This conclusion assumes the absence of boot.

2

The corporation owes this tax, but if it does not pay it there is transferor

liability B. See § 6901.

3

This example expressly discusses the effect on the shareholder of the

corporate-level tax liabilit y incurred in a liquidation. Unless otherwise stated, other

examples in this chapter streamline the discussion by disregarding any tax incurred

by the liquidating corporation, or any transferee liability therefor, when describing

distributions received by the shareholder(s).

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LIQUIDATIONS

Ch. 8

B takes a $15,000 basis in the distributed property. § 334(a).

Assume that B sells the property for that amount and pays off the

tax liabilities. On the sale, B recognizes no gain or loss and after

paying the tax liabilities nets $12,424 ($15,000 less the sum of $1,470

and $1,106).

If B had retained the property, rather than contributing it to X

Corp. and then sold the property for $15,000, she would have

recognized a $7,000 gain, incurred a $1,400 tax (assuming a 20%

rate), and netted $13,600 after tax. Thus, the interposition of X Corp.

cost B $1,176 or 7.8% of the property’s value.

Notice that in general there is nonrecognition treatment for

incorporations under § 351 and recognition treatment for

liquidations. One reason for the difference may be that there is a

continuity of investment when an unincorporated business

incorporates, a continuity that is often lacking in a liquidation. An

incorporation usually signifies the continuation of a business in

corporate form. A corporate liquidation, on the other hand, often

signifies the discontinuation of the business with the assets sold or

converted to personal use.

But of course that is not always the case. It may be that

incorporated assets were used for some other purpose prior to

incorporation or that following a liquidation the shareholders will

continue the business. Congress, however, has chosen to draw a

bright line, giving nonrecognition to corporate formations while

generally denying nonrecognition treatment to “disincorporations.”

A liquidation presents the last opportunity to tax shareholders

on any earnings and profits that the corporation has accumulated.

But that reason does not explain why a shareholder will be taxed on

a corporation’s unrealized appreciation—particularly, as in the

example, where the appreciation occurred before incorporation.

Additionally, the taxation of the shareholders in a liquidation is

independent of the corporation’s earnings and profits account.

In any event, a liquidation is typically treated as if the

shareholders had sold their stock to the corporation in exchange for

the corporation’s assets. The liquidating corporation recognizes gain

(or generally loss) as if it had sold the distributed assets to the

shareholders at fair market value. § 336. Each shareholder

recognizes gain (or loss) on the difference between the adjusted basis

of the shareholder’s stock and the amount realized. § 331; § 1001.

Finally, each shareholder takes a fair market value basis in the

assets received on liquidation. § 334(a).

There is an alternative liquidation pattern that applies to the

liquidation of a subsidiary into its parent corporation. See § 332.