Tax consequences of de facto liquidations.

• Author: Pedersen, C.

As a result of the recent recession, many taxpayers have been evaluating their legal entities and structures. Generally, a corporation is respected as a distinct entity and not ignored unless it is used to defraud the law (Moline Properties, Inc., 131 F.2d 388 (5th Cir. 1942)). However, under specific facts, a corporation may be deemed to have liquidated for income tax purposes without an actual legal liquidation. This is referred to as a de facto liquidation. This principle can trigger income tax consequences for both the company and its shareholders.

Identifying a De Facto Liquidation

Whether a corporation has had a de facto liquidation is a subjective determination based on case law. Thus, it is sometimes difficult to determine precisely in which corporate tax year the de facto liquidation occurs, if at all, especially if the company has been slowly winding up its existence over a period of time. In Estate of Maguire, 50 T.C. 130 (1968), the Tax Court used a three-pronged test to determine whether a corporation had a de facto liquidation. Such a liquidation encompasses:

* A "manifest intention to liquidate";

* A continuing purpose to terminate corporate affairs; and

* Corporate activities directed toward termination of the corporation.

In analyzing these three prongs, the court cited certain factors, such as board resolutions, the adoption of a plan of liquidation, the sale of assets and cancellation of debt, termination of contracts, and the distribution of corporate assets in complete cancellation or redemption of all shareholders' interests. Rev. Rul. 61-191 cited several similar factors in its determination that a de facto liquidation had occurred.

On the other hand, otherwise seemingly "shell" or "dormant" companies were respected as corporations for tax purposes where there were business and/or legal reasons to keep the corporation in existence. For example, in Rev. Rul. 74-462, the IRS deemed that no de facto liquidation had occurred, even though the corporation had terminated its "regular" business activities, because the corporation continued to retain counsel and actively defended and prosecuted legal actions brought against it and on its behalf, and it maintained a reserve against possible adverse judgments in pending lawsuits. The retention of a reserve against possible future liability was a valid business reason for continuation of the corporate charter.

The taxpayer's intention with respect to liquidation is also relevant...