Understanding the tax consequences of liquidation to an S shareholder.

• Author: Ellentuck, Albert B.

The shareholder consequences of a complete liquidation of an S corporation are governed by Secs. 331 and 1001. The dividend rules that otherwise apply to corporate distributions are not applicable to distributions in complete liquidation. Distributions received by the shareholder are treated as payment in flail for the exchange of stock. The shareholder's adjusted basis in the stock is subtracted from the cash and fair market value (FMV) of other property received from the corporation. If the shareholder assumes known corporate liabilities or receives corporate property subject to a liability (such as the distribution of mortgaged land), the amount realized is reduced by the amount of the liability (Ford, 311 F2d 951 (Ct. Cl. 1963)).

The general rule is that a shareholder's stock basis is determined as of the end of the S corporation's tax year. It appears that the adjusted basis of stock held in a liquidating corporation is adjusted for current-year passthrough items prior to determination of gain or loss from the receipt of the liquidating distributions (see Regs. Sec. 1.1367-1(d)(1) and Letter Ruling 200106009).

If the shareholder has different bases in different blocks of stock, the computation of gain or loss depends on whether there is a single distribution or a series of liquidating distributions (Rev. Ruls. 68-348 and 85-48). The shareholder recognizes gain when the adjusted basis of each block has been recovered, while loss is not recognized until the corporation has made its final distribution.

Example 1: T holds 30 shares of stock in an S corporation, represented by two blocks of stock. T has a basis of $10,000 in Block 1 (which represents 10 shares) and a basis of $40,000 in Block 2 (which represents 20 shares). The corporation distributes $45,000 cash to Tin return for his stock.

The $45,000 is allocated pro rata to the two blocks, so $15,000 is allocated to Block 1 (10/30 x $45,000) and $30,000 to Block 2 (20/30 x $45,000). T recognizes a $5,000 gain on Block 1 ($15,000 - $10,000 basis) and a $10,000 loss on Block 2 ($30,000 - $40,000 basis).

If T receives $45,000 in 2007 and an additional $135,000 in 2008, each distribution is allocated ratably between the blocks based on the number of shares in each block. The 2007 distribution is allocated the same as before. T recognizes a $5,000 gain on Block 1 ($15,000 - $10,000 basis), which reduces his basis in that block to zero. T recognizes no gain or loss on Block 2 ($30,000 - $40,000 basis) and has a remaining basis of $10,000 in Block 2.

The 2008 distribution is allocated $45,000 to Block I (10 / 30 x $135,000) and $90,000 to Block 2 (20 / 30 x $135,000). T recognizes a $45,000 gain on Block 1 ($45,000 - $0 basis) and an $80,000 gain on Block 2 ($90,000 - $10,000 basis).

Determining the Character of Gain or Loss

The character of gain or loss recognized by the S shareholder depends on whether the stock is a capital asset in the shareholder's hands and whether the transaction constitutes a complete or a partial liquidation of the corporation. Long-term or short-term classification of a...