Avoiding the dangers of a liquidation-reincorporation.

A liquidation followed by a reincorporation can be used to obtain a basis increase in property in a new corporation's hands; however, the increased basis is acquired at a cost. A corporation that sells low-basis assets to another corporation controlled by the former's shareholders pays a corporate-level tax to obtain the increased basis. The result is the same when a corporation distributes low-basis assets to its shareholders in a liquidation and the shareholders transfer them to a new corporation controlled by the liquidating corporation's shareholders.

Practice tip: The liquidation-reincorporation technique may be useful when the liquidating corporation has sufficient net operating losses (NOLs) to offset the gain recognized on its disposition of low-basis property in complete liquidation.

Recharacterization

However, the IRS may recharacterize the liquidation-reincorporation transaction as a dividend distribution or a transaction in which gain recognition is limited and no loss is recognized. Regs. Sec. 1.331-1 (c) collapses the two transactions (the liquidation of the old corporation and the formation of the new one) into one transaction when determining how the transactions should be treated. The regulation provides that if a liquidation is followed or preceded by a transfer to another corporation of all or part of the liquidating corporation's assets, it may have the effect of a dividend distribution or a transaction in which gain recognition is limited and no loss is recognized.

Example

Sam Jones owns 100% of the stock of SJ, Inc., with a $200,000 basis. SJ's basis in its depreciable assets is $100,000, with a $200,000 fair market value (FMV). SJ has an unused $100,000 NOL carryover that will expire at the end of its current tax year.

Sam wants to (1) depreciate SJ's assets using a basis equal to FMV, instead of the current adjusted basis and (2) use the $100,000 NOL before it expires. To do this, he plans to liquidate SJ in the current year and have it distribute the depreciable assets to him as part of the liquidation. SJ would use its $100,000 NOL carryover to offset the $100,000 gain ($200,000 FMV of assets--$100,000 basis) it would recognize on the liquidating distribution. Sam would not recognize any gain, because his basis in the stock would equal the FMV of the assets distributed to him.

Sam would then transfer the assets to a new corporation in return for $200,000 of stock. Sam anticipates the new corporation would have a basis in the assets equal to their $200,000 FMV and would depreciate that higher basis; in effect, the transaction would be a liquidation-reincorporation.

If recharacterized as a dividend distribution, Sam would have $200,000 in taxable dividends (limited by SJ's earnings and profits). Sam's $200,000 basis in the SJ stock would offset any part of the distribution not classified as taxable dividends. Also, SJ's $100,000 NOL carry forward would offset the $100,000 capital gain realized on its distribution of the appreciated property to Sam.

Asset Sale?

To avoid a liquidation-reincorporation recharacterization problem, Sam could consider SJ's sale of all of its assets, resulting in a $100,000 corporate-level gain. Its $100,000 NOL carryover could then be used to offset such gain; SJ could use the $200,000 sale proceeds to purchase new assets. However, if SJ sells substantially all of its assets, retains the proceeds without purchasing new assets and does not liquidate, it could be deemed a personal holding company (PHC) subject to the PHC tax.

Further, if Sam forms a new corporation, sells the assets of the old corporation to the new one and then liquidates the old corporation, the transaction could be construed as a device to withdraw corporate earnings at capital gain rates; see Rev. Rul. 61-156. The IRS would likely argue that there is no reality to the sale of the corporate assets or the corporate liquidation; thus, the transaction would be a sham.

This case study has been adapted from PPC's Tax Planning Guide-Closely He/d Corporations, 17th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Gary W. Brown, James J. Mogelnicki and William R. Bischoff, published by Practitioners Publishing Company, Fort Worth, TX, 2004 ([phone]; www.ppcthomson.com).

Editor: Albert B. Ellentuck, Esq. Of Counsel King & Nordlinger, L.L.P. Arlington, VA