Liquidating a corporation: how to structure a plan of liquidation to avoid unanticipated tax liabilities.

Before the Tax Reform Act of 1986 (TRA) was enacted, a corporation generally did not recognize any gain or loss on the distribution of property in liquidation, or from corporate asset sales conducted pursuant to a plan of liquidation. (1) Corporate assets sales are now fully taxable, and distributions in liquidation are treated as a deemed sale of property between the corporation and its shareholders for fair market value (FMV) on the date of distribution. (2) This deemed sale can present valuation problems if not an arm's-length transaction. This article will discuss the issues connected with the liquidation of a corporation--valuation of assets, limitations on losses for certain liquidating distributions and other problem areas--and offer planning opportunities and techniques to minimize the overall tax consequences of a liquidation.

Distribution of Assets

Sec. 336(a) provides, in general, that a liquidating corporation will recognize gain or loss on the distribution of its property in a complete liquidation as if the property were sold to its shareholders at FMV. If, however, any of the assets are subject to a liability, or if the shareholder assumes a liability, FMV cannot be less than the liability. (3) This corporate "exit tax" will reduce the amount of assets available to distribute to the shareolders. See Example 1 on page 149.

While there is no limitation on the recognition of gain from a liquidating distribution, statutory anti-abuse provisions may restrict the recognition of losses. (These loss limitations will be discussed in detail later in the article.)

The distribution of assets in liquidation of the corporation will be treated as full payment in exchange for the shareholder's stock. The amount of gain or loss recognized by the shareholder will be the difference between the FMW (net of liabilities) of the assets received and the shareholder's basis in his canceled stock. (4)

Example 2: A, the sole shareolder of ABC Corporation in Example 1, has a tax basis in his stock of $750,000. A receives a liquidating distribution of $814,900 and recognizes a gain of $64,900 ($814,900 -- $750,000).

The gain or loss recognized by the shareholder is generally capital in nature. However, there are exceptions to this general rule (which will be discussed later).

Concerns of the

Liquidating Corporation

* Valuation of assets

In theory, the tax consequences of a liquidation should be the same whether the corporation sells assets to a third party and then distributes the proceeds to its shareholders or simply distributes all assets in liquidation. However, the deemed sale created by a distribution may produce valuation problem not present in an actual sale to a third-party purchaser. Because the burden of proof of valuation is on the taxpayer, the corporation should retain a qualified appraiser to defend the value assigned to the assets.

Obtaining an appropriate value for individual assets is not the only concern for the liquidating corporation. Since a liquidating distribution is a deemed sale of all corporate property, the IRS may seek to value the company as a going concern, if a shareholder continues the business as a sole proprietorship, prietorship, with a resultin valuation in excess of the aggregate vlaue of the company's identifiable assets. In this regard, it is necessary to consider the applicability of Sec. 1060. If Sec. 1060 applies to the deemed sale, it is possible that an allocation to goodwill or going concern value would be required, increasing the corporate and shareholder tax burden.

* Rules and applicability of Sec. 1060

Under pre-TRA law, there existed a competing interest between buyers and sellers in the allocation of purchase price in asset purchases. Sellers generally benefited from a larger allocation to capital assets, including goodwill or going concern value, because of preferential capital gains taxation. Buyers generally benefited from a larger allocation to depreciable tangible assets or amortizable intangible assets, with goodwill or going concern allocations avoided to the extent possible. This adverse interest between the buyer and seller gave the allocation of a fixed purchase price to individual assets a measure of credibility. When the TRA eliminated preferential capital gains taxation, selles could be expected to be indifferent to how a lump-sum sales price was allocated, since this allocation generally no longer had an effect on their tax liability. As a result, Congress was concerned about potential abuses in purchase price allocations, with particular emphasis on the assignment of value to goodwill or going concern value. Its response was to enact Sec. 1060, which mandates the use of the "residual method" of valuation to asset acquisitions. (5)

Sec. 1060 applies to any "applicable asset acquisition," which is defined as any direct or indirect transfer of assets that constitute a trade or business in the hands of either the seller or the purchaser, and with respect to which the transferee's basis is determined solely by reference to the consideration paid for the assets. (6) The regulations issued under Sec. 1060 define a group of assets to constitute a trade or business if -- the use of the assets would constitute an active trade or business for purposes of Sec. 355; or -- the character of the assets is such that goodwill or going concern value could attach to those assets. (7)

Sec. 1060(a) provides that a lump-sum purchase price will be allocated among specific assets using the residual method approach prescribed in Sec. 338(b)(5). Under the Sec. 338 temporary regulations, the residual method allocates the purchase price to identifiable tangible and intangible assets, up to their FMV, with any remainder allocated to goodwill or going concern value. (8)

Example 3: ABC Corporation, from Example, 1, is valued as a going concern at $1,200,000. Since the identifiable underlying assets were assumed to have an FMV of $990,000, ABC will have $210,000 allocated to goodwill. The corporate level gain will increase from $515,000 to $725,000, and the corporate level tax will increase by $71,400 (0.34 X $210,000).

To the extent that the liquidating corporation is involved in the active conduct of a trade or business, Sec. 1060 may apply to the deemed sale transaction. Sec. 1060 also requires that the transferee's basis be determined solely by reference to purchase consideration. The shareholder's basis in assets acquired in a liquidating distribution is the FMV of such assets. (9) This is not necessarily the sane as the cost basis that would be acquired in a purchase transaction. For example, if a distributed asset is subject to a liability in excess of the fair value of the asset, the demmed corporate sales price will be the amount of the liability. (10) The shareholder's basis will be the FMV of the asset, resulting in a difference between the deemed sales price and the distributee's basis. The absence of a purchase price basis for the shareholder provides an argument for the nonapplicability of Sec. 1060 to the liquidation.

Avoiding an allocation to goodwill is an assential planning consideration when corporate assets are distributed in liquidation. In Example 3, if the transaction had involved an actual sale to a third party, the shareholder would have had the funds available to satisfy any tax liability attributable to a goodwill allocation. However, the deemed sale does not provide any purchase consideration to satisfy a tax liability. Further, an actual sale fixes an aggregate value for corporate assets, with Sec. 1060 simply operating to allocated a fixed amount among individual assets. Sec. 1060 can be particularly troublesome for deemed sales, since there is no limitation on the aggregate value (including goodwill) to be assigned to the corporation.

The Tax Court has identified nine factors to be used in determining the presence of goodwill. (11) These factors should be explicitly considered in defending against a goodwill allocation. A qualified appraister should be retained to value the company as a going concern with an effort made to substantiate the absence of goodwill. No single approach to valuation is appropriate because of the inherently factual nature of the question. However, if the assets will not be retained for trade or business use by the shareholders, a goodwill allocation should be avoidable. This is particularly true when any goodwill would be associated with the continued participation of one or more shareholders in the business activity.

* Disallowance of losses

Losses are disallowed to the liquidating corporation on the distribution of any property to a related person if the distribution is not pro rata or consists of "disqualified property." (12) For this purpose a related party generally refers to any shareholder owning, directly or indirectly, more than 50% in value of the outstanding stock of the liquidating corporation. (13) Disqualified property includes any property acquired by the liquidating corportion in a Sec. 351 transaction or as a contribution to capital during the five-year period ending on the date of distribution.

Example 4: B owns 100% of the stock in XYZ Corporation. One year before XYZ's liquidation, B transfers property with a basis of $200,000 and an FMV of $50,000 to XYZ in a transfer qualifying under Sec. 351. XYZ distributes the asset in liquidation when its FMV is $65,000 and the basis is $200,000. XYZ has a realized loss of $135,000, which will be unrecognized because the property is disqualified property. B will acquire a basis of $65,000 in the asset (FMV), with the result that the loss will never be recognized.

This is a harsher result than the Sec. 267(a)(1) disallowance of loss on sales between related parties because Sec. 267(d) permits a disallowed loss to offset future realized gains of the transferee. No similar provision is found in Sec. 336(d). while B benefits from the $200,000 basis adjustment to his stock holdings, the loss that might have been recognized at the corporate level is forfeited under the Sec. 336(d) provisions. Thus, the potential for two levels of loss recognition from the existence of a separate taxable entity disappears.

Losses may also the limited for certain distributions or sale or exchange transactions with a tax-avoidance motive. This limitation is to prevent shareholders from shifting losses to the corporation by contributing property with a built-in loss, with the objective of recognizing the loss on a sale or distribution in liquidation. Any built-in loss cannot be recognized with respect to any property contributed in a Sec. 351 transaction or as a contribution to capital, if the contribution had a tax-avaoidance motive. (14) Any decline in value occurring after the contribution will result in a deductible loss. If the contribution occurs within two years of the adoption date of a plan of liquidation, the transaction is presumed to have a tax-avoidance motive. (15)

Example 5: A and B are nonrelated shareholders in ABC Corporation. One year before ABC's liquidation, B contributes property with a basis of $200,000 and an FMV of $150,000. A transfers $150,000 of cash as part of the same transaction, making the transfers tax-free under Sec. 351. One year later, ABC distributes B's asset in liquidation, when the FMV is $140,000. ABC will have a realized loss of $60,000, but will only recognize a $10,000 ($150,000 - $140,000) loss. The $50,000 precontribution loss is disallowed because the property is presumed to have been contributed with a tax-avoidance motive.

There is presently no regulatory guidance on how the presumption of a tax-avoidance motive can be refuted. However, the Senate Report to the Technical and Miscellaneous Revenue Act of 1988 (TAMRA) indicated that Congress intended the regulations to provide that the tax-avoidance presumption is to be disregarded "unless there is no clear and substantial relationship between the contributed property and the conduct of the corporation's . . . business enterprises." (16) The report stated that establishing a clear and substantial business relationship would generally require demonstrating a business purpose for placing the property in the corporation as opposed to retaining the property outside the corporation. If the corporation has substantial unrealized gains at the time that assets with substantial built-in losses are contributed, special scrutiny is expected. A clear and substantial relationship would also be difficult to support if the company is liquidated immediately following the contribution of built-in loss property. (17). Contributions of property with built-in losses that are made more than two years before the adoption of a plan of liquidation might be made with a prohibited purpose; however, the limitation on losses" will apply only in the most rare and unusual cases." (18)

The loss disallowance rule may be difficult to apply for two reasons. First, determining the allowed loss requires knowing the asset's FMV at the date of contribution. It is unlikely the taxpayer had the foresight to appraise the asset at that time, creating significant potential for controversy. Second, the adoption date of a plan of liquidation is subjective. The taxpayer's purposes may be served by delaying the adoption of a formal plan to a date more than two yers from the contribution of the asset. The IRS would then be expected to argue that an informal plan had been previously adopted.

Planning to avoid the loss disallowance or limitation provisions may prove to be difficult because the rules can overlap. The Sec. 336(d)(1) loss disallowance rules apply only to distributions of property in complete liquidation, while the Sec. 336(d)(2) loss limitation rules apply to sales, exchanges and distributions. Thus, if disqualified property (acquired within five years of distribution in a nonrecognition transaction) is sold rather than distributed, the loss might be limited under the tax-avoidance presumption.

A sale (as opposed to a distribution) of a corporate asset to a related-party shareholder will avoid the Sec. 336(d)(1) loss disallowance provisions, but any loss will be disallowed under Sec. 267(a)(1). The Sec. 267(a)(1) loss disallowance will apply even if the asset does not constitute disqualified property. However, if the asset is disqualified property, a sale may be preferable to a distribution because Sec. 267(d) permits the transferee to offset future gain by any disallowed loss.

Example 6: ABC Corporate sells property with a basis of $200,000 to its sole shareholder S for $50,000. No loss is recognized on the sale and S acquires a $50,000 basis in the property. If the asset constituted disqualified property, the corporate level tax result is the same as if the property had been distributed in liquidation ratherthan sold. However, the sale transaction permit S to use the $150,000 disallowed loss to offset any future realized gain from a disposition of the asset. No future benefit would be possible if the asset is distributed. Since ABC substitutes one asset valued at $50,000 for another of similar value (cash or a shareholder note), the shareholder level gain under Sec. 331 is not affected by the sale.

Conceivable, the IRS could argue a step transaction. However, if a step transaction is not argued, a separate tax-avoidance issue is raised. Assume that ABC sells the property for $10,000 rather than $50,000. Since any loss would be disallowed at the corporate level, the only effect of the reduced sales price is to decrease the value of assets to be distributed to S. Thus, S could conceivably reduce his gain by $40,000. The IRS should e expected to contest such an arbitrary sales price.

Property acquired in a Sec. 351 transfer and held for five years may still be subject to the loss limitation rules. This could occur when the corporation adopts a plan of liquidation within two years of the sec. 351 transfer, but retains the asset for more than five years to satisfy contingent claims of the liquidated corporation. Determining the amount of precontribution loss would be particularly difficult in such a situation.

* Using capital losses at the corporate level

Since capital losses of a corporation are allowed to offset only capital gains, (19), it is particularly important that the liquidating corporation generate sufficient capital or net Sec. 1231 gains to offset capital loss carryforwards and capital losses arising in the year of liquidation. Otherwise, all tax attributes disappear on liquidation, and no tax benefit will ever be realized from the capital losses.

On the sale or distribution of Sec. 1245 property, any recognized gain will be ordinary income up to the amount of depreciation claimed. (20) Sec. 1250 requires the corporation to recognize ordinary income to the extent that depreciation claimed under the accelerated method exceeds the amount that would have been claimed using the straightline method. (21) If real property is sold or distributed in liquidation, Sec. 291(a) requires the corporation to recognize ordinary income in an amount equal to 20% of the excess (if any) of the amount treated as Sec. 1245 recapture if that section had applied, over the amount treated as Sec. 1250 recapture. These recapture provisions may limit the ability of the liquidated corporation to offset capital losses.

A less obvious concern for the liquidating corporation with unused capital losses is the provision in Sec. 1239(a) requiring the recognition of ordinary income when depreciable property is sold to a related person. (22) Since the liquidating distribution is treated as a sale to the distributee, a distribution to a related-party shareholder will be subject to Sec. 1239. See Example 7 above.

To avoid losing the benefit of the capital loss, the corporation in Example 7 could sell the gain asset to a third party, thus recognizing a Sec. 1231 gain (for non-Sec. 291 recapture). This sale will allow the corporation to offset the Sec. 1231 gain against the capital loss from the distribution, provided the loss is not limited by Sec. 336(d).

Tax Treatment to the Shareholder

* Character of gain or loss

The character of gain or loss recognized by the shareholder from a liquidating distribution is generally capital in nature. However, if an individual shareholder holds Sec. 1244 stock, any loss may qualify as an ordinary loss. (23) The annual limitation for orindary loss treatment is $50,000, or $100,000 for a husband and wife filing a joint return. (24) Following the Supreme Court decision in Arkansas Best Corp., (25) it is extremely unlikely that a shareholder could successfully argue that an ordinary loss would result due to a business purpose for acquiring the stock.

If the liquidated corporation meets the definition of a collapsible corporation, any shareholder gain will be consdered ordinary income. (26) A collapsible corporation basically entails a distribution of property by a corporation to its shareholders before the corporation realizes a substantial part of the taxable income to be derived from such property. (27) Following the TRA, collapsibility is unlikely to be an issue because all corporate level income is recongized.

* Gain deferral through

the open-transaction doctrine

A corporation may make a series of distributions in the course of a complete liquidation extending over several tax years. Provided a legitimate business purpose exists for delaying the liquidating distributions, shareholder gain may be deferred by permitting the shareholder to first fully recover his basis. (28) Losses cannot be recognized until all distributions are completed. Ligitimate business purposes may include the retention of assets to satisfy liabilities, continued efforts to sell assets and the completion of all steps necessary to wind up the corporation's affairs.

Example 8: On Sept. 1, 1990, X Corporation adopts a plan of complete liquidation. A, a calendar-year taxpayer, has stock basis of $750,000. On Oct. 1, 1990, X distributes $500,000 to A pursuant to its plan. On June 2, 1991, X distributes an additional $500,000 to A. The delay in distribution was attributable to a business purpose. A has no gain in 1990 and $250,000 of gain in 1991.

If there is no legitimate business purpose for delaying corporate distributions, the shareholder will be in constructive receipt of all funds, with all gain recognized immediately. In Rev. Rul. 80-177, (29) a corporation discharged all of its liabilities and liquidated all of its assets. The company notified its shareholders that they would be able to receive a liquidating distribution on surrender of their shares of stock after a given date. Although a cash-basis shareholder postponed surrendering his shares until the following year, all income was recognized in the year in which the corporation notified the shareholder that a distribution was available.

Postponement of gains recognition may be available when a disributed asset has no ascertainable value. In Burnet v. Logan, (30) a taxpayer sold shares of stock in exchange for cash and a contract to receive 60 cents per ton of iron ore to be mined in the future. The taxpayer received payments under the contract, but did not include them in income because she felt that thecontingent nature of the payments should permit the use of basis recovery. The Supreme Court ruled that the mere promise of future monetary payments contingent on nonascertainable factors is not equivalent to the receipt of cash. Therefore, as annual payments based on the amount of extraced ore were received, they were apportioned first as return of capital and later as profit. The IRS has taken the view that only in "rare and extraordinary cases" will the valuation of an asset be nonascertainable. (31)

* Income shifting through

a preliqidation gift of shares

If a shareholder has charitable desires or is interested in transferring wealth to a family member, a corporate liquidation presents a tax planning opportunity. A taxpayer may be reluctant to transfer shares in a closely held corporation because the transfer may result in a loss of control or a shift of ownership outside a family group. However, if a complete liquidation is contemplated, a transfer of shares can create tax savings without adverse ownership changes.

As a general rule, income can be assigned provided the property that produces the income is transferred. A gift of shares to a family member can shift the income from a liquidating distribution to the donee. Similarly, a donation of shares to a qualified charitable organization can produce an immedciate charitable contribution deduction while also shifting income to the exempt entity. Thus, the donation can be effectuated wtih pretax, rather than after-tax, dollars. The contributio deduction, will be the FMV of the donated shares, unless the taxpayer is subject to the alternative minimum tax for the year of the transfer. (32) Also, if a gift of nonpublicly traded stock is made to a private foundation, the regular tax deduction is limited to adjusted basis. (33)

The assignment of icome may not be effective if property is transferred in contemplation of a taxable disposition. As a rule of thumb, a transfer of shares should not occur after a plan of liquidation has been adopted. If there is no irrevocable plan of liquidation, a transfer of shares should be effective in shifting income. (34) It is expected that the IRS would be more aggressive in seeking to prevent an assignment of income to a charitable organization, since the revenue loss would be greater.

Conclusion

Following the TRA's repeal of General Utilities, liquidating corporations will now be subject to an exit tax as a result of terminating the corporate entity in liquidation. This additional level of taxation can be particularly onerous if the corporation fails to consider carefully the myriad of tax issues raised in a liquidation transaction. Careful attention to the structure of the plan of liquidation and potential pitfalls will enable the corporation and its shareholders to avoid incurring unanticipated tax liabilities.

(1) Exceptions existed for certain recapture items.

(2) Sec. 336, as amended by TRA Sections 631(a).

(3) Sec. 336(b).

(4) Sec. 331(a).

(5) S. Rep. No. 99-313, 99th Cong., 2d Sess. 253-254 (1986).

(6) Sec. 1060(c).

(7) Temp. Regs. Sec. 1.1060-1T(b)(2).

(8) Temp. Regs. Sec. 1.338(b)-2T(b)(2).

(9) Sec. 334(a).

(10) Sec. 336(b).

(11) See Bradley Broyles, TC Memo 1962-215.

(12) Sec. 336(d)(1). Under the Sec. 1502 regulations, a deduction will be disallowed for any loss recognized by amember with respect to disposition of stock of a consolidaed subsidiary to the extent the loss does not exceed the sum of the three factors described in Regs. SEc. 1.1502-20(c).

(13) Sec. 267(b).

(14) Sec. 336(d)(2)(B).

(15) Sec. 336(d)(2)(B)(ii).

(16) S. Rep. No. 100-445, 100th Cong., 2d Sess. 69, n. 28 (1988).

(17) Id., 68-70, n. 28.

(18) H. Rep. No. 99-841, 99th Cong., 2d Sess. II-200 (1986).

(19) Sec. 121(a).

(20) Sec. 1245(a)(1). This can include nonresidential real property for which accelerated cost recovery was claimed.

(21) Sec. 1250(a).

(22) This provision is a remnant of pre-TRA law. It is intended to prevent a basis step-up to the purchaser, with the seller using preferential capital or Sec. 1231 gain treatment.

(23) Sec. 1244(a). This treatment applies to the first $1 million of capitalization. The tax treatment applies to any original noncorporate shareholder, including a noncorporate partner in a partnership that is the original shareholder.

(24) Sec. 1244(b).

(25) See Arkansas Best Corp., 485 US 212 (1988)(61 AFTR2d 88-655, 88-1 USTC p9210). Arkansas Best interpreted an earlier decision of the Supreme Court (Corn Products Refining Co., 350 US 46 (1955)(47 AFTR 1789, 55-2 USTC p9746)) and in the minds of many practitioners reversed a long-standing judicial doctrine. It remains unclear what effect Arkansas Best will have in this area. See, e.g., The Circle K Corp., Cl. Ct., 1991 (67 AFTR2d 91-1055, 91-1 USTC p50,260), mod'd, Cl. Ct., 1991 (68 AFTRwd 91-5462, 91-2 USTC p50,383), and vac'd, Cl. Ct. 1991 (68 AFTR2d 91-5458, 91-2 USTC p50,382).

(26) Sec. 341(a).

(27) Sec. 341(b).

(28) Rev. Rul. 68-348, 1968-2 CB 141.

(29) Rev. Rul. 80-177, 1980-2 CB 109.

(30) See Burnet v. Edith Andrews logan, 283 US 404 (1931)(9 AFTR 1453, 2 USTC p736).

(31) See Rev. Rul. 58-402, 1958-2 CB 15.

(32) Secs. 170 and 57(a)(6).

(33) Sec. 170(e)(1)(B)(ii) and (5)(A).

(34) See Edwin W. Hudspeth, 471 F2d 275 (8th Cir. 1972)(31 AFTR2d 73-488, 73-1 USTC p9136), rev'g 335 F Supp. 1401 (E.D. Mo. 1971)(29 AFTR2d 72-472, 72-1 USTC p9161).