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Liquidation vs. retention: the personal holding company alternative.

Since the Tax Reform Act of 1986 (TRA 86) repealed the General Utilities doctrine, it has become more attractive to retain a liquidated corporation as a personal holding company (PHC). The main reasons are that the corporation can no longer avoid gain on liquidating sales and/or distributions, the dividend received deduction is still available to PHCs (albeit in reduced form), the PHC tax has been reduced dramatically and is still only imposed if there is "undistributed PHC income." However, the "liquidate or retain" decision is still not obvious, as demonstrated below.

The Impact of TRA 86 on the Retention

Decision

TRA 86 made the retention of a liquidated corporation far more attractive than before. The reasons are as follows: 1. The liquidating corporation must recognize gain (or

loss in some instances) on liquidating sales and distributions

under Section 336 whether or not its assets

and/or proceeds are retained.

Because of the repeal of the General

Utilities doctrine ("old" Sections

336 and 337), the corporation no longer has to

give up nonrecognition at the corporate level to

remain in existence as a PHC. 2. The personal holding company tax was reduced to

28% since it is linked to the "highest" marginal tax

rate for individuals. 3. The maximum average tax rate on corporations was

reduced to 34%, with a rate of only 15% $50,000

or less in taxable income.

The only feature of TRA 86 which favors liquidation is the reduction of the dividend received deduction from 80% to 70% (unless a 20% control requirement is met).

Retention Advantages

1. The shareholder postpones and perhaps completely

avoids gain on the liquidating distribution. (If the

stock is retained for life). 2. Gain is deferred on any retained appreciated assets. 3. The immediate tax savings may be invested and

reinvested, generating income which may be consumed

or accumulated. 4. When the shareholder dies the

stock receives a basis equal to

its fair market value under Section

1014(a). This value will reflect

the corporation's net worth

so that little gain or loss will

result to the successor in interest's

receipt of a liquidating distribution. 5. The corporation may recognize

a net loss upon the eventual

liquidation.

Retention Disadvantages

1. No loss is recognized on retained

depreciated assets. 2. Some double taxation will result

even though it may be minimized

by investing in stocks earning

dividends eligible for the

dividend received deduction. The

complete elimination of double

taxation may only be achieved by

investing in vehicles with no

current yield (growth stock, art

works, collectibles), or with a

tax-free yield (municipal bonds,

life insurance policies). 3. Taxable income must be distributed

currently to avoid the flat

28% PHC tax on "undistributed

PHC income" under Section 541. 4. Expenses, such as legal and accounting

cost, are invariably incurred

in order to keep the corporation

in existence. 5. The corporation may recognize a

net gain on the eventual liquidation.

Making A Rational Decision

To make a rational decision, i.e., "retain or liquidate," the following assumptions are made: 1. All shareholders are individuals. 2. The corporation sells all its assets

at a net gain. 3. The corporation's net gain is independent

of whether a liquidating

distribution is made (no installment

sales!) and may therefore

be disregarded. 4. The shareholders' stock bases are,

on the average, significantly below

the value of the corporation's

assets after tax. 5. The parties have the same investment

opportunities. 6. The corporation, if retained, will

invest its funds solely in domestic,

dividend paying stocks, such

as preferred stock, eligible for

the 70% dividend received deduction. 7. All after-tax corporate income is

distributed to the current shareholders. 8. The corporation is in the 34%

tax bracket and the shareholders

in the 28% bracket. 9. The corporation's ultimate gain

or loss on a possible future liquidation

is disregarded. 10. Expenses of retaining the corporation

are disregarded.

Example. After selling all its assets, L. Corp. has $20 million of after-tax proceeds to invest or distribute and the shareholders have an aggregated basis of 5% million in their stock. If retained, the corporation will invest its funds in preferred stock yielding 8%. The comparison indicated in Table 1 must be made.
Table 1
Retention
Dividend yeild 8% of $20 million $ 1,600,000
Less 70% dividend received deductions 1,120,000
Taxable income $ 480,000
Corporate tax 34% 163,200
Distribution ($1,600,000 less $163,200) $ 1,436,800
Less 28% shareholder tax 402,304
After-tax return to shareholders $ 1,034,496
Liquidation
Liquidating distribution $ 20,000,000
Less tax on distribution
 Section 331:.28 ($20 million - $5 million 4,200,000
Net proceeds available for investment $ 15,000,000
Dividend yield 8% $ 1,264,000
Less 28% shareholder tax 353,920
After-tax return $ 910,000


In this example, the shareholders increase their after-tax return by not liquidating the corporation. However, the result could easily be the opposite if the shareholders' stock basis has been closer to the corporation's net worth. For example, if the shareholders' bases has been $15 million instead of $55 million, the liquidation alternative would yield the results in Table 2.
Table 2
Liquidating distribution $ 20,000,000
Less tax on distribution
 .28 ($20 million - $15 million) 1,400,000
Net proceeds $ 18,600,000
Dividend yield 8% $ 1,488,000
Less 28% shareholder tax 416,640
After-tax return $ 1,071,361


Here, the shareholders should liquidate the corporate since the extra corporate tax on income more than offsets the effect of their own tax on the gain on the liquidating distribution.

APPENDIX A

The shareholders' annual after-tax return, RC, in the retention ease equals

RC = V X D{1 - [T.sub.s] (I-DRD)]} where

V = Value of corporate assets

D = Dividend yield

.3 = Portion of dividend yield taxable after 70% dividend

received deduction

[T.sub.c] = Corporate tax rate

[T.sub.s] = Shareholder tax rate

In the liquidation case the annual after-tax return, RS, equals

RS = {V-[T.sub.s](V-[AB.sub.s]} D (1-[T.sub.s]) where

[AB.sub.s] = Shareholders' adjusted bases in their stock.

Thus, the corporation should bc retained if RC > RS, liquidated if RS > RC.

Computing Break-Even Point

If the corporation is retained, the shareholders indefinitely postpone the tax on the gain on the liquidating distribution, but the corporation is subject to a 10.2% tax on dividends received (34% on the 30% remaining after the dividend received deductions).

If the corporation is liquidated the shareholders pay a 28% tax on their stock gains (liquidating distribution received less stock basis), but they receive their annual return on after-tax proceeds without any corporate tax.

It follows that the indifference point (of "break-even") is where the tax on the percentage gain, G, on the liquidating distribution equals 10.2% of such distribution where:

.28 G = 10.2

G = 10.2/.28 = .3643 From this we can conclude: 1. If the shareholders' stock basis is

in excess of 63.57% (1-.3643) of

the liquidating distribution, the

corporation should liquidate. 2. If the stock basis is less than

63.57% of the liquidating distribution,

the corporation should

be retained.

The accuracy of these conclusions may be illustrated be revisiting the example above.

In the retention alternative the shareholders' after-tax return was $1,034,496. If the shareholders' stock basis was $12,7144,000 (63.57% of $20 million) the return in the liquidation alternative would be as shown in Table 3. Thus, at corporate and shareholder tax rates of 34% and 28% respectively, and a dividend received deduction of 70%, the break-even point is indeed where stock basis equals 63.57% of the liquidating distributions.
Table 3
Liquidating distribution $ 20,000,000
Less tax on distribution
 .28 ($20 million - $12,714,000) 2,040,008
Net proceeds available for investment $ 17,959,992
Dividend yield 8% $ 1,436,799
Less 28% shareholder tax 402,303
After-tax return $ 1,034,496


APPENDIX B

The break-even point is where the corporate tax rate, adjusted for the dividend received deduction, equals the shareholders' tax rate times their gain on the liquidating distribution, or

[T.sub.c](1-DRD) = [V-AB/V.sub.s] [T.sub.s]

[T.sub.c] = Corporate tax rate

DRD = Dividend received deduction

V = Value of liquidating distribution

[AB.sub.s] = Shareholders' stock basis

[T.sub.s] = Shareholder tax rate

When Retention Should not

Take Place

Although retention is often attractive it is not always the case. In the following cases retention is unattractive or even impossible: 1. The shareholder's basis in his

stock is higher than the value of

the potential liquidating distribution.

Thus, retention would

simply deny the shareholder a

recognized tax loss. 2. The shareholder's gain on the

liquidating distribution is too

small to justify the continued

expense and inconvenience of

keeping the corporate alive. 3. The shareholder needs the corporate

funds for purposes other

than investment, such as retirement

income, trips, personal

loans, medical expenses, etc.

The Effect of New or Existing

S Elections

The decision rules discussed must be modified in the case of corporations who are or will be S corporations.

Liquidating Existing S

Corporations

Whether or not the S corporation is retained or not the same gains and losses on liquidating sales pass through to the shareholders who increase (decrease) their stock bases for gains (losses) reported. Also, the after-tax return on investments will be the same, whether earned directly by the shareholders or earned by the corporation, then passed through to them. The decision rule therefore boils down to this: If the shareholders, on the average, realize a net gain on the liquidating distribution, the corporation should be retained. If the shareholders, on the average, realize a net loss on the liquidating distribution, the corporation should be liquidated and dissolved.

Liquidating C Corporations,

Then Making the S Election

If the C corporation has no Subchapter C earnings and profits and would make an S election if retained, the after-tax return to the shareholders would be the same as if the shareholders invest on their own. Therefore, the retention should take place if the shareholders would thereby avoid or postpone their gain on a liquidating distribution.

If the corporation has Subchapter C earnings and profits, the decision rules set forth in this paper would still apply, since the S election should not be made for the following reasons: 1. The tax on passive income would

apply at the S corporation level. 2. The S election would terminate

after three years.

Conclusion

The "liquidation v. retention" decision has been simplified after TRA 86 since nonrecognition of gain at the corporate level no longer exists. Therefore, it no longer has to be sacrificed to retain the corporation as an investment vehicle. As a result, the decision rule is primarily a function of the shareholders' stock basis as a percentage of corporate after-tax proceeds from the liquidating sales, given the parties' tax rates and the dividend received deduction. Overall, a significant increase in the conversion of closely held liquidated corporations into PHC's should be expected.

Rolf Auster, PhD, CPA, LLM, is a professor of taxation at Florida International University in Miami, Florida. He is the author of many books on finance and taxation, and has published in numerous professional publications.
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Author:Auster, Rolf
Publication:The National Public Accountant
Date:Apr 1, 1992
Words:1869
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