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Timing liquidation distributions for tax savings.

Facts: Jack owns all the stock in Trinity, Inc., a calendar-year S corporation. Trinity has been an S corporation since its 1990 inception. Jack, age 71, contacts his tax adviser in November of the current tax year, stating he would like to liquidate the corporation due to health reasons. * By the end of the current year, Jack expects the corporation to have paid an its liabilities and own $10,000 in cash, equipment with a fair market value (FMV) of $80,000, and land with a FMV of $120,000. The equipment originally cost $100,000 and currently has an adjusted basis of $20,000. The land currently has an adjusted basis of $50,000. * Jack's sole source of income has been his salary and distributions from Trinity. For 1998, Trinity expects to realize net income of $10,000 after paying Jack a salary of $80,000 for the year. Trinity normally distributes its entire net income to Jack annually. At the beginning of the year, Jack's stock basis was $55,000 and Trinity's accumulated adjustments account (AAA) was zero. Jack does not expect to work after the corporation is liquidated, but expects to have taxable retirement income of about $30,000 beginning in 1999. * Jack states he has separate buyers for the equipment and real estate. The sales price is expected to equal the FMVs indicated. The buyers are flexible as to the timing of the proposed sales. Issue: What are Jack's options and how should he proceed in liquidating the corporation?

Analysis

* Complete Liquidation in the Current Tax Year

Jack has at least two options in proceeding with the liquidation. Trinity can adopt a plan of compete liquidation under Sec. 331(a) to distribute all assets to Jack in the current year in a liquidating distribution in exchange for his stock. The cash will not be included in the liquidating distribution, but instead will be distributed under the normal distribution rules of Sec. 1368. If this plan is followed, Trinity recognizes a gain or loss on the distribution as if the property had been sold at FMV Thus, Trinity would recognize a gain of $130,000 ($200,000 -- $20,000 -- $50,000). Of this amount, $60,000 is ordinary income from Sec. 1245 recapture, and $70,000 is long-term capital gain. The gain and Trinity's $10,000 net income for the year pass through and increase Jack's stock basis to $195,000 ($55,000 + $10,000 + $130,000). The cash distribution will reduce AAA and stock basis by $10,000. After the cash distribution, stock basis will be $185,000. Jack would recognize a $15,000 ($80,000 + $120,000 -- $185,000) capital gain on the liquidating distribution of the equipment and land in exchange for his stock.

On his 1998 return, Jack would report total income of $235,000 ($80,000 salary + $140,000 passthrough + $15,000 liquidation gain). The maximum tax rate on the $70,000 capital gain is 28%; however, the remainder of the income is taxed at ordinary tax rates. In 1999, Jack's retirement income would be taxed at ordinary rates.

* Complete Liquidation Spanning More Than One Year

Alternatively, Trinity can adopt a plan of complete liquidation under Secs. 331 (a) and 346(a) to sell its property in sales that span 1998 and 1999, with final liquidation occurring in 1999. Again, the cash will be distributed under the normal distribution rules apart from the liquidation. Assume the land is sold in 1998 and the equipment in 1999. This plan defers the recognition of the Sec. 1245 ordinary gain to 1999. Thus, Trinity would pass through $10,000 of ordinary income and $70,000 of long-term capital gain from the sale of the land. Jack's total income for 1998 would be $160,000 ($80,000 salary + $80,000 passthrough), and his stock basis would increase to $135,000 ($55,000 + $80,000). The cash distribution, reduces AAA and stock basis by $10,000. After this distribution, stock basis is $125,000.

A shareholder who receives a series of distributions in complete liquidation of a corporation does not recognize any gain until the cost or other basis in the stock has been recovered. Thus, Jack can receive a liquidating distribution, for example, of $80,000 in 1998 without recognizing gain on the liquidation. The $80,000 liquidating distribution would reduce his stock basis (without regard to AAA or accumulated earnings and profits, if it existed) to $45,000 ($125,000 -- $80,000).

For 1999, Trinity would pass through ordinary income of $60,000 on sale of the equipment. This passthrough gain increases his stock basis to $105,000 ($45,000 + $60,000). Assuming the final liquidating distribution is $120,000, Jack recognizes a $15,000 capital gain ($120,000 -- $105,000). Jack's total income for the year would be $105,000 ($30,000 retirement income + $60,000 passthrough + $15,000 liquidation gain).

Assuming Jack is in the 36% marginal tax bracket in 1998 and the 28% marginal tax bracket in 1999, the deferral of the ordinary gain on the equipment to 1999 provides a $4,800 ((36% -- 28%) X $60,000) tax savings. In addition, deferral of the capital gain on the liquidation defers liability for tax on the gain to 1999.

Conclusion

A liquidation may take more than one tax year to complete, and the property may be distributed directly to the shareholders or sold by the corporation with the sales proceeds distributed to the shareholders. While the character and amount of the gain will be the same either way, the tax adviser has shown that tax savings can be realized by planning to recognize gain on the corporation's assets in two or more tax years. Sec. 346(a) provides that a distribution will be treated as part of a complete liquidation if it is one in a series of distributions in redemption of all of the stock pursuant to a plan of liquidation. In Rev. Proc. 97-3, the IRS stated it will not ordinarily issue a ruling on the tax effects of a corporate liquidation that covers a period of more than three years. Many tax advisers believe Rev. Proc. 97-3 provides a three-year safe harbor during which a liquidation can occur.
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Author:Ellentuck, Albert B.
Publication:The Tax Adviser
Date:Apr 1, 1998
Words:1039
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