Avoiding dividend treatment on distributions by liquidating.
Potential Basis FMV corporate gain (loss) Property A $100,000 $ 25,000 $(75,000) Properly B 50,000 125,000 75,000 Total $150,000 $150,000 $ 0
The corporation has $275,000 in earnings and profits (E&P). John's basis in the stock is $200,000. When John picks up his individual income tax return, he mentions to his tax adviser that he is planning to have the corporation execute a quitclaim deed next year (Year One) to transfer A to him. He plans to have the corporation transfer B to him the following year (Year Two) in the same manner. he also mentions that it will probably be several years before his health improves enough for him to work full-time again in the paving business. Issue: how should the tax adviser recommend that John and Peters, Inc. structure the transfer of the two properties?
After reviewing the transaction, the tax adviser should tell John that the transaction, as John plans to structure it, will result in the worst possible tax scenario, with the property distributions treated as dividends.
The corporation will not be able to take a deduction for the distributions, but John will have to report them as ordinary income (because the amount of the distribution will not exceed the corporation's $275,000 of E&P). In Year One, when A is distributed, the corporation will not be able to recognize the $75,000 loss. However, when B is distributed in Year Two, the corporation will have to recognize gain on the distribution. If property that has depreciated in value is distributed as a dividend or in redemption of stock, the corporation will not receive any tax benefit from the potential loss, because losses on nonliquidating distributions are not recognized. Corporations must, however, recognize any gain on distributions of property that has appreciated in value.
To address this problem, the tax adviser could recommend that the corporation be liquidated. The two properties could then be distributed to John in complete liquidation of the corporation.
Corporations are allowed to recognize some losses on liquidating distributions. While losses on distributions of disqualified property and non-pro rata distributions to related shareholders are not recognized in a liquidation (and losses on basis reduction property are limited), generally losses are otherwise recognized in complete liquidations. For this purpose, a shareholder and a corporation are considered related if the shareholder owns (directly or indirectly) more than 50% in value of the corporation's outstanding stock.
Related-party losses will be disallowed if:
1. The distribution is not pro rata or
2. The property distributed is disqualified property (property acquired by the liquidating corporation in a Sec. 351 transfer or as a contribution to capital during the five-year period ending on the distribution date, or property whose adjusted basis is determined in whole or in part by reference to the adjusted basis of such property).
Although John and the corporation are related parties, the two pieces of property are not "disqualified property" (they were purchased by the corporation six years ago) and the distribution of the property will not be non-pro rata (there is only one shareholder).
If the corporation is liquidated and the properties are distributed to John as liquidating distributions, the tax results to Peters, Inc. will be:
Fair market value (FMV) of assets distributed to shareholder $ 150,000 Corporation's basis in assets (150,000) Corporate-level gain $ 0 John's tax results will be: FMV of assets received $ 150,000 Basis in stock (200,000) Recognized loss $ (50,000)
The tax adviser should recommend that John liquidate Peters, Inc. She should also recommend that both pieces of land be distributed to John as a liquidating distribution. The corporation will not recognize gain on the distribution of the properties to John, and he will recognize a loss of $50,000.
If John's health should improve sufficiently in future years for him to re-enter the paving business, he can establish a new corporation. The costs of liquidating Peters, Inc. and establishing a new corporation when John's health improves should be much less than the costs of dividend treatment on distribution of the properties to John.
Corporate Reporting Requirements
Liquidating corporations must comply with the following reporting requirements:
1. Form 966, Corporate Dissolution or Liquidation, must be filed within 30 days after adoption of the liquidation plan. The willful failure to file can result in the imposition of penalties.
2. If liquidating distributions made to a shareholder in any one tax year equal $600 or more, Form 1099-DIV, Dividends and Distributions, must be provided to the shareholder. Form 1096, Annual Summary and Transmittal of U.S. Information Returns, must be used to transmit a copy of the Form 1099-DIV to the IRS.
Shareholder Reporting Requirements
If a shareholder transfers stock to a corporation in exchange for corporate property, the facts of the transaction must be reported on the shareholder's return. An exception to this rule exists if the property is part of a distribution made pursuant to a corporate resolution stating that the distribution is made in liquidation of the corporation, and the corporation is completely liquidated and dissolved one year after the distribution.
Request for Prompt Assessment
It may be worthwhile to request a Sec. 6501(d) prompt assessment from the IRS in certain instances. Dissolution of a corporation is one situation in which a prompt assessment can be requested, using Form 4810, Request for Prompt Assessment Under Internal Revenue Code Section 6501(d).
The normal assessment period is three years from the date the return is filed. The Service has 18 months from the date a request for prompt assessment is filed to assess tax. However, filing Form 4810 does not extend the regular statute beyond three years from the date the return is filed.
An example of a situation in which a request for prompt assessment might be appropriate is the liquidation of a corporation because of shareholder differences. If the IRS should assess a liability after the assets have been divided among the shareholders, disagreements could arise as to who is responsible for the deficiency.
In this situation, because John is the sole shareholder, there appears to be little reason to call undue attention to the corporation by requesting a prompt assessment.
The tax adviser should be aware of several things when considering a request for a prompt assessment:
1. The assessment period will not be limited to 18 months in the case of a false or fraudulent return with the intent to evade tax, a substantial omission of items or failure to file a required personal holding company schedule.
2. The Service has one year after the expiration of the normal three-year statute of limitations (not the 18-month period) to make an assessment against a transferee of the dissolved corporation. Thus, filing Form 4810 will not reduce the assessment period for the shareholders.
In addition to the reporting requirements, legal steps must be taken to liquidate the corporation. The tax adviser should recommend that the client contact an attorney to handle the legal aspects of the liquidation.
Editor's note: This case study has been adapted from PPC Tax Planning Guide--Closely Held Corporations, 13th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Linda Ketter-Craig and Gregory B. McKeen, published by Practitioners Publishing Company, Fort Worth, Tex. 2000 ((800) 323-8241; www.ppcnet.com).
Albert B. Ellentuck, Esq. Of Counsel King and Nordlinger, L.L.P. Arlington, VA
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|Author:||Ellentuck, Albert B.|
|Publication:||The Tax Adviser|
|Date:||Sep 1, 2001|
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