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Section 331 liquidations.

A complete liquidation exists for tax purposes when a corporation ceases to be a going concern and exists solely to wind up its affairs, pay its debts and distribute any remaining balance to its shareholders. [1] Conversely, a legal dissolution under state law is not required for the liquidation to be complete for tax purposes. A liquidation will occur even though the corporation retains a nominal amount of assets to pay any remaining debts and preserves its legal status. [2]

Liquidations occur for various reasons. The business may have been unsuccessful, or the shareholders may decide to terminate the corporate existence and acquire the assets of the corporation.

Generally speaking, a liquidation occurs when a person or a corporation wants to purchase the assets of the corporation. The purchaser may buy the stock of the shareholders and then liquidate the corporation to acquire the assets. Conversely, the purchaser may buy the assets directly from the corporation; thereafter, the corporation will distribute the sales proceeds to its shareholders. The different means used to liquidate a corporation will produce varying tax results.

The tax effects to the corporation in a complete liquidation are somewhat like those in a stock redemption in that a liquidation is also afforded exchange treatment. A liquidating corporation recognizes gain and loss upon distribution of its assets, and the shareholders receive exchange treatment of receipt of the property from the liquidating corporation. The asset distribution is treated as payment for the shareholder's stock, resulting in either a gain or loss.

For the corporation in the process of complete liquidation, Sections 336 and 337 govern the tax results. The general rules relating to complete liquidations are covered in Section 336 which provides that gain or loss is recognized to the distributing corporation. An exception provides that no loss is recognized to the distributing corporation for certain distributions of disqualified property and same distributions to related shareholders.

Prior to 1986 law, a corporate distribution of property, whether a liquidating or a nonliquidating distribution, produced neither gain nor loss to the distributing corporation. This was knows as the General UtilitieS3 rule. Through the years, various statutory rules have chipped away the nonrecognition concept so that certain items are now taxed, such as depreciation and investment credit recapture and previously expensed items.

Under the 1986 act, the General Utilities doctrine was repealed, with a few exceptions: distributions in kind, sale of investment assets and the Section 1231 element as to assets used in a trade or business. Accordingly, the repeal of the General Utilities rule now causes a liquidating corporation to recognize, as a general rule, all gains and most losses on property distributions.

Section 336 provides that, with the exception of property distributed to a parent in complete liquidation of a subsidiary, gain or loss is recognized to a liquidating corporation on the distribution of property in complete liquidation as if such property were sold to the distributee at the fair market value. Thus, liquidating distributions are subject to tax both at the corporate level and at the shareholder level.

When property distributed in a complete liquidation is subject to a liability of the liquidating corporation, the fair market value of that property cannot be less than the amount of the liability.

Losses on the distribution of property in a complete liquidation are generally recognized. However, there are two exceptions. The first exception applies to certain distributions to related parties pursuant to Section 267. The second prevents a built-in loss that was contributed to the corporation shortly before the adoption of a plan of liquidation. Thus, the loss is disallowed even if the property distribution is to an unrelated party.

Losses will be disallowed on distributions to related parties in either of the following cases: 1) the distribution is not pro rata or 2) the property distributed is disqualified property. Disqualified property is defined as property acquired by the liquidating corporation in a Section 351 transaction or as a contribution to capital during a five-year period ending on the date of the distribution.

The general expenses involved in liquidating a corporation are deductible to the corporation as business expenses under Section 162, including legal and accounting expenses and expenses relating to the disposition of corporate assets.

A copy of the minutes of the shareholders' meeting in which the plan of liquidation was adopted must be attached to the final corporate income tax return for the liquidating corporation. Furthermore, detailed information regarding sale of assets must be provided, including computation of gain or loss.

Form 966, Corporate Dissolution or Liquidation, must be filed with the IRS within 30 days after the adoption of the plan of liquidation. Information returns Form 1099) must be transmitted to each shareholder on or before January 31 of the year following the liquidation. in addition, Form 1096 which notifies shareholders of their respective gains or losses must be sent to the IRS by February 28.

Tax Effect to the Shareholder

The corporate shareholder's tax treatment is governed by the general rule of Section 331. There are two exceptions found in Sections 332 and 338.

For a complete liquidation, Section 331 (a) (1) provides for exchange treatment, and Section 1101 (c) requires the recognition of gain or loss on the sale or exchange of property. The result is that the shareholder is treated as having sold his or her stock to the liquidating corporation. The amount that is recognized to the shareholder is the difference between the fair market value of the assets received from the corporation and the adjusted basis of the stock surrendered (realized gain or loss). Capital gain or loss results to the stockholder if the asset is a capital asset in the hands of the stockholder.

It must be stated that a cardinal rule of taxation is that the taxpayer must furnish evidence on the adjusted basis of the stock. Otherwise, the stock will be deemed to have a zero basis, and the full amount of the liquidation proceeds represents the amount of the gain to be recognized.

Exhibit 1 shows the tax consequences of a Section 331 liquidation. The liquidation will occur in 1989 to avoid the transitional rules as enacted by the 1986 Tax Reform Act.

The book value of assets in Exhibit 1 is not the same as their fair market value; as previously stated, Section 336 provides that gain or loss will be recognized to a liquidating corporation as if the corporation had sold the assets at fair market value.

The net $2,560,000 realized gain shown in Exhibit 2 is net of a $40,000 loss on the valuation of the accounts receivable. This ordinary loss of $40,000 can be utilized against the ordinary income of $120,000 earned in the corporation's last year prior to the Section 331 liquidation.

The gains and losses resulting from the deemed sale must be separately netted by type of asset-capital, ordinary or Section 1231 asset. The gain on the sale of land, building and furniture and fixtures are deemed Section 1231 gains. Although the distinction between capital and ordinary items still exists in the Code, the tax rates currently show no differential.

Thus, the total Section 1231 gain is $2,600,000. Under Section 11(b), the tax to Buzz Inc., would be $884,000. This tax is the same regardless of whether the assets are sold or distributed.

The net proceeds available to the corporation would be $2,600,000-$884,000 or $1,716,000. This amount would then be distributed to the two shareholders of Buzz Corporation, namely, Princess and Cinderella.

The shareholders would compute their gain under Section 331 based upon the assumption that a "sale" had occurred, as shown in Exhibit 3.
 Exhibit 1
 Buzz Inc.
 Balance Sheet
 Balance sheet prior to liquidation
Assets Book Value
Cash $ 100,000
Notes Receivable 240,000
Accounts Receivable-Net 1,140,000
inventory 720,000
Land 500,000
Building-net of depreciation 2,400,000
 Furniture & Fixtures-net of depreciation 880,000
Other Assets 20,000
 Total Assets $6,000,000
Liabilities and Stockholder's Equity
Accounts Payable $1,200,000
Mortgage Payable 2,000,000
Loans Payable 600,000
Capital Stock 1,200,000
Paid In Capital 180,000
Retained Earnings - 12/31/88 $700,000
Add: Net Income - 1989 120,000 820,000
 Total liabilities and Capital $6,000,000
 Exhibit 2
 Buzz, Inc., obtains the following appraisals
Assets Fair Market Value
Cash $ 100,000
Accounts Receivable 1,100,000
Notes Receivable 240,000
Inventory 720,000
Land 840,000
 Building 3,860,000
 Furniture & Fixtures 1,680,000
 Miscellaneous assets 20,000
 Total $7,560,000
 The determination of gain or loss is as follows
 Adjusted Fair market
Asset Basis Value Gain or Loss
Asset $ 100,000 $ 100,000
Accounts Receivable 1,140,000 1,100,000 40,000
Notes Receivable 240,000 240,000
Inventory 720,000 720,000
Land 500,000 840,000 340,000
Building 2,400,000 3,860,000 1,460,000
Furniture & Fixtures 880,000 1,680,000 800,000
Miscellaneous 20,000 20,000
 Total $6,000,000 $8,560,000 2,560,000
 Exhibit 3
 Princess Cinderella Total
Liquidating $858,000 $858,000 $1,716,000
Basis of Stock 690,000 $690,000 $1,380,000
Capital Gain 168,000 168,000 336,000

This illustration, however, does not consider state or local income taxes.


[1] Regulations 1. 332-2(c)

[2] Rev. Rul. 54-518,1954-2C.B142.

[3] General Utilities & Operating Co., V. Helvering 36-1 USTC 9012,16AF7R 1126, 56 Superior Court 185 (1935).
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Author:Guardino, Joseph Richard
Publication:The National Public Accountant
Date:Feb 1, 1990
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