4.11.7  Corporate Liquidations/Dissolutions

4.11.7.1  (12-01-2004)
References for Corporate Liquidations/Dissolutions

  1. The references for Corporate Liquidations/Dissolutions are:

    • IRC 302(b)(4) - Redemption from Noncorporate Shareholder in Partial Liquidation

    • IRC 331 - Gain or Loss to Shareholders in Corporate Liquidations

    • IRC 332 - Complete Liquidations of Subsidiaries

    • IRC 334 - Basis of Property Received in Liquidations

    • IRC 336 - Gain or Loss Recognized on Property Distributed in Complete Liquidation

    • IRC 338(h)(10) - Elective Recognition of Gain or Loss by Target Corporation

    • IRC 346 - Definition and Special Rule - Complete Liquidation

    • Rev. Proc. 90-52, 1990-2 C.B. 626

    • Rev. Rul. 71-129, 1971-1 C.B. 397

    • Burnet v. Logan, 283 U.S. 404 "1931 "

    • Arrowsmith v. Commissioner of Internal Revenue, 344 U.S. 6

    • IRM 4.61, Section 11 - Transfers of Property by and to Foreign Corporations

4.11.7.2  (12-01-2004)
Overview for Corporate Liquidations/Dissolutions

  1. A corporate liquidation should be considered at two levels, the shareholder level and the corporate level. On the shareholder level, a complete liquidation can be thought of as a sale of all outstanding corporate stock held by the shareholders in exchange for all of the assets in that corporation. Like any sale of stock, the shareholder receives capital gain treatment on the difference between the amount received by the shareholder in the distribution and the cost or other basis of the stock. At the corporate level, the corporation recognizes gain or loss on the liquidation in an amount equal to the difference between the fair market value and the adjusted basis of the assets distributed.

  2. Some corporations adopt plans of liquidation which on the surface appear to meet the various statutory requirements for liquidations. When the substance of these transactions is analyzed, however, the liquidations may actually be corporate reorganizations or other schemes which have been devised for the purpose of tax avoidance.

  3. The purpose of this chapter is to assist revenue agents in identifying issues related to such liquidation transactions. The following audit techniques are not intended as an exhaustive list, but rather, as guidance to the identification and development of some of the more common issues. Once an issue is identified the examiner should conduct further research.

4.11.7.3  (12-01-2004)
Filing Requirements

  1. In cases involving the examination of a liquidated corporation or its shareholders, the following steps should be taken to ensure that all filing requirements have been met:

    1. Check whether Forms 1099-DIV were filed for all shareholders receiving distributions in the amount of $600 or more in a single calendar year. If not, consider the applicability of penalties. Examiners are required to secure all unfiled Forms 1099 and process them through the Submission Processing Center. Consideration should be given to coordinating with Planning and Special Programs (PSP) to determine whether a project should be started on the individual recipients of the Form 1099 income. Generally, these cases are best worked by correspondence or by office examination.

    2. If dividends were paid to foreign parties, verify that Form 1042 was filed.

    3. Verify that Form 966, Corporate Dissolution or Liquidation, was properly filed and inspect the form.

    4. In Rev. Proc. 90-52 the Service issued a checklist questionnaire detailing the information to be included by taxpayers in submitting ruling requests for liquidation of subsidiaries under IRC section 332. Examiners may wish to refer to the checklist as an information source when examining cases involving liquidation issues.

    5. Rev. Rul. 71-129 states that a corporation that has completed liquidation is considered dissolved, and must file its return and pay the tax due thereon for the short period on or before the fifteenth day of the third full month following the dissolution.

    6. The following documents are typically prepared by corporations in the process of liquidating. The examiner should request these documents and inspect them for any irregularities/unusual items:

    A resolution adopted by directors recommending corporate liquidation;
    A resolution adopted by shareholders approving the directors' recommendation;
    A resolution adopted by directors authorizing the directors and officers to take all necessary steps to carry out the plan of complete liquidation;
    The plan of complete liquidation;
    The corporation's final tax returns; and
    Statements furnished to shareholders detailing the fair market values of the assets that were distributed to the shareholders.

4.11.7.4  (12-01-2004)
Definition of "Complete Liquidation"

  1. "Complete liquidation" is a term not defined by the Code. The regulations under IRC section 332 suggest that the status of liquidation exists when the corporation ceases to be a going concern and its activities are merely for the purpose of winding up its affairs, paying its debts, and distributing any remaining balance to its shareholders. The Tax Court applies a three-pronged test to determine whether a complete liquidation has taken place (see Joseph Olmstead v. Commissioner T.C. Memo 1984-381):

    • Was there a manifest intent to liquidate?

    • Was there a continuing purpose to terminate corporate affairs and dissolve?

    • Were the corporate activities directed and confined to that purpose?

  2. Dissolution under state law or lack thereof will not be controlling for federal tax purposes. Intent coupled with actual distributions to the shareholders are the usual determining elements.

  3. IRC section 346(a) allows for a series of distributions pursuant to a plan of liquidation to be treated as being part of a complete liquidation. If the plan is not formal or is ambiguous, there may be uncertainty as to which distributions are made pursuant to the plan. Distributions made before there is evidence to support an intention to liquidate should be taxable as dividends (ordinary income to a shareholder).

  4. The U.S. Tax Court's decision in Pittsburgh Realty Investment Trust v. Commissioner, 67 T.C. 260, 1976, shed some light on a corporate liquidation. The Court stated that:

    1. The determination as to whether and/or when a corporation has liquidated is a question of fact. Proof of a distribution in complete liquidation not only depends on an intent to liquidate but also requires acts which demonstrate and effect that intent.

    2. A corporation in existence during any portion of a taxable year is required to make a return. If a corporation was not in existence throughout an annual accounting period (either calendar year or fiscal year), the corporation is required to make a return for that fractional part of a year during which it was in existence. A corporation is not in existence after it ceases business and dissolves, retaining no assets, whether or not under State law it may thereafter be treated as continuing as a corporation for certain limited purposes connected with winding up its affairs, such as for the purposes of suing and being sued. If the corporation has valuable claims for which it will bring suit during this period, it has retained assets and therefore continues to exist. A corporation does not go out of existence if it is turned over to receivers or trustees who continue to operate it.

4.11.7.5  (12-01-2004)
Shareholder's Gain or Loss

  1. As a general rule, the fair market value of property received by a shareholder via a corporate liquidation less the stock's adjusted basis represents the gain or loss to the shareholder as governed by IRC section 1001(a).

  2. The following are some potential issues which might be encountered by examiners involving shareholder gain or loss:

    1. TIMING OF LOSS RECOGNITION BY SHAREHOLDER - When a shareholder receives a series of distributions in liquidation, gain is recognized once all of the shareholder's stock basis is recovered. A loss, however, will not be recognized until the final distribution is received [see Rev. Rul. 69-334, 1969-1 C.B. 98, Rev. Rul. 68–348, 1968–2 C.B. 126, and Ethel M. Schmidt, 55 T.C. 335 (1970)].

    2. UNVALUED ASSETS - A taxpayer may advance the position that contingent contract rights/disputed claims/mineral royalties, etc., should not be recognized because an accurate valuation cannot be ascertained [see Burnet v. Logan, 283 U.S. 404 (1931)]. Consideration should be given to referring the valuation of contingent claims to an IRS engineer and/or to obtaining an appraisal. It is rare when an asset cannot be valued.

    3. DISTRIBUTIONS WITH UNKNOWN LIABILITIES - If the amount of a liability distributed is unknown at the time of distribution, or so speculative that it is properly disregarded in computing a shareholder's gain/loss on liquidation, any subsequent payment of the debt by the shareholder should be a capital and not an ordinary loss. This is based upon the theory that the original capital gain on the liquidation was overstated [see Arrowsmith , 344 U.S. 6 (1952)].

    4. DIVIDEND INCOME - A dividend is defined in section 301. IRC section 331(b) holds that IRC section 301 will not apply to a liquidating distribution.

    5. IRC SECTION 1244 STOCK LOSS – IRC section 1244 provides special rules. If stock qualifies as IRC section 1244 stock then the shareholder can claim an ordinary loss instead of a capital loss on the disposition or worthlessness of the stock.

  3. The requirements of IRC section 1244 stock are as follows:

    1. The stock was issued by a domestic corporation which was a " small business corporation" at the time the stock was issued;

    2. The stock was issued by such corporation for money or other property (other than stock and securities), and

    3. The aggregate amount received for the stock was less then $1M; and

    4. The corporation, during the period of its 5 most recent taxable years ending before the date the loss on such stock was sustained, derived more than 50 percent of its aggregate gross receipts from sources other than royalties, rents, dividends, interests, annuities, and sales or exchanges of stocks or securities.

  4. For any taxable year the aggregate amount treated by the taxpayer as an ordinary loss pursuant to IRC section 1244 shall not exceed:

    1. $50,000 or

    2. $100,000, in the case of a husband and wife filing a joint return.

4.11.7.6  (12-01-2004)
Corporation's Gain or Loss

  1. Pursuant to IRC section 336(a), a corporation will recognize gain or loss separately on each asset that is distributed in liquidation equal to the asset's fair market value less the asset's adjusted basis. Possible issues include:

    1. TAX BENEFIT RULE - RECAPTURE OF PRIOR DEDUCTIONS - There may be items of value not appearing in the asset accounts because they were expensed or written-off (e.g., small tools, cattle feed, supplies, etc.). To the extent that these items have a fair market value in excess of their adjusted basis, IRC section 336(a) gain would be recognized. Prior to the 1986 legislative change in IRC section 336, the tax benefit doctrine was invoked to recapture those prior deductions [Hillsboro National Bank v. Commissioner , 460 U.S. 370 (1983)].

    2. FAIR MARKET VALUE (FMV) OF ASSETS - Taxpayers often argue that book value approximates fair market value because tax depreciation is a measure of wear and tear on an asset. Often, a fully depreciated asset will have a higher fair market value than its book value. For instance, a fully depreciated luxury auto with a high resale value. The examiner should be alert to the possibility that the FMV of the assets may greatly exceed the adjusted basis of the assets. Therefore, a gain on disposition should be computed on the corporate return under IRC section 336.

    3. CHARACTER OF GAIN – Examiners should ensure the gain on liquidation has been properly classified. Frequently, all gain on liquidation is not IRC section 1231 gain. IRC section 1231 gain results in capital gain treatment. The gain on liquidation may be ordinary. For example, gain on the sale of inventory.

    4. RECAPTURE - IRC section 291 recapture or IRC section 1245 recapture. The examiner should be alert to the possibility of recapturing depreciation, investment credit and any other recapture provisions that may be applicable to a liquidating corporation. The proper character of gain from a liquidating S corporation is very important because the character of the gain is determined at the entity level and flows through to the shareholder’s return.

    5. LIQUIDATING CORPORATION INCOME - Problems involving the amount of income a liquidating corporation will report during the year of liquidation will frequently arise. Many cash-basis corporations will have substantial accounts receivable, as in the case of professional corporations. Although these receivables may not appear on the books, records of some type will exist to keep track of billings. If IRC section 336(a) does not serve as an argument that all of these receivables are taxable (as in the case where the fair market value of the billings is less than the face value of the receivables), then either the assignment of income or clear reflection of income doctrines should be advanced.
      ASSIGNMENT OF INCOME DOCTRINE - This provides that the rights to receive income cannot be distributed to shareholders upon liquidation. Since the corporation is the one that rendered the services for which customers were billed, then the receivables must be taxed to the corporation [see J. Ungar Inc. v. Commissioner, 244 F.2d 90 (2nd Cir. 1957) and Williamson v. United States, 292 F.2d 524 (Ct. Cl., 1961)].
      CLEAR REFLECTION OF INCOME DOCTRINE - This argument maintains that in light of the requirement that an accounting method must clearly reflect income [IRC section 446(b)], an accounting method that is acceptable for a continuing business may not be allowable for a liquidating business. A corporation that is on the completed contract method and liquidates when a project is only partially completed must include in income a percentage of the profit on the contract under the percentage completion method [Jud Plumbing & Heating, Inc., 153 F.2d 681 (5th Cir. 1946)].

    6. LOSS RECOGNITION - Examiners should be aware of any assets being contributed by shareholders which result in losses (see IRC section 336(d) for the "anti-stuffing" rules). Also, a liquidation followed by reincorporation of the working assets could be a device to recognize losses. The Government has been successful in establishing that such arrangements constitute a reorganization.

    7. EXPENSE ACCRUALS - Any expense accruals should be recaptured as income if they are forgiven or not paid pursuant to the liquidation. This typically occurs with accruals of interest owed to commonly controlled entities.

4.11.7.7  (12-01-2004)
Liquidation Expenses

  1. Generally, the expenses incurred to liquidate a corporation are deductible. The expenses of selling the assets are normally charged against the gain for each asset.

  2. The following are exceptions to the general rules:

    1. COSTS OF REORGANIZATION - If the liquidation is related to a reorganization, the expenses allocated to the cost of the reorganization are not deductible [see Kingsford Corp. v. Commissioner, 41 T.C. 646 (1964, acq. 1964-2 C.B. 6)].

    2. LIQUIDATION COSTS PAID BY SHAREHOLDERS - If a shareholder incurs costs in effecting a complete or partial liquidation, the costs should be classified as capital expenditures. The costs will affect the shareholder's gain or loss upon liquidation (Rev. Rul. 67-411, 1967-2 C.B. 124).

    3. COSTS OF REDEEMING STOCK - IRC section 162(k) specifically provides that no deduction is allowed for any amount paid or incurred by a corporation in connection with reacquisition of its stock. This rule applies to redemptions in partial liquidations per IRC section 302(b)(4) and Income Tax Regulations section 1.346-1(a)(2) [see Bittker and Eustice, paragraph 10.07(3)].

    4. EXPENSES OF ISSUING/RESELLING STOCK - A corporate taxpayer may generally write-off organization and merger expenditures that have been capitalized over the life of the corporation, since they are considered worthless at the date of liquidation. However, the expenses of issuing or reselling stock are never deductible [see McCrory Corp. v. United States, 651 F.2d 828 (2nd Cir. 1981) and Bittker and Eustice, paragraph 5.04(9), footnote 164].

    5. ABANDONMENT LOSSES ON INTANGIBLES - A corporation will frequently claim abandonment losses on intangibles, such as leasehold costs and trademarks, upon liquidation. If the likelihood exists that the items will be used after liquidation, then the assets are not considered worthless and no IRC section 165 loss is available.

4.11.7.8  (12-01-2004)
S Corporations

  1. (1) Pursuant to IRC section 1371, except to the extent inconsistent with Subchapter S, all provisions of Subchapter C (dealing with C corporations) will apply to S corporations. Therefore, under IRC section 336(a), an S Corporation will recognize gain upon a distribution of appreciated assets in liquidation in the same manner as a C Corporation. As a "pass-through" entity, this gain is taxed on the shareholder’s return and it gives the shareholder a stock or debt basis step-up.

  2. If a corporation has always been an S corporation, there is generally little to no IRC section 331 gain or loss at the shareholder level. If the shareholder return reflects a significant IRC section 331 gain or loss, the shareholder's basis computation needs to be examined.

  3. On the other hand, if the corporation was formerly a C Corporation, there may be a built-in gains tax to the S Corporation on the appreciation of assets while the C Corporation was in existence (see IRC section 1374) and there could be IRC section 331 gain or loss on liquidation. Also, examiners should be aware of potential IRC section 1245 recapture at the time of conversion as another possible source of built-in gain.

  4. Distribution of installment obligations. There are special rules dealing with the distribution of an installment obligation in a corporate liquidation. Under normal C corporation rules, the C corporation would recognize any remaining deferred installment gain upon distribution of the installment note in liquidation (IRC section 453B(a)). For S corporations, two separate rules deal with the distribution of installment obligations in liquidation. The two situations are as follows:

    • If the S corporation has an installment obligation from the sale of an asset in the normal course of business (before the adoption of the plan of liquidation), the S corporation must recognize any deferred gain when it distributes the installment obligation to its shareholders. (IRC section 453B(a)).

    • If the S corporation acquires an installment obligation from the sale of its assets during the 12-month period beginning with the adoption of the plan of liquidation, the S corporation will not be required to report the deferred gain when it distributes the installment obligation to its shareholders in liquidation. (IRC section 453(h) and IRC section 453B(h)). If the S corporation is not required to report the deferred gain when it distributes the installment obligation (i.e., the obligation was acquired during the final 12 months and after the adoption of a plan of liquidation), then the shareholder reports the gain on the installment obligation as payments are received. In other words, the shareholder can treat the payments received on the note, rather than the note itself, as consideration received for the stock in liquidation. The basis of the installment obligation is ignored, and the shareholder's "allocated" stock basis in substituted for the basis in the installment obligation.

  5. IRC section 338(h)(10) Election - If the shareholder sells the corporate stock to the purchaser, the shareholder would report the gain or loss on sale, but there is no corporate gain or loss and the corporation continues to operate as before. There is no corporate liquidation. But, if the purchaser wants a step-up in basis, as if it had acquired the assets directly, an IRC section 338(h)(10) election can be made. In that situation, there is a deemed sale of the assets by the corporation. The S corporation reports the gain on the final S corporation return, which flows-through to the old shareholder(s). There is then a deemed distribution of the sales price in liquidation of the S corp. Note, there is no one-day return in an S corporation IRC section 338(h)(10) election. Both the purchaser and the shareholder(s) must elect IRC section 338(h)(10). The election is made on Form 8023 and is due the 15th day of the ninth month beginning after the month in which the acquisition occurred.

  6. Nondeductible and noncapital expenditures must reduce the S Corporation's basis, per Treas. Reg. section 1.1367-1(c)(2). Otherwise, an S Corporation paying a large nondeductible item could then liquidate, and ultimately reduce the amount of gain reportable by the shareholders under IRC section 1001(a).

4.11.7.9  (12-01-2004)
Statute Control

  1. Examiners should be aware of the possibility of a liquidating corporation requesting a prompt assessment of tax under IRC section 6501(d). Such a request will shorten the statute of limitations from three years to 18 months.

  2. The life of a corporation which has been dissolved, liquidated, or merged out of existence is governed by state law. If, under state law, a corporation's existence has terminated, than any power-of-attorney secured prior to the "death" of the corporation would also be terminated. A consent to extend the statute of limitations signed by the representative after the termination of the corporation may be held invalid.

  3. The Tax Court has held that a Form 872-A signed by a representative after a Delaware corporation was merged out of existence was invalid. The Court ruled that under Delaware law, the corporation's existence ceased upon its merger into another entity. Thus, the representative was no longer authorized to act on behalf of the corporation (Malone: T.C. Memo 1992-661).

  4. If there is any question involving state law on a dissolved, liquidated, or merged corporation, and/or the validity of a statute extension or power-of-attorney, an opinion should be promptly requested from Area Counsel.

  5. If there is a valid S election, there is generally no S corporation statute and the statute is controlled at the shareholder level. However, there are two situations where the S corporation statute must be protected. They are as follows:

    • There is an entity level tax, such as the built-in gains tax.

    • There is doubt as to whether the S Corporation election is valid.


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