Corporate Taxation Chapter Seven: Complete Liquidations

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1 Presentation: Corporate Taxation Chapter Seven: Complete Liquidations Professors Wells March 4, 2013

2 Chapter 7 Corporate Complete Liquidations p.318 The Structure of Part II of Subchapter C Subpart A Effects on Recipients 331, 332, & 334 Subpart B Effects on the Liquidating Corp. 336, 337, & 338 Subpart C Repealed in Subpart D Definitions Complete Liquidation Defined 346(a) 2

3 Liquidation vs. Dissolution p.319 Liquidation as a tax concept termination of corporate activities, satisfaction of liabilities, and distribution of the corporation s assets. Dissolution a state law concept (termination of the charter). See Texas Business Organizations Code re terminated entity and winding up re winding up procedures re certificate of termination 3

4 Shareholder Tax Treatment For Liquidation Distribution p (a) a complete liquidation enables sale or exchange income tax treatment to the shareholder of liquidating corporation. 334(a) tax basis to the shareholder for any property received in a liquidation is its FMV at the time of the liquidation distribution. Timing issues: (i) installment obligations distributed - 453(h)(1)(A) and (ii) creeping liquidation distributions (and cost recovery)? 4

5 Problem (a) p.322 Liquidation Distribution FACTS: A owns 100 shares of Humdrum Corp. purchased for $10,000 (i.e., tax basis). Humdrum has $12,000 accumulated E&P. Humdrum distributes $20,000 to A in exchange for A s stock in its liquidation. A $20,000 cash Humdrum Stk B=$10,000 Humdrum Result: $10,000 LTCG under 331. ($20,000 received less $10,000 basis). E&P account is not relevant for this transaction. Acc. E&P= $12,000 5

6 Problem (b) p.322 Several Liquidation Payments FACTS: $10,000 is received in two consecutive years. RESULT: 1. If the two cash transfers are both liquidating distributions, then Rev. Rul permits full recovery of tax basis before reporting any gain (i.e., open transaction treatment A Year 1: $10,000 Year 2: $10,000 Humdrum Stk B=$10,000 Humdrum Acc. E&P= $12,000 appears available). But, 453(j)(2) provides for ratable tax basis recovery even when the selling price is not readily ascertainable. 2. Unresolved Issue is whether the first distribution is part of a liquidation plan. This is a factual question. 6

7 Problem (c) p.323 Installment Reporting? FACTS: Humdrum distributes $8,000 cash and an installment obligation of $12,000, payable $1,000 per year for 12 years, with market rate interest. $10x basis. The obligation is received by Humdrum upon its sale of a capital asset after liquidation plan adopted. A $8,000 cash Installment note Humdrum RESULT: Gain of $10,000 is realized on the liquidation, but the shareholder may report gain on the installment note under 453(h)(1). Installment sales reporting treatment: (i) $4,000 LTCG on the $8,000 cash payment and (ii) $500 LTCG for each later $1,000 payment It is possible that A could use Rev. Rul to get basis recover first for the $8,000 and then report the remainder on an installment basis. If stock were publicly traded, then 453 is not available (see 453(k)(2)(A)) so $10,000 immediate 7 gain. Acc. E&P= $12,000

8 Problem (d) p.323 Installment Note Received FACTS: Installment obligation was received two years ago and no payment has been made on the obligation. A $8,000 cash Installment note RESULT: Installment method is not Humdrum available to the shareholder. The use of the installment sale method is not permitted when the note is created more than 12 months before the plan of liquidation. See 453(h)(1)(A). A would: (1) recognize $10,000 LTCG (20,000 less 10,000 basis) and (2) take a $12,000 basis in the installment obligation under 334(a). Acc. E&P= $12,000 8

9 Problem (e) p.323 Later Payment of Judgment FACTS: A required to pay a $5,000 judgment against Humdrum in his capacity as a transferee. RESULT: A must report a long-term capital loss on the payment. Why? Arrowsmith tax case. The payment characterization relates back to the. A $20,000 cash Humdrum Stk B=$10,000 Humdrum Acc. E&P= $12,000 Earlier liquidation where long-term capital gain was reported. If the judgment had been paid by Humdrum prior to liquidation, it would have produced a $5,000 ordinary deduction to Humdrum and reduced its net porceeds distributed to A by $5,000 (less a $1,750 tax benefit). 9

10 Consequences to the Liquidating Corporation p.323 Issue: Does a distribution of property in kind in a complete liquidation trigger gain recognition to the distributor corporation as to the distributed asset? Result: 336(a) (1) requires recognition by the distributing corporation of accrued property gain and (2) provides for the availability (in some situations) of a loss deduction. Reversing former 337 and the General Utilities doctrine. Cf., treatment of loss on property distribution in the dividends context. 10

11 Historical Perspective Corporate Level Gain Tax? 1) Commissioner v. Court Holding Co. (p.324) Substance of the transaction was a sale of an apartment house (corporation s sole asset) by the corporation, not by the shareholders. 2) U.S. v. Cumberland Public Service Co. (p.326) Property transferred to the shareholders as a liquidation distribution in kind. Held: Sale by the shareholders and not by the corporation (and no corporate level gain). Minnie Miller S/Hs Cash Form Apt Bldg Buyer Rejected Form Court Hldg Cash Distribution Assets Accepted Buyer Cumberland 11

12 Response to Court Holding Decision p.328 1) Former Code 337 Anti-Court Holding provision enabled income tax immunity for sales of corporate assets after the adoption of the liquidation plan. Seller could be either corporation or shareholder but no corporate level gain. 2) Subsequent response: 1986 appeal of the General Utilities doctrine and gain recognition is required at the corporate level for all asset sales, including after the liquidation plan adoption. Code

13 Limitations on Corporate Loss Recognition p.331 Loss can be recognized (sometimes). 336(a). Cf., 311 no loss can be recognized when a corporation distribution is not in liquidation. Certain losses are allowed even though the 267 loss limitation may apply to transfers of loss property between related persons. Double loss may be permitted (corporation and shareholder levels) after a 351 dropdown of loss property. But, note: 362(e)(2). 13

14 Limitations on Corporate Loss Deduction Availability p.333 Related Persons: 1) If the distribution is not prorata. 336(d)(1)(A)(i). 2) Where the property is acquired by the corporation within five years of distribution. An anti-stuffing rule. 336(d)(A) (ii). All shareholders: 336(d)(2) losses with a tax avoidance motive. Then only those losses accruing after contribution of loss property to the corporation are allowed to corp. on distribution. 14

15 Problem (a) p.335 Prorata Asset Distributions Prorata distribution of assets to Ivan and Flo as tenants in common. 1. Corporation: $400 loss recognized and $300 gain is recognized. 336(d) loss limitation rule is not applicable because assets have been held by Corp. for five years and distributed pro ratably. 2. Shareholders: take FMV basis in each asset. Ivan X Flo Basis FMV Gainacre $100 $400 Lossacre $800 $400 Cash $200 $200 15

16 Problem (b) p.335 Loss Asset to Majority Owner FACTS: Lossacre and cash to Ivan. Gainacre to Flo. Not a prorata distribution. Ivan Flo RESULT: Gain is recognized by X on the transfer to Flo per 336(a), but loss is not recognized since: (1) the distribution is not prorata - 336(d)(1)(A)(i) and (2) Ivan is related, i.e., he owns more than 50 percent of X Corporation - 267(b)(2). Lossacre & Cash X Gainacre Basis FMV Gainacre $100 $400 Lossacre $800 $400 Cash $200 $200 16

17 Problem (c) p.335 Loss Asset to Minority Owner FACTS: Gainacre and cash to Ivan. Lossacre to Flo. RESULTS: X Corporation recognizes the $300,000 of gain on the distribution to Ivan. X also recognizes the loss of $400 on Lossacre to Flo because Flo is not a related person and so the 336(d)(1)(A) loss limitation is not applicable. Ivan Gainacre & cash X Flo Lossacre Basis FMV Gainacre $100 $400 Lossacre $800 $400 Cash $200 $200 Flo and Ivan basis in property is $400,000. Planning: Target loss property to minority shareholder. 17

18 Problem (d) p.335 Loss Asset Held Less Than 5 Years Prorata distribution as tenants in common. Lossacre was acquired as a contribution to X Corporation capital four years ago. RESULT: The $300,000 gain on Gainacre is recognized. Distribution of of Lossacre represents disqualified property under 336(d)(1)(B). Consequently, only $160,000 (40%) of the $400,000 loss on Lossacre is Ivan X Flo Basis FMV Gainacre $100 $400 Lossacre $800 $400 Cash $200 $200 recognized. Lossacre had a value of $1 million and a basis of $800,000 at the time contributed to X Corporation (i.e., appreciated). Loss is not built-in but the property is disqualified property. 336(d)(1)(B). Property is distributed to a related person. The loss on the distribution to Ivan is not recognized (i.e., 60% of the $400,000 loss). 18

19 Problem (e) p.335 Loss Asset Held Less Than 2 Years FACTS: Lossacre (no relationship to X s business operations) is transferred to X by Ivan and Flo in a 351 transaction 18 months prior to the adoption of the liquidation plan when Lossacre had a FMV of $700,000 and an adjusted basis of $800,000. Ivan Gainacre & cash X Flo Lossacre Basis FMV Gainacre $100 $400 Lossacre $800 $400 Cash $200 $200 RESULTS: Recognize $300 gain on Gainacre. FMV declines to $400,000 FMV. If no 362(e)(2) application (no basis step-down), then a partial loss is recognized by X on its transfer of Lossacre to Flo of $300,000. The $400,000 is reduced by the amount of the pre-contribution builtin loss. 19

20 Problem (f) Gainacre and Lossacre transferred to X by Ivan. Flo contributes 200x. Ivan assets: 900x total basis and 800x FMV; Lossacre basis reduced by 100x to 700x at time of contribution to X by reason of 362(e)(2). Prorata distribution from X means that 336(d)(1)(A) does not apply (distribution is prorata). However, Lossacre is disqualified property within the meaning of 336(d)(1) (B). X has no loss deduction for 80% of the 300x remaining built-in loss since 80% was distributed to a related party. 20% of the loss (i.e., 20% of 300 = 60) is deductible. Ivan Prorata X p.335 Flo Prorata Basis FMV Gainacre $100 $400 Lossacre $800 $400 $700 Cash $200 $200 20

21 Problem (g) p (e)(2) and 336(d)(2) Assume: (1) 362(e)(2) applied to Ivan s contribution to X and (2) 336(d)(2) applies to Lossacre because a plan by X existed to recognize the loss on that property. Ivan Gainacre & cash X Flo Lossacre No loss recognition is permitted. Basis FMV Gainacre $100 $400 Lossacre $800 $400 $700 Cash $200 $200 21

22 Consequences of 331 Liquidation Concluding Thoughts A 331 Liquidation creates a separate taxable event at the shareholder and at the corporate level. Shareholder: 331 Gain* or Loss. * 453(h) allows installment sale treatment for distribution of installment note 334 FMV basis in property received Corporation: 336 Gain or Loss* * 336(d) sets forth exceptions for loss recognition 22

23 Liquidation of a Controlled Subsidiary 332 p.336 Liquidation of a subsidiary into a parent corporation assets remain held in corporate form (i.e., held by the parent corporation). Liquidate Parent Result to controlling corporate shareholder: Under 332 no gain or loss on the receipt by the corporation of property in the complete liquidation of an 80% or more subsidiary. Corp. parent s sub stock basis disappears. 334(b)(1) transferred asset bases to parent. Subsidiary E&P of 100x Appreciated Property of $1 million 23

24 George L. Riggs p.338 Liquidation Plan Adoption Question: What timing for measuring the ownership of at least 80% of the stock? Step One: Redeem Minority Shareholder G Riggs, Inc. Minority Redemptions implemented by corporation to get to the 90% share ownership level in sub. Held: The liquidation plan was adopted when the formal shareholder action was taken (and not adopted previously). When is the liquidation plan adopted? 72% 28% Standard Step Two: Liquidate Standard into Riggs G Riggs, Inc. Liquidate 95.6% Result: 332 is an elective provision. Standard 24

25 Consequences to the Distributing Corporation p nonrecognition of gain or loss results on distributions of property by a subsidiary to its parent corporation in a complete liquidation to which 332 applies. 334(b)(1) parent corporation takes (i) a transferred basis for assets and (ii) carryover of recapture of depreciation, etc. potential. No acceleration of the installment gain upon the upstream distribution of notes. 453(d). 25

26 Distributing Corporation & Minority Shareholders p.345 Distribution of assets by the corporation in 332 liquidation to minority shareholders triggers gain but not loss to the corporation. Loss distributions see 336(d)(3) limitation. No loss deduction to avoid directed distributions of loss property to the minority shareholders (who do have a recognition event upon the receipt of the distribution). 26

27 Cancellation of Debt Owing From Sub to Parent p.345 Situation: Transfer of property to satisfy debt of the subsidiary to the parent corporation. 337(b)(1) any transfer of property in satisfaction of a debt is treated as a distribution and not as a taxable event. Objective: Precludes picking loss property for transfer in eliminating debt while having a tax-free transfer of the appreciated property in the 332 liquidation. 334(b)(2). 27

28 Tax-Exempt & Foreign Parent Corp. Recipients p (b)(2) nonrecognition treatment for the liquidation of a subsidiary is not available where the parent recipient corporation is a tax-exempt organization. Exception: This taxability treatment is not applicable if the property is used in the tax exempt s unrelated trade or business What impact when liquidation distribution is made to a foreign parent corporation? 28

29 Problem 1(a) p.347 Property Distributions S distributes inventory (appreciated) to I (10%) and other assets to P, Inc. (90%). i) No recognition to P realized gain of $6,000 ($9,000 less $3,000) and P gets 90% of the E&P. 334(b) transferred basis for assets received. P Co. 90% (B=3,000) S Inc. Minority 10% (B=$200) Acc. E&P= $2,000 Land (B=3,000 FMV=8,000) Equip (B=2,500 FMV=1,000) Inv. (B=100 FMV=1,000) ii) Individual Shareholder-- recognize stock gain. $800 LTCG basis 200 and inventory of 1,000 received. 334(a) re inventory basis to I. iii) Treatment to S? Recognition for inventory. 29

30 Problem 1(b) p.347 Depreciated Property to Indiv. Equipment to I and other assets to P. 1) P has land and inventory received with 334(b)(1) basis, plus 90 percent of 2,000 E&P (or 1,800) to P. P Co. 90% (B=3,000) S Inc. Minority 10% (B=$200) Acc. E&P= $2,000 Land (B=3,000 FMV=8,000) Equip (B=2,500 FMV=1,000) Inv. (B=100 FMV=1,000) 2) I recognizes 800 stock gain 1,000 FMV less 200 basis equals 800 gain; 1,000 (stepped-down) basis to I for the equipment received. 3) S - 336(d)(3) No loss recognition to S on the distribution to I (& no E&P adjustment). 30

31 Problem 1(c) High Tax Basis for Sub Stock p347 P s basis in its S stock is $30,000 and S also had a $30,000 basis in the land. P Co. 90% (B=30,000) 10% (B=$200) Minority If S is liquidated, the $30,000 basis for the stock and the loss potential for the stock disappears. S Inc. Acc. E&P= $2,000 Land (B=30,000 FMV=8,000) Equip (B=2,500 FMV=1,000) Inv. (B=100 FMV=1,000) The potential tax loss on the land is preserved in P s hands through a transferred tax basis for the land under 336(a). Loss on the equipment to I is not preserved. 31

32 Problem 2(a) p.347 When/How to Adopt Plan? Child adopts plan of complete liquidation and distributes $2,000 cash to Uncle and remaining assets to Mother Corp. No ) Child recognizes 3,000 on the distribution of the installment obligation; 900 gain on the land; gain on the equipment. Mother Co. 75 C.S. B=1, C.S. B=$3,000 Child Co Uncle NOL= $10,000 Cash=2,000 Inst. Note (B=1,000 FMV=4,000) Land (B=100 FMV=1,000) Equip (B=100 FMV=1,000) 2) Uncle 1,000 loss on the stock. 3) Mother has 5,000 gain, also, not succeeding to the $10,000 NOL of Child (less any gain). 32

33 Problem 2(b) p.347 Redemption of Uncle s Shares 2,000 cash to Uncle for a redemption of his 25 shares and the subsequent adoption of a plan of liquidation by Child (into Mother). Distribution of remaining assets to Mother pursuant to a plan of complete liquidation when Mother then owns 100 percent of shares of Child. Mother Co. 75 C.S. B=1,000 No gain recognition then occurring. The $10,000 NOL be preserved. NOL= $10,000 Step One: Redeem Uncle Shares 25 C.S. B=$3,000 Child Co Mother Co. Child Co Uncle Step Two: Liquidate Child once whollyowned Inst. Note (B=1,000 FMV=4,000) Land (B=100 FMV=1,000) Equip (B=100 FMV=1,000) 33

34 Problem 3 p.348 Debt Owing by Subsidiary P owns all the S stock (having $1,000 basis in the stock) and holds S bonds with a tax basis and a face value of $1, % C.S. B=1,000 Parent Distribution of inventory in satisfaction of $1,000 debt prior to adopting a formal plan of liquidation. Subsidiary Inventory (B=10,000 FMV=1,000) Land (B=200 FMV=10,000) Objective of S is to recognize the $9,000 loss on the inventory. Result: Step-transaction doctrine applicable so collapsed and treated as all part of a liquidation. 34

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