Accounting 6073
Fall, 2010

Lesson 8A--Complete Liquidations (In General)

Overview:  Basically what we are talking about here is a transfer of all the corporation's
	assets out of corporate solution, and the receipt of those assets by its shareholders.
	Shareholders also assume any liabilities of the corporation, and a formal
	 dissolution of the corporation as an entity may or may not occur under state law.

	As we will see, purchasers of a business being carried on by the a corporation
	generally prefer to buy assets, rather than the corporation's stock.  The two main
	reasons for this are 1) that the purchaser of assets will get a fair market value basis 
	in those assets, (and therefore more depreciation deductions down the road), and
	2) the purchaser may avoid the corporation’s hidden/contingent liabilities.

	So that tax consequences will not dictate whether a buyer of a corporation's 
	business purchases assets or stock, the code has a mechanism to enable 
	purchasers to obtain the same overall result whether they buy stock or assets.
	This regime is in Section 338 IRC.  

I.  Introduction to Complete Liquidations

	A.  Section 331 IRC (general rule) provides that amounts received by a 
		shareholder in complete liquidation of a corporation shall be treated
		as received in full payment in exchange for the stock.

		1. Section 301 is made inapplicable to amounts received in complete
			liquidation.

		2.  Rationale:  Shareholder is surrendering his/her interest in the
			 corporation and receiving money in its place.

		3.  Earnings and profits account:  DISAPPEARS.  This is in contrast to
			a sale of shareholder's stock to another where the corporation 
			continues.  The new shareholder in such case will be taxed on
			subsequent corporate distributions to extent of E&P

	B.  Advantages of liquidating distributions over dividend distributions are clear:
		
		1.  Offsetting of basis against amount received.
		2.  Offsetting of unused capital losses against any gain on liquidation.

II. Meaning of "Complete Liquidation"

	A.  Term is not defined in 331, but regulations under 332 are helpful:

		a 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...legal dissolution is not required.  Nor
		will mere retention of a nominal amount of assets for the sole purpose of 
		preserving the corporation's legal existence disqualify the transaction.

	B.  Courts follow a pragmatic approach.  Key is intention to liquidate rather
		than observation of specific formalities.  The Tax Court follows
		three pronged test:
		
		1.  Manifest intent to liquidate?
		2.  Continuing purpose to terminate corporate affairs and dissolve?
		3.  Were corporate activities directed and confined to this purpose?

					  HOWEVER:

	C.  Although no formal plan of liquidation is specifically required by the code,
		it is dangerous to make distributions  to shareholders before the 
		intention to liquidate is evidenced by some formal corporate action.
		Failure in this area may result in some distributions being severed from
		the liquidating distributions and treated as 301 distributions to extent
		of corporate e&p.

	D.  It is well established that liquidating distributions may be in cash (corporation
		sells assets and distributes proceeds to shareholders) or in kind
		(corporation distributes assets and liabilities directly to shareholders).		

III.  Liquidating Corp's Gain or Loss on Distribution of Property in Liquidation

	A.  Introduction

		1.  As noted above, since 1986, corp. now recognizes gain or
			loss on liquidating distributions under 336(a).

		2.  See example p 10-26.  Note that the result is to put the 
			corporation and shareholder in the same position as if 
			the corporation had sold its assets, paid the tax liability
			and distributed the proceeds to the shareholders.

		3.  336(a) can be seen as the ultimate enforcer of the two-tiered
			tax system.

		4.  Because there are few exceptions to this rule, care should
			be taken in choosing a form for doing business.  It is easy
			to form a corporation, but can be very expensive to get out, 
			especially if assets and/or stock have appreciated  substantially

		5.  336(a) also applies to S corps, but note that gain/loss on disposition
			of corporate assets is recognized only at shareholder level.  
			Shareholders receive an adjustment to the basis of their stock
			to the extent they recognize gain or loss on such a transaction.

		6.  Query:  Why can't liquidating C Corp avoid 336 by electing S?  

		7.   Note:  336(a) is N/A to liquidation of a controlled sub (at least 80% 
			vote and value).  Section 332 applies in that case (no gain/loss to 
			transferee corporation).

	B.  Computation of Corporate Gain or Loss:

		1.  In general
			a.   gain or loss computed separately for each asset
			b.  debt has no effect unless it exceeds fmv of property
				it encumbers.  In such case, fmv of property
				is deemed = to amount of debt (336(b) IRC).

		2.  Earnings and Profits
			a.  ordinarily don't survive the corp's liquidation
			b.  however, they may be relevant in certain cases, such 
				as in computation of AMT, and in the case
				of liquidation of certain controlled foreign corps.
			c.  therefore, corp gains and losses on distributions in 
				liquidation generate adjustments to e&p.

C.  Limitations on Corporate Loss Recognition 

		1.  Losses not recognized on distributions to related persons (336 d 1) if 
			a.  not pro-rata OR
			b.  pro rata, but distributed asset was acquired within
				5 years by corp. in a 351 transaction or as a
				capital contribution.

			c.  this provision applies notwithstanding:
				--valid business reasons for distribution
				--lack of tax avoidance motive
				--fmv of asset exceed basis at time acquired by corp

			d.  avoid by selling depreciated prop to unrelated person and
				distributing proceeds to shareholders.

		2.  Losses with tax avoidance purpose (336 d 2) ("anti-stuffing" rule):
			loss may not be recognized if:

			a.  built in loss in property (i.e. fmv less than basis) contributed
				in a 351 or as contrib to capital OR

			b.  acquisition of property was part of a plan, a principal 
				purpose of which was to enable the corp to claim
				a loss on a liquidating distribution or sale of the prop.

			c.  applies no matter how long before the liquidation the prop
				was acquired

			d.  if acquisition of prop occurred within 2 years of adoption of 
				a plan of complete liquidation, a tax avoidance motive
				is presumed.

			e.  see example p 10-35

	D.  Tax Free Corporate Reorganization Exchanges:  336 (c) IRC provides that 
		the general rule requiring recognition of gain or loss in liquidation context
		defers to the non-recognition regime of 361 IRC and following if a 
		transaction qualifies under those sections.

	E.  Prior Law--prior to 1986, general rule was that corps recognized no gain
			or loss on distribution in liquidation of their assets.

	F.  See examples on pp 10-44 and 10-45.

IV.  Assignment of Income and Related Problems for Liquidating Corporations

	A.  Introduction

		1.  336 IRC requires liquidating corp to recognize gain or loss on
			distributed property as if the property were sold to
			shareholders at its fmv.

		2.  This rule represents change from pre 1986 days in which liquidating
			corps did not recognize gain or loss on distribution of assets
			in kind.  (General Utilities Doctrine)

		3.  Assignment of income rules may be asserted by IRS where deemed 
			sale of assets to shareholders at fmv may not reflect
			asset's capacity to  shift income from the corp to shareholders.
			This is especially the case if the corp's accounting method
			in the view of the service does not "clearly reflect income."

		4.  E.g.—distribution by accrual basis corporation of accounts payable to 
			cash basis taxpayer.

	B.  Application of General Anti-Tax-Avoidance principles to liquidations
 
		1.  With new 336(a), corp. assigning income to shareholders by 
			distributing say, uncollected accounts receivable is less of 
			an issue than it used to be for the government.	

		2.  But govt. may argue that taxpayer's accounting method doesn't 
			clearly reflect income, or use section 482.

	C.  Section 336(a) and the Tax Benefit Doctrine

		1.  Some "gains" not taxed to corp. under 336(a) may be taxed under
			tax benefit doctrine

		2.  Example: Corporation has bought supplies and not consumed them all, 
			but has taken a deduction for the full amount of supplies.
			The tax benefit rule would say that the deduction related
			to the unconsumed supplies should be "recaptured" via
			recognition of "gain" equal to the fmv of the unconsumed
			supplies.

		3.  A good case that illustrates this is Hillsboro Natl. Bank v CIR 
			460 U.S. 370 (1983).

		4. Tax benefit doctrine can also apply when C corp. converts to S 
			and S corp. receives income related to deductions taken
			when corp. was a C corp.  In such case, the income may
			be taxed as built in gain under IRC 1374.

V.  Liquidating Corporation's Deductions

	Key issues here:
		1.  Whether deductible expenses are still deductible if corp. liquidates
			before its income stream reflects the benefit of deductions.
		2.  Can unamortized deferred expenses be deductible on liquidation?
		3.  Can corp. and/or shareholders deduct expenses of liquidation?

	A. Adjustment for current expenditures with continuing economic benefit

		1.  In general, clear reflection of income language of section 446 supports
			apportionment of deducted but unused expenses between 
			corporation and shareholders.  (e.g. real estate taxes)

		2.  However, where income is accelerated into corp.'s last tax year,
			makes sense to match accelerated income with expenses.

		3.  Point:  In general deductions that benefit a fixed period pro rata
			should be apportioned.  This approach may not be favorable
			to cash method taxpayers who are entitled to deduct expenses
			when paid.

	B.  Unamortized deferred expenses-
		1.  if unused benefit expires with liquidation, deduction should be
			 allowed for unamortized portion of expenses in liquidating corp.'s
			 final return.

		2.  This principle should apply to corp. organization expenses or goodwill
		3.  Principle does NOT apply to stock issue or stock dividend costs.

	C.  Liquidation expenses
		1.  Generally deductible as incurred
		2.  Expenses related to sale of prop are selling expenses.
		3.  Expenses incurred by shareholders are capital expenses, which 
			enter into computation of their gain or loss on distribution.
		4.  Expenses incurred in resisting liquidation may be deductible under 
			212 IRC (conservation of income producing property).

VI.  Liquidation Followed by Reincorporation

	A.  Not much of an issue anymore, since liquidating corporation must recognize
		gain or loss under 336(a).  

	B.  But, since contrary to assumption of liquidation statute that shareholder
		is "giving up" his/her investment, IRS may try to re-characterize
		liquidation/reincorporation transactions if tax benefits involved
		(e.g. use of expiring loss carryovers, etc.)

VII.  Shareholder Gain or Loss on Liquidating Distributions	

	A.  In general

		1.  Liquidating Distribution is treated under 331 as payment received
			in exchange for stock.

			a.  thus, rules of 1001 IRC are operative
			b.  gain or loss will be capital if stock is capital asset

		2.  If shareholder's debt to corp. is cancelled in connection with the 
			liquidation, that cancellation is treated as part of liquidating
			distribution.  If shareholder acts as creditor in receiving
			the distribution, the event will be taxed in view of that
			capacity.

		3.  Shareholder gain or loss computed on a per share basis.  Receipts
			are applied first to recover basis.  Gain is reported only after
			basis is recovered.

		4.  Note that 267 IRC (which disallows certain losses sustained in 
			dealings between related parties) is specifically made not
			applicable to losses of shareholders and corporations in com-
			plete liquidation.  

		5.  Losses may be especially likely in connection with the liquidation of
			an S corp., because gain the S corp. reports on its distribution of
			appreciated property will pass through to shareholders, but also
			increase the basis in their stock.

	B.  Problems of Valuation and Timing

		1.  General principles of valuation apply in determining fmv of assets
		2.  If any/some assets not able to be valued with reasonable 
			accuracy, may hold transaction "open" until such assets are
			sold, collected or valuation can be made.  This problem is
			discussed in Burnet v. Logan 283 US 404 (1931).

			a.  such a delay will affect year in which s/h recognizes 
				gain or loss, as well as amount.

			b.  See e.g. pp 10-16-10-17.

		3.  Because open transaction approach offers possibility of deferral
			of tax and of converting OI into CG, IRS usually resists
			arguments that assets cannot be valued.

		4.  If an asset that cannot be valued is recovered in periodic payments
			as an open transaction item, courts generally allow basis
			recovery before recognizing any gain.

	C.  Effect of Liabilities on Shareholder Gain or Loss

		1.  To the extent that shareholders assume corporate liabilities, their
			gain should be reduced or their loss increased.

		2.  If shareholder was already liable for distributed liabilities, he may
			not reduce his amount realized by the liability distributed, but
			may be able to deduct a loss.

		3.  If shareholder pays a liability that reduced his liquidation proceeds, 
			no deductible loss.

		4.  Later payment of contingent or speculative liabilities by s/h probably
results in capital loss, not in recalculation of liquidation transaction.  See Arrowsmith v. Commissioner.

VIII.  Basis of Property Received in Complete Liquidation

	A.  Section 334(a) IRC provides generally that basis of property received
		by shareholders in complete liquidation is its FMV.

	B. Any gain or loss on later sale of property by shareholder will be
		capital or ordinary depending on nature of property in 
		hands of the shareholder.

	C.  Property taken subject to liabilities still takes a fmv basis, un-
		encumbered by the liability.  If shareholder subsequently 
		pays the liability, likely that this payment can be 
		added to asset's basis.