A Quick Guide to Corporate Liquidations
Complete Corporate Liquidations
There comes a point for most businesses when it’s time to throw in the towel. Maybe the economy is down and the business can’t weather the downturn. Maybe the owners want out and there’s no buyer available. Either way, the business is done, and the owner is trading in all of their shares and taking cash or other property out of the business. The question is how can this impact the shareholders taxes? With the C Corporation structure, the tax effects occur at two levels, the shareholder and the corporation. It’s this double taxation that makes C corps an organization of last resort for most businesses.
One issue that arises is that the term “Complete liquidation” is never explicitly defined by the Internal Revenue Code.
According to the regulations regarding Section 332, the business is considered to have completely liquidated when it ceases to be a going concern and exists only to wrap up its business. But that can be a rather nebulous definition. Many businesses limp along, making little or no revenue, struggling to pay debts but take years to finally close. So at what point does the tax code draw the line? Well the Tax Court has defined a three part test to help clarify. First, there has to be intent to liquidate, as shown by a written statement from the Board of Directors and signed by shareholders that clearly define the intent to close the business. Second, was there a continuing purpose that focused on wrapping up the affairs of the business and dissolving it? Third, did the business activities further the goal of liquidating, or does there appear to be attempts to grow or maintain the business. One other point to remember is federal tax law and state incorporation laws are not bound together. Dissolving your business at the state level without submitting your dissolution to the IRS can have tax consequences later on for the shareholders. Also, choosing not to dissolve the business at the state level can complicate things. Yes, you can leave the business intact for state purposes, but understand that the IRS will watch to see if you have essentially restarted the same business. If they decide you have, then what was originally a capital gain could now be taxed as ordinary income in its entirety.
Let’s look at the effect on the shareholder first.
On the shareholder level, a complete liquidation is essentially a sale of all the outstanding shares of corporate stock held by the shareholders in exchange for all the assets of the corporation. Just like any other sale of stock, the shareholder gets capital gains treatment on the difference between their adjusted basis in the stock (i.e. their cost) and the amount they received from the liquidation. Any amount received is determined at fair market value, so cash fairly straight forward. But what if the shareholder receives property other than cash? Maybe the business can’t find a buyer for an asset and simply distributes it to the shareholder.
Because the exchange of stock for property in liquidation is considered a sale, property received is valued at fair market value. Let’s say that the corporation decides that rather than sell the company car, which was bought in 2011 for $5,000 and is currently valued at $4,000, they are going to give it to the shareholder, who has a basis in his stock of $3,000. The shareholder will recognize capital gain of $1,000. And what is the shareholder’s basis in the car? It is $4,000, just as if he had bought the car rather than received it in a distribution. Similarly, his holding period starts as of when the liquidation occurred and the sale is deemed to have occurred.
When does a gain or loss on the liquidation have to be recognized? If it’s a gain, the IRS says it should be recognized as soon as the shareholders basis has been recovered. If it’s a loss, however, it isn’t recognized until the final distribution has been made. This way a shareholder can’t manipulate the timing in order to take a loss early and as well as gain later.
What about the corporation that has liquidated? I already mentioned that corporate liquidations, like most corporate issues, are taxed twice, once at the shareholder level and once for the corporation. For that reason, the liquidating corporation also has to recognize gains or losses associated with the distribution of assets. Let’s look back at our car. We said the car was purchased for $5,000 and the fair market value was $4,000. The company had used MACRS to depreciate the car and it had a book value of $3,000. How much gain or loss will the company recognize? The company will recognize a GAIN of $1,000, the variance between the adjusted basis in the car and the fair market value. It is important to remember that this calculation is made for each asset distributed. You cannot take the aggregate and say, we distributed 5 cars to the shareholder for a total of $X and they had a total basis of $Y, so our gain is… The gain and loss must be calculated separately for each asset.
Another point to remember is that when a business is liquidating, the IRS considers the business to be switching from being an accrual basis to a cash basis for reporting purposes, which makes sense when you think about it. If you plan to dissolve your business, you are not likely to allow people to buy on credit, nor are you likely to start prepaying expenses and assuming more liabilities. Converting from accrual to cash brings everything into the present period and allows the corporation to track income and expenses. But what if you do have receivables on the books?
The IRS applies the assignment of income doctrine, which means that the rights to receive income cannot be transferred to someone else. Therefore the corporation will be taxed on the outstanding receivables, not the shareholder.
Another issue involves businesses in construction contracts. Let’s say that you build airplanes, a process that could take longer than a year. Normally you recognize income on a completed contract basis. Because this method is intended to recognize income that was earned on an accrual basis, you would have to switch to a percentage of completion method, which recognizes income more closely to a cash basis.
And so there you have a quick introduction to complete corporate liquidations. Generally they are pretty straight forward, but it is always valuable to consult with a CPA or tax attorney to make sure everything is done correctly. There are different rules for S corps, for subsidiaries and for partnerships. I will eventually tackle those topics as well. If you find anything here that is in error, or could use further clarification, please let me know. I’m happy to incorporate feedback.