Tax 4022/5022 Federal Income Tax II Chapter 20 Dr. Robert R. Oliva Professor and Chairperson Department of Accounting University of Arkansas at Little Rock

CORPORATE LIQUIDATIONS  I. Liquidating a free-standing corporation  II. Liquidating a subsidiary

I. Liquidating a free-standing corporation

LIQUIDATIONS: IRC 331/336  Was it a liquidation or something else?

 If a liquidation, – General rule: IRC 331/336 – One exception [IRC 336(d)(1)]:  Dont recognize loss to distributing corp if recipient is – Related and – Distributing • Non-prorata/any property • Pro-rata/disqualified property – One special rule [IRC 336(d)(2)]:  Distributions with tax avoidance

Was it a liquidation?

 Based on interpretations.  No specific plan of liquidation requirement.

– But better to have a plan because  Is it a 331 or a 301 distribution?

 Necessary for recogniton of loss.

If a liquidation, what is the tax effect?

 Effect on recipients: IRC 331 – “Amounts received by a shareholder in a distribution in complete liquidation of a corporation shall be treated as in full payment in exchange for the stock”  Effects on corporation: IRC 336 – Except as otherwise provided in this section . . . gain or loss shall be recognized to a liquidating corporation on the distribution of property in complete liquidation as if such property was sold to the distributee at its fair market value.

DISTINGUISH: Corporate effect: IRC 336 v. IRC 311(a)  and (b) IRC 311: No gain or loss shall be recognized by corporate distributor in IRC 301 property distributions. – Exception: recognize gain if distributing appreciated property.  IRC 336: Recognize gain or loss.

EFFECT OF DISTRIBUTING PROPERTY SUBJECT TO  LIABILITIES ON FMV IRC 336(b)  “FMV” = NOT LESS THAN LIABILITY

THEREFORE, BARRING EXCEPTIONS, TREAT AS A  SALE IRC 1001 TRANSACTION AS TO BOTH PARTIES  CAPITAL GAIN/CAPITAL LOSS RECOGNITION

EXCEPTION AND SPECIAL RULE  AS TO RECIPIENTS: NONE  AS TO LIQUIDATING CORPORATION: – EXCEPTION: RELATED PARTY  NON-PRORATA/ANY PROPERTY  PRO-RATA/DISQUALIFIED PROPERTY – SPECIAL RULE: TAX AVOIDANCE

EFFECT OF IRC 267(a)(1): FIRST SENTENCE  “. . . NO DEDUCTION SHALL BE ALLOWED IN RESPECT OF ANY LOSS FROM THE SALE OF EXCHANGE OF PROPERTY . . . BETWEEN PERSONS SPECIFIED IN ANY OF THE PARAGRAPHS IN SUBSECTION (b) . . . .”

EFFECT OF IRC 267(a)(1): SECOND SENTENCE  THE PRECEDING SENTENCE SHALL NOT APPLY TO ANY LOSS OF THE DISTRIBUTIING CORPORATION (OR THE DISTRIBUTEE) IN THE CASE OF A DISTRIBUTION IN COMPLETE LIQUIDATION  DOES THAT MEAN THAT IRC 267 DOES NOT APPLY TO LIQUIDATING DISTRIBUTIONS?

EFFECT OF IRC 267(a)(1)’S SECOND SENTENCE ON  RECIPIENT IRC 331 CONTAINS NO LIMITATIONS OR REFERENCE TO IRC 267.

 THUS: 2ND SENTENCE HAS CRITICAL EFFECT, E.G., AN EXCEPTION TO THE EXCEPTION.

 ALLOWS RECIPIENTS TO RECOGNIZE LOSS EVEN IF RELATED PARTIES.

EFFECT OF IRC 267(a)(1)’S SECOND SENTENCE ON LIQUIDATING  REFERENCE TO IRC 267, THEN IRC 267(a)(1) WOULD NOT PREVENT RECOGNITON OF LOSS BY THE LIQUIDATING CORPORATION.  HOWEVER, – EXCEPTION: IRC 336(d)(1) – SPECIAL RULE: IRC 336(d)(2)

EXCEPTION [IRC 336(d)(1)]: NO LOSS SHALL BE  RECOGNIZED TO A LIQUIDATING CORPORATION ON THE DISTRIBUTION . . . TO A RELATED PERSON ( WITHIN THE MEANING OF SECTION 267)  IF SUCH DISTRIBUTION IS NOT PRO RATA OR (EVEN IF PRO-RATA), SUCH PROPERTY IS DISQUALIFIED PROPERTY

WHEN TO RECOGNIZE LOSS IF RELATED  RECIPIENTS?

PRO RATA DISTRIBUTION AND THE DISTRIBUTION IS OTHER THAN “DISQUALIFIED PROPERTY”

SUMMARY OF 267(a)/336(d) RELATIONSHIP:  IRC 267 1ST SENTENCE: NO LOSS  IRC 267(a)(1)’S 2ND SENTENCE: BUT OK TO RECOGNIZE LOSS IN LIQUIDATION  IRC 336(d)(1), BY ITS OWN TERMS, NO LOSS RECOGNIZED IF RECIPIENT IS RELATED AND DISTRIBUTION IS – NON-PRORATA / ANY PROPERTY OR – PRO-RATA / “DISQUALIFIED PROPERTY”

HENCE: FOR THIS EXCEPTION NEED TO KNOW  IRC 267  DEFINITION OF PRO-RATA  DEFINITION OF “DISQUALIFIED PROPERTY”

WHO’S RELATED? > 50% OWNERSHIP  CORPORATIONS AND INDIVIDUAL SHAREHOLDERS  CORPORATIONS IN CONTROLLED GROUP  CORPORATIONS AND TRUST SHAREHOLDERS  CORPORATION AND PARTNERSHIP SHAREHOLDERS  AN S AND A C CORPORATION

INDIVIDUALS AND THEIR CORPORATIONS [IRC  267(b)(2)] MORE THAN 50% IN VALUE OF THE OUTSTANDING STOCK OF WHICH IS OWNED, DIRECTLY OR INDIRECTLY, BY OR FOR SUCH AN INDIVIDUAL.

TWO CORPORATIONS IN CONTROLLED GROUP [IRC  267(b)(3)] MORE THAN 50% OWNERSHIP IN PARENT/SUB GROUP OR BROTHER/SISTER GROUP – SEE IRC 267(f) AND IRC 1563(b)  IRC 1563 HAS ITS OWN SET OF ATRIBUTION RULES

FIDUCIARY OF TRUST AND CORPORATION [IRC  267(b)(8)] MORE THAN 50% IN VALUE OF THE OUTSTANDING STOCK OF WHICH  IS OWNED, DIRECTLY OR INDIRECTLY, BY OR FOR THE TRUST OR BY OR FOR A PERSON WHO IS A GRANTOR OF THE TRUST.

CORPORATION AND PARTNERSHIP [IRC  267(b)(10)] IF THE SAME PERSONS OWN  MORE THAN 50% IN VALUE OF THE OUTSTANDING STOCK OF THE CORPORATION AND MORE THAN 50% OF THE CAPITAL INTEREST, OR THE PROFITS INTEREST, IN THE PARTNERSHIP.

AN S AND A C CORPORATION [IRC  267(b)(12)] IF THE SAME PERSONS OWN  MORE THAN 50% IN VALUE OF THE OUTSTANDING STOCK OF EACH CORPORATION.

NOTE  “267 RELATED” IS DEFINED BY “>50%”.  BUT IRC 318 ATTRIBUTION PERMITTED FROM/TO CORPORATIONS WHEN “50% OR MORE” OWNERSHIP

IRC 267(c): CONSTRUCTIVE OWNERSHIP  FOR PURPOSES OF DETERMINING, IN APPLYING SUBSECTION (b), THE OWNERSHIP OF STOCK . . . CONSIDER IRC 267(c)(1)-(5): – ATTRIBUTION FROM ENTITIES – FAMILY ATTRIBUTION – PARTNER ATTRIBUTION

IRC 267(c)(1): ATTRIBUTION FROM ENTITIES (% AFE)  STOCK OWNED, DIRECTLY OR INDIRECTLY, BY OR FOR A CORP, PARTNERSHIP, ESTATE, OR TRUST SHALL BE CONSIDERED AS BEING OWNED PROPORTIONATELY BY OR FOR ITS SHAREHOLDERS, PARTNERS, OR BENEFICIARIES.

NOTE: UNLIKE IRC 318  NO % REQUIREMENT (IRC 318 requires “50% or more” ownership to get attribution from a corporation)  NO “ATE ALL” (IRC 318 contains an attribution to entities) – BUT B/C OF 267(c)(1), AS SHDRS, P’S, OR BENES COULD BE ENTITIES, THERE COULD BE ENTITIES RECEIVING ATTRIBUTION.

IRC 267(c)(2): FAMILY ATTRIBUTION  AN INDIVIDUAL SHALL BE CONSIDERD AS OWNING THE STOCK OWNED, DIRECTLY OR INDIRECTLY, BY OR FOR HIS FAMILY  IRC 267(c)(4): THE FAMILY OF AN INDIVIDUAL SHALL INCLUDE ONLY HIS BROTHERS AND SISTERS (. . .WHOLE OR HALF BLOOD), SPOUSE, ANSCESTORS, AND LINEAL DESCENDANTS.

NOTE: UNLIKE 318, “FAMILY’ MEANS:  ALL THE WAY UP (not 1 up)  ALL THE WAY DOWN (not 2 down)  ALL THE WAY TO THE SIDES (only spouses permitted in IRC 318)

IRC 267(c)(3): PARTNER ATTRIBUTION  AN INDIVIDUAL OWNING . . . ANY STOCK IN A CORPORATION SHALL BE CONSIDERED AS OWNING THE STOCK OWNED, DIRECTLY OR INDIRECTLY, BY OR FOR HIS PARTNER.

 DO NOT ATTRIBUTE PARTNER’S FAMILY ATTRIBUTION STOCK  318 HAS NO PARTNER ATTRIBUTION

IRC 267(c)(5): REATTRIBUTIONS  STOCK ATTRIBUTED FROM AN ENTITY TO ENTITIES, FAMILY, AND PARTNERS IS REATTRIBUTABLE TO OTHERS.

– INDIVIDUALS RECEIVING ATTRIBUTION FROM ENTITIES MAY REATTRIBUTE  BUT INDIVIDUALS RECEIVING ATTRIBUTION FROM A FAMILY MEMBER OR A PARTNER CANNOT REATTRIBUTE TO ANYONE.

PRO-RATA DEFINITION:  DISTRIBUTION MUST BE ROPORTIONATE TO STOCK OWNERSHIP

EXAMPLE 2: PRO-RATA DISTRIBUTION  CORP OWNED BY A (40%) AND BY B (60%)  CORP HAS TWO ASSETS:ASSET 1 W/FMV $40, ASSET 2 W/ FMV $60  PRORATA MEANS – A GETS 40% OF ASSET 1 AND 40% OF ASSET 2 – B GET 60% OF ASET 1 AND 60% OF ASSET 2.

DISQUALIFIED PROPERTY: IRC 336(d)(1)(B)  DEFINED BY HOW AND WHEN ACQUIRED  HOW: IRC 351 OR CONTRIBUTION TO CAPITAL  WHEN: WITHIN FIVE YEAR PERIOD ENDING ON DISTRIBUITON DATE – LOOKBACK 5 YEARS FROM DATE OF DISTRIBUTION

EXAMPLE 3  DAY1/YR1: B SOLE SHDR OF X, TFRS CASH AND PTY W/120 FMV/90AB.

 DAY1/YR4: X LIQUIDATES WHEN PTY FMV=70: 70-90=(20) NOT RECOGNIZED. B IS RELATED/PTY 2 IS “DISQUALIFIED”

SOLUTION  DAY1/YR2: B TRFR PTY TO NEW Y CORP  DAY1/YR3: MERGE Y AND X  DAY1/YR4: X LIQUIDATES.  PTY NOT ACQUIRED IN IRC 351 BY THE LIQUIDATING CORP.  IT WAS ACQUIRED BY THE MERGING CORPORATION.

EXAMPLE 4  Y CORP HAS CASH 4K AND PTY 12FMV/40AB (NOT DISQUALIFIED). OWNED 75% BY B AND 25% BY C.

 IF PTY DISTRIBUTED PRO-RATA, CORP RECOGNIZES LOSS.

 PTY IS JOINTLY OWNED, BUT B COULD PURCHASE C’S 25% AFTER LIQUIDATION. C RECOGNIZES NO GAIN B/C AB = FMV.

COLLAPSIBILITY?

 IF COLLAPSED: NON-PRORATA AND Y CORP’S LOSS DISALLOWED.  HOWEVER SHOULD BE RESPECTED IF C HAD NO PRE-ARRANGED OBLIGATION TO SELL TO B. AMERICAN BANTAM CAR CO.

SPECIAL RULE: IRC 336(d)(2)  APPLIES TO DISTRIBUTIONS TO RELATED AND NONRELATED PARTIES  DEFINED BY HOW AND WHEN ACQUIRED

THE “HOW”:  IRC 351 OR CONTRIBUTION TO CAPITAL AND  ACQUISITION’S PRINCIPAL PURPOSE WAS TO RECOGNIZE LOSS – FOR PRACTICAL PURPOSES: ACQUISITIONS OF LOSS PROPERTIES, E.G., AB > FMV.

THE “WHEN”:  TAINT EXISTS IF PROPERTY ACQUIRED WITHIN THE 2 YEARS ENDING ON THE ADOPTION OF PLAN OF LIQUIDATION  LOOKBACK 2 YEARS FROM PLAN’S ADOPTION  LEGISLATIVE INTENT: APPLY RARELY IF ACQUIRED LONGER THAN 2 YEARS FROM ADOPTION.

EFFECT OF SPECIAL RULE: IRC 336(d)(2)(A)  REDUCE AB OF PROPERTY BY THE AMOUNT OF THE BUILT-IN LOSS AT TIME OF ACQUISITION.

EXAMPLE 5  Z OWNS PTY FMV 15/AB 20, CONTRIBUTED 1 YEAR AGO.

 THUS: AB = 20 - 5 AB EXCESS OVER FMV = 15  Z LIQ. PTY 1 TO UNRELATED PARTY WHEN FMV=10.  RESULT: 10 FMV -15 AB = (5 ) RECOGNIZED LOSS

EXAMPLE 6  SAME AS 3. BUT NOW LIQ PTY 1 TO RELATED PARTY.

 NO LOSS RECOGNIZED. SEE B/E 10-30. IF 336(d)(1) AND (2) OVERLAP, 336(d)(1) SHOULD APPLY TO DENY ALL LOSS.

EXAMPLE 7  W CORP OWNED 70% BY A AND 30% BY B. W OWNS PTY 1, FMV 15/AB30 AND PTY 2, FMV 7.5/AB 3. PTY 1 CONTRIBUTED LAST YR WHEN FMV WAS 27.

 W LIQ PRO-RATA: 70% OF PTY 1 AND PTY 2 TO A; 30% OF PTY 1 AND PTY 2 TO B.

TAX EFFECT TO W?  PTY 1: 336(d)(2): NEED TO ADJUST AB: 30 - 3 AB EXCESS OVER FMV = 27 AB.  THUS 15 FMV- 27 AB = (12) LOSS REALIZED.  AS A IS RELATED AND PTY 1 IS “DISQUALIFIED”. 70% OF LOSS (8.4) IS NOT RECOGNIZED.

 WHAT ABOUT B?

B IS NOT RELATED, BUT 336(d)(2) APPLIES.  AS AB ADJUSTED TO 27, 30% (15 FMV 27 AB) = (3.6) LOSS RECOGNIZED  THUS: OF THE 12 LOSS REALIZED, ONLY 3.6 IS RECOGNIZED

NOTE:  336(d)(1): – APPLIES ONLY TO RELATED PARTIES  DISALLOWS ALL LOSSES: PRE AND POST ACQUISITION  336(d)(2): – APPLIES TO DISTRIBUTIONS TO BOTH RELATED AND NONRELATED PARTIES – ALLOWS POST-ACQUISITION LOSSES

FILING REQUIREMENTS  ATTACHED TO RETURN: MINUTES @ PLAN ADOPTION AND INFO ABOUT PROPERTIES  FORM 966: TO IRS WITHIN 30 DAYS OF ADOPTION  FORM 109-DIV: TO SHAREHOLDERS BY 1/31 YEAR AFTER LIQ.

 FORM 1096: TO IRS BY 2/28 YEAR AFTER LIQ.

CONCLUSION  LIQUIDATIONS TREATED AS SALES.

 ISSUE: WHETHER CORPORATION CAN RECOGNIZE LOSS – DISTRIBUTION IS NON-PRORATA (ANY PROPERTY) – DISTRIBUTION PRO-RATA + DISQUALIFIED PROPERTY – TAX AVOIDANCE, E.G., B/I LOSS PTY W/I 2 YRS OF PLAN ADOPTION.

II. SUBSIDIARY LIQUIDATIONS  IRC 332/337

Introduction  Definition of a liquidation  Tax effect

DEFINITION OF “COMPLETE LIQUIDATION”

Treas. Reg. 1.332-2(c)(1) and (2)  one of a series . . . plan of liquidation . . . status of liquidation . . . completed when liquidating corporation and receiver or trustees in liquidation are finally divested of all the property . . .

Treas. Reg. 1.332-2(c)(2) cont.

 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.

Treas. Reg. 1.332-2(c)(2) cont.

 A liquidation may be completed prior to the actual dissolution of the liquidating corporation. However, legal dissolution is not required. Nor will the mere retention of a nominal amount of assets for the sole purpose of preserving the corporation’s legal existence disqualify it.

Treas. Reg. 1.332-2(d)  If a transaction constitutes a distribution in complete liquidation within the meaning of the IRC. . . it is not material that it is otherwise described under local law.

TAX EFFECT

Tax effect of corporate liquidation: Subchapter C; Part  II Subpart A: Effect on recipients: IRC 331; 332; 334 – IRC 331:  In other than IRC 332 liquidations: Applies to majority and minority shareholders  In IRC 332 liquidations: Applies to minority shareholders – IRC 332: Liquidation of subsidiary  Subpart B: Effect on corporation : IRC 336; 337; 338

Tax effect on recipients (parent): IRC 332(a)  “No gain or loss shall be recognized on the receipt by a

(parent)

corporation of property distributed in complete liquidation of another

(its subsidiary)

corporation.”  Rationale: Liquidation of a subsidiary represents a change of form and not a change in economic investment.

Elements in IRC 332(b)  Ownership  Timing of ownership  Complete cancellation or redemption of stock  Timing of distribution

Ownership  80% direct

(not constructive)

ownership: – > 80% of combined voting power, and – > 80% total value of all stock  Except nonvoting, nonparticipating preferred

Timing (length) of ownership:  From: Day plan was adopted  To: Last liquidating distribution

Complete cancellation or redemption of stock  Legal dissolution of subsidiary is not required.  OK to retain minimal amount to protect legal existence and preserve corporate charter

Timing of distribution: Two alternatives  One year liquidation  Multiyear liquidation

One year liquidation  Liquidating distribution completed within one (1) of the subsidiary’s taxable year. – Shareholders’ resolution will suffice.

 It is considered a “plan of liquidation”: IRC 332(b)(2) – Liquidation does not have to take place in year of resolution.

Multiyear liquidation  Liquidating distributions to be completed in > 1 of the subsidiary’s taxable year – Formal plan must be adopted – Distributions completed within 3 taxable years after the close of the taxable year of the first distribution.  Note: Distribution will not be considered a “liquidating distribution” if there is a failure to complete liquidation timely or a failure to meet the ownership requirements.

Tax Planning  Like IRC 351, IRC 332 is section: You either fall “within” or “without”.

not

an elective  Hence, like IRC 351, to avoid IRC 332, you can plan – to fail one of the requirements, e.g., get below 80%. – to make sure you meet the requirements, e.g., get to 80%.

Issues  Insolvent subsidiary  Subsidiary debt (not classified as a security)  Minority shareholders

Insolvent subsidiary: IRC 165(g)(3)  As parent gets no “property” for its stock, IRC 332 does not apply.  Instead treat as loss from worthless securities [IRC 165(g)].

– Capital or Ordinary?

Generally capital, but ordinary loss treatment if falls under  IRC 165(g)(3) Parent has IRC 351 “control”  = > 80% of aggregate voting class and power and  => 80% of each non-voting class; – o/t nonvoting stock limited and preferred as to dividends  “Active” type subsidiary for all taxable years  > 90% of gross receipts from non-passive income

Subsidiary debt [o/t “security” under IRC 165(g)(2)]  Debt considered a “security” if it has interest coupons or issued in registered form.

 Thus, loss from receipt of “debt” in bearer form and without interest coupons in a liquidating distribution is deductible as a business bad debt.

Effect on liquidating corporation:  IRC 336  IRC 337

IRC 336  Except as otherwise provided in this section or section 337, gain or loss shall be recognized to a liquidating corporation on the distribution of property in complete liquidation as if such property was sold to the distributee at its fair market value.

Therefore, barring exceptions, treat liquidating distributions as a sale of property

Exceptions  Various, within IRC 336, covered in Tax 6105.

 IRC 337

IRC 337  No gain or loss shall be recognized to the liquidating corporation on the distribution to the 80-percent (parent) distributee of any property in complete liquidation to which section 332 applies.  No depreciation recapture by subsidiary – AB c/o to parent corporation

Loss distributions to minority shareholders  While minority shareholders may recognize a loss in the receipt of a liquidating corporation, IRC 336(d)(3) prohibits recognition of loss by the liquidating subsidiary in a IRC 332 liquidation.

Issue: Liquidating distribution is “debt”  Indebtedness of one of the parties is distributed as “property” in a liquidating distribution – Parent’s indebtedness to subsidiary (subsidiary is the creditor).

– Subsidiary’s indebtedness to parent (subsidiary is the debtor; parent is the creditor)

Parent’s indebtedness to subsidiary.

– Is parent’s receipt of its own note to the subsidiary produce gain from discharge of indebtedness?

– Answer: No, because debt is “property” received in an IRC 332 liquidation.

Subsidiary’s indebtedness to parent  IRC 337(b)  Sub distributes appreciated property in cancellation of debt to parent. – Treat as “property” transferred in a liquidating distribution. – Sub does not recognize gain on appreciated property – Parent takes c/o AB

Tax Planning for the subsidiary  Distribute appreciated property to parent corporation  Distribute cash to minority shareholders  But sell loss property to unrelated taxpayers to recognize loss.

Other tax effects  Parent inherits subsidiary’s AB in assets: IRC 334(b)(1)  Parent inherits tax attributes: IRC 381 – EP: IRC 381(c)(2) – capital loss carryovers: – NOL carryover: – Potential depreciation recapture: 1245(b)(3)  Parent’s AB on subsidiary’s stock disappears.