Disastrous Tax Consequences to Avoid When Liquidating an S Corporation
This article discusses the tax consequences of liquidating an S corporation that owns certain assets and describes three plans of liquidation.
Pursuant to I.R.C. §1361(a)(1),1 an S corporation is a small business corporation created through an I.R.C. tax election and is governed by subchapter S, unless contradicted by subchapter C or otherwise indicated. For purposes of subchapter S of the I.R.C., a “small business corporation” is a domestic corporation that meets certain statutory criteria.2 S corporations are advantageous to small businesses because the business itself is not subject to federal taxation (although, some states subject S corporations to taxation); only the S corporation shareholders are subject to federal taxation.
In our hypothetical, we have an S corporation that owns a warehouse, a promissory note, and cash. The precise tax consequences to the corporation and its sole shareholder are not possible to know without knowing the fair market values and basis of the corporation’s assets. This information is essential because the tax liability of corporation and shareholder is based on the gain recognized from the liquidating distributions. In a typical transaction, the gain recognized, if any, is the difference between the basis (the cost) and the fair market value of the asset being sold or distributed.
Generally, if the fair market value of the asset exceeds the basis of the asset, the difference is the gain recognized; if the basis exceeds the fair market value, you recognize a loss. Despite not knowing the fair market value and basis of corporations’ assets, we can describe the general tax consequences to corporation and shareholder when liquidating an S corporation. When a corporation distributes an asset to a shareholder, the shareholder’s stock basis increases by the gain recognized in that distribution and decreases by the fair market value of the asset being distributed.
Liquidating Without Tax Planning
In general, pursuant to I.R.C. §336, unless the liquidation is part of a reorganization plan, gain or loss is recognized to a liquidating corporation upon the distribution of property in complete liquidation as if the property were being sold to the distributee at its fair market value. If the shareholder’s stock basis is large enough, the corporation can liquidate and incur no tax liability because the shareholder’s stock basis will not be depleted, only reduced, in the liquidating distributions.
After all assets have been distributed, if the shareholder’s stock basis is more than $0, there will be a capital loss in the amount by which the stock basis exceeds $0, and that loss can be used to offset any capital gains incurred in other distributions. However, if the stock basis is depleted before the corporation distributes all of its assets, then any subsequent distributions will result in taxable gain to the extent there is gain recognized in those subsequent distributions.
Distribution of Cash
In either a liquidating or a nonliquidating distribution, a distribution of cash to the shareholder will only decrease the shareholder’s stock basis by the amount of cash distributed. Accordingly, if the corporation has any outstanding debts, it should pay off those debts with cash to reduce the amount of cash to be distributed to the shareholder. When the cash is finally distributed to the shareholder, there will be less cash to reduce the shareholder’s stock basis, leaving a larger stock basis to minimize the tax liability, if any, from the liquidating distribution of the other assets.
Distribution of Warehouse
If the corporation were to distribute the warehouse in a liquidating distribution, any gain recognized would be ordinary gain pursuant to I.R.C. §1239. I.R.C. §1239 applies when depreciable property is sold or exchanged, directly or indirectly, between related persons and treats any gain recognized in that sale or exchange as ordinary income. Pursuant to I.R.C. §167, a warehouse is depreciable property.
Pursuant to I.R.C. §336(a), a distribution in a complete liquidation of a corporation is treated as if the distributed property were sold to the distributee. Pursuant to I.R.C. §1239(b)(1) and §1239(c)(1)(A), a corporation and a person are related persons if the person owns more than 50 percent of the value of the outstanding stock of the corporation. If the corporation were to completely liquidate and distribute the warehouse to a shareholder, a “related person” because the shareholder owns more than 50 percent of corporation, that liquidating distribution would be treated as a sale, and I.R.C. §1239 would apply so that any gain recognized would be taxed as ordinary income.
When appreciated, depreciable real property is distributed, any gain recognized is allocated between the land and the property. Pursuant to I.R.C. §1239, any gain allocated to the land is taxed as capital gain, and any gain allocated to the property is taxed as ordinary income. An attempt to allocate more of the gain to the land to avoid I.R.C. §1239 ordinary income would come at a cost. Less gain would be allocated to the warehouse, which can depreciate the cost of the warehouse over 39 years, because the warehouse, under I.R.C. §1250, is depreciable nonresidential real property. You also run the risk that the IRS will challenge the disproportionate allocation of gain as an attempt to game the system.
Distribution of Note
Pursuant to I.R.C. §331(a), amounts received by a noncorporate shareholder in a distribution in complete liquidation of a corporation shall be treated as in-full payment in exchange for the stock. Pursuant to I.R.C. §453B(a)(1), if a note is sold or exchanged, gain or loss shall result to the extent of the difference between the basis of the note and the amount realized. Any gain or loss shall be considered as resulting from the sale or exchange of the property in which the note was received. Pursuant to I.R.C. §453B(b), the basis of the note shall be the excess of the face value of the note over an amount equal to the income that would be returnable were the obligation satisfied in full.
Effectively, a liquidating distribution of the note is treated as if the note is exchanged for stock, and gain or loss must be recognized to the extent the value of shareholder’s stock exceeds the basis. However, there is a way we can postpone gain recognition to shareholder in the distribution of the note. Pursuant to I.R.C. §453(h)(1), if, in a liquidation to which I.R.C. §331 applies (pertaining to gain or loss to shareholders in complete liquidation of a corporation), the shareholder receives (in exchange for shareholder’s stock) a note acquired in respect of a sale or exchange by the corporation during the 12-month period beginning on the date a plan of complete liquidation is adopted, and the liquidation is completed during such 12-month period, then the receipt of payments under such note (but not the receipt of such note) by the shareholder must be treated as the receipt of payment for the stock.
If the corporation distributes the note to a shareholder in a complete liquidating distribution, and a shareholder receives the note in exchange for shareholder’s stock within 12 months of the corporation adopting a plan of liquidation, and the liquidation is completed within that 12-month period, then the shareholder’s receipt of the note is not treated as a receipt of payment for shareholder’s stock. Instead, a shareholder’s receipt of the payments on the note is treated as receipt of payment for the shareholder’s stock and he or she would not owe any taxes on the note until the shareholder actually receives each payment.
However, according to I.R.C. §453(h)(2), if the shareholder receives an installment obligation in a complete liquidation, then the shareholder’s stock basis must be allocated among all the property received by shareholder in the liquidation. If the corporation liquidates and distributes the assets to the shareholder, then the shareholder will have to allocate his or her stock basis among all the assets received in the liquidation, including the note that will have deferred gain, which will cause the shareholder to recognize more gain on the cash and warehouse because less basis is allocated to those assets.
If the shareholder has sufficient stock basis, then a simple liquidating distribution of all of corporation’s assets will not result in a tax liability. Every asset that is distributed will increase the shareholder’s stock basis by the gain recognized in the distribution and decrease shareholder’s stock basis by the fair market value of the asset distributed.
Nonliquidating Distribution of Note
Due to the tax treatment of a nonliquidating distribution of a note, it may be advisable for the corporation to distribute the note before it distributes the warehouse in a liquidating distribution. Pursuant to I.R.C. §453B(a)(2), if a note is distributed, gain or loss shall result to the extent of the difference between the basis of the obligation and the fair market value of the obligation at the time of distribution. Any gain or loss so resulting shall be considered as resulting from the sale or exchange of the property in respect of which the note was received. Pursuant to I.R.C. §453B(b), the basis of the note shall be the excess of the face value of the note over an amount equal to the income that would be returnable were the obligation satisfied in full.
If the corporation distributes the note in a nonliquidating distribution, the corporation will recognize gain to the extent that the fair market value of the note at the time of distribution exceeds the difference between the face value of the note and the amount of income the corporation would receive if the note were satisfied in full. If the fair market value of the note is less than the value of the shareholder’s stock, less gain will be recognized in a nonliquidating distribution of the note than compared to a liquidating distribution.
Planning the Liquidation of the Corporation
We have three plans to minimize the tax liability of the corporation from the liquidating distributions. In every plan, the first step is the distribution of all the cash in the corporation to shareholder. The cash distribution will not cause gain to the extent the shareholder’s stock basis in the corporation exceeds the amount of cash distributed. Other distributions of property will increase the shareholder’s stock basis by the gain recognized in the distribution and decrease shareholder’s stock basis by the fair market value of the property received in the distribution. The cash distribution will only decrease the shareholder’s stock basis by the amount of cash distributed.
Plan One
In this plan, to avoid the tax consequences of I.R.C. §1239, we contribute the warehouse to a newly formed limited liability company (LLC) after we elect to have the LLC treated as a C corporation so we can take advantage of I.R.C. §351. Pursuant to I.R.C. §351, provided certain conditions are met, no gain or loss is recognized when a contribution is made to a corporation solely in exchange for stock. This plan may be beneficial if the shareholder has enough stock basis so that no gain is recognized on the distribution of the cash and the note but does not have enough basis to avoid recognition of gain on the distribution of the warehouse.
After the corporation distributes the cash to the shareholder, we have the LLC file IRS Form 8832 (Entity Classification Election) and elect to have the LLC treated as a C corporation.3 The effective date of this election will be the day before the effective date of the deed transfer of the warehouse from corporation to LLC, Inc., so that the warehouse transfer to LLC, Inc., can be treated as an I.R.C. §351 contribution.
Pursuant to I.R.C. §351, no gain or loss shall be recognized if property is transferred to a corporation by one or more persons solely in exchange for stock in the corporation, and immediately after the exchange, the person or persons own more than 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation.
If one or more people contribute property to a corporation solely in exchange for stock in that corporation, and immediately after the exchange the person(s) own more than 80 percent of the total combined voting power of all classes of stock entitled to vote and at least 80 percent of the total number of shares of all other classes of stock of the corporation, then neither the corporation nor the contributing person(s) will have a tax liability from that exchange.
In this plan, after the C corporation election by the LLC, the corporation will contribute the warehouse into LLC, Inc., solely in exchange for LLC, Inc., stock. After the contribution, the corporation will own 100 percent of LLC, Inc., thus, satisfying the requirements for I.R.C. §351 nonrecognition. Neither the corporation nor LLC, Inc., will have a tax liability from the exchange. The corporation will effectively contribute itself into LLC, Inc. Because we are transferring an interest in an entity, and not an interest in real property, no Florida documentary stamp tax or recording fee above the $0.70 minimum should be owed.
• Basis of Property — Pursuant to I.R.C. §358(a)(1), in the case of an exchange to which I.R.C. §351 applies, the basis of the property permitted to be received under such section without the recognition of gain or loss shall be the same as that of the property exchanged decreased by the fair market value of any other property (except money) received by the taxpayer, the amount of any money received by the taxpayer, and the amount of loss to the taxpayer that was recognized on such exchange. The basis shall be increased by the amount that was treated as a dividend and the amount of gain to the taxpayer that was recognized on such exchange (not including any portion of such gain, which was treated as a dividend).
When the corporation contributes the warehouse into LLC, Inc., solely in exchange for stock, the corporation’s LLC, Inc., stock basis will be the basis of the warehouse minus the fair market value of any other property (except money) received by corporation, the amount of any money received by corporation, and the amount of loss to corporation, which was recognized on such exchange, plus the amount that was treated as a dividend, and the amount of gain to the corporation that was recognized on such exchange (not including any portion of such gain, which was treated as a dividend).
• Avoidance of I.R.C. §1239 — effectively contributing the corporation to LLC, Inc., solely in exchange for LLC, Inc., stock, instead of just distributing the warehouse to shareholder or another LLC, we are able to avoid the adverse tax consequences of I.R.C. §1239 by qualifying for I.R.C. §351 nonrecognition of gain. The corporation can then sell its LLC, Inc., stock to the shareholder. Be aware, such a transaction is subject to alternative minimum tax review. This will leave the corporation as an existent business entity but with no assets. The shareholder’s basis in the LLC, Inc., stock will be the purchase price of the stock. The corporation will recognize gain to the extent that its basis in the LLC, Inc., stock, which is the basis of the warehouse, as adjusted by I.R.C. §358(a), that it transferred to LLC, Inc., in exchange for the stock, exceeds the purchase price in the sale to shareholder. The gain recognized, if any, will be capital gain and, because we are not selling or exchanging the warehouse (we are selling stock, which is nondepreciable property), in the entity that owns the warehouse, we can avoid I.R.C. §1239.
Plan Two
In this plan, to avoid the tax consequences of I.R.C. §453, we will contribute the note into a newly formed limited liability company (LLC2) after we elect to have LLC2 treated as a C corporation so we can take advantage of I.R.C. §351. This plan may be beneficial if the shareholder has enough corporation stock basis so that no gain is recognized on the distribution of the cash and the warehouse, but does not have enough basis to avoid recognition of gain on the distribution of the note.
After the corporation distributes the cash to the shareholder, we will have LLC2 file IRS Form 8832 and elect to be treated as a C corporation.4 The effective date of this election will be the day before the effective date of the contribution of the note from the corporation to LLC2, Inc., so that the contribution can be treated as a I.R.C. §351 contribution.
• Effect on I.R.C. §453 — As previously described, the contribution of the note will not result in gain being recognized by either LLC2, Inc., or the corporation. After the contribution, the corporation will sell its LLC2, Inc., stock to the shareholder, and the shareholder will then be the 100 percent owner of LLC2, Inc., the owner of the note. having corporation contribute the note into LLC2, Inc., instead of distributing the note to the shareholder, we avoid the consequences of I.R.C. §453 and §453B, which would result in gain being recognized by both the corporation and shareholder.
Plan Three
In this plan, we form a new limited liability company (LLC3). LLC3 will file IRS Form 8832 and elect to be a treated as a C corporation.5 The corporation will then contribute all of its assets into LLC3, Inc., in an I.R.C. §351 nonrecognition contribution. LLC3, Inc., will then elect to be treated as an S corporation. After LLC3, Inc., becomes an S corporation, it will file IRS Form 8869 (Qualified Subchapter S Subsidiary Election) and elect to treat the corporation as a qualified subchapter S subsidiary (QSUB) of LLC3, Inc., which effectively liquidates corporation in a nonrecognition transaction.
Pursuant to I.R.C. §1361(b)(3)(B), a QSUB is a domestic corporation in which 100 percent of the stock of such corporation is held by an S corporation, and the S corporation elects to treat such corporation as a QSUB. Because only S corporations can elect to treat another corporation as a QSUB, LLC3, Inc., would have to file another IRS Form 8832 to elect to classify itself as an S corporation. LLC3, Inc., should be a C corporation for just long enough to have the corporation contribute its assets into LLC3, Inc. After LLC3, Inc., elects to treat itself as an S corporation, LLC3, Inc., will file a QSUB election and elect to treat the corporation as a QSUB of LLC3, Inc.
Under I.R.C. §1361(b)(3)(A), a QSUB must not be treated as a separate corporation. All assets, liabilities, and items of income, deduction, and credit of a QSUB shall be treated as assets, liabilities, and items of income, deduction, and credit of the parent S corporation. In our case, LLC3, Inc., would own all the assets, liabilities, deductions, and credits of corporation. The corporation will be a disregarded entity for tax purposes and will not be required to file a tax return after the QSUB election is made, but it will still exist for state law purposes. Basically, the QSUB election effectively liquidates the corporation.
• I.R.C. §332: Nonrecognition of Gain from Property Received in Liquidation of Subsidiary — Pursuant to I.R.C. §332(a), no gain or loss shall be recognized on the receipt by a corporation of property distributed in complete liquidation of another corporation. In our case, because the corporation is treated as being completely liquidated when the QSUB election is made, and any assets or liabilities then owned by the corporation will then be considered owned by LLC3, Inc., no gain or loss shall be recognized by LLC3, Inc., when the corporation liquidates.
Pursuant to I.R.C. §332(b), the nonrecognition rule of I.R.C. §332(a) only applies to liquidations if the corporation receiving such property was, on the date of the adoption of the plan of liquidation, and has continued to be at all times until the receipt of the property, the owner of stock in such other corporation. (“Owner of stock” means that person or entity possesses at least 80 percent of the total voting power of the stock of such corporation, and has a value equal to at least 80 percent of the total value of the stock of such corporation.)6 LLC3, Inc., can only qualify for I.R.C. §332 nonrecognition of gain if it receives the property while it owns at least 80 percent of the total voting power of the stock of corporation and has a value equal to at least 80 percent of the total value of the stock of corporation.
Furthermore, the nonrecognition rule of I.R.C. §332(a) only applies if either 1) the distribution of assets by the corporation is in complete cancellation or redemption of all its stock, and the transfer of assets occurs within the taxable year; or 2) the distribution is one of a series of distributions by the corporation in complete cancellation or redemption of all its stock in accordance with a plan of liquidation under which the transfer of all the property under the liquidation is to be completed within three years from the close of the taxable year during which is made the first of the series of distributions under the plan, except that if such a transfer is not completed within such period, or if the taxpayer does not continue to be the “owner of stock” until the completion of such a transfer, no distribution under the plan must be considered a distribution in complete liquidation.7
• Nonrecognition of Gain from Property Distributed in Liquidation of Subsidiary — Pursuant to I.R.C. §337(a), no gain or loss shall be recognized to the liquidating corporation on the distribution to the 80-percent distributee of any property in a complete liquidation to which I.R.C. §332 applies. Pursuant to I.R.C. §337(c), the term “80-percent distributee” means only the corporation that possesses at least 80 percent of the total voting power of the stock and has a value equal to at least 80 percent of the total value of the stock of such corporation.
In our case, the corporation will not recognize any gain in the QSUB liquidation if LLC3, Inc., owns 80 percent or more of the total voting power of the stock of the corporation and has a value equal to at least 80 percent of the total value of the stock of corporation. When LLC3, Inc., makes the QSUB election and the corporation liquidates, the corporation will not recognize any gain or loss because LLC3, Inc., will own at least 80 percent of the total voting power of the stock of the corporation and have a value of at least 80 percent of the total value of the stock of corporation.
• Termination of QSUB Election — One thing to be wary of regarding the QSUB election is I.R.C. §1362(d), which pertains to the termination of the QSUB election, especially I.R.C. §1362(d)(3). Under I.R.C. §1362(d)(3), if passive investment income, such as rental income from a warehouse, exceeds 25 percent of the gross receipts for three consecutive taxable years and the corporation has accumulated earnings and profits, the QSUB election must be terminated whenever the corporation has accumulated earnings and profits at the close of each of three consecutive taxable years and has gross receipts for each taxable year more than 25 percent of which are passive investment income. However, this provision only applies to S corporations that used to be C corporations, so it should not apply to corporation.
Conclusion
There are many factors to keep in mind when planning the liquidation of an S corporation. The type of assets being distributed and the nature of the recipient of the distributed assets are chief among them. With proper planning, you can minimize or eliminate the tax liability of the liquidating corporation and the recipient of the distributed assets.
1 All statutory references in this article are to the Internal Revenue Code of 1986, as amended.
2 I.R.C. §1361(b)(1).
3 LLC post-C corporation election shall be referred to as LLC, Inc.
4 LLC2 post-C corporation election shall be referred to as LLC2, Inc.
5 LLC3 post-C corporation election shall be referred to as LLC3, Inc.
6 I.R.C. §1504(a)(2).
7 I.R.C. §332(b)(2) and (3).
David Fall is an associate attorney with Older, Lundy & Alvarez in downtown Tampa. He obtained his law degree from Washburn University and his LL.M. in taxation from the University of Alabama. His primary areas of practice are business, tax, estate planning, and probate.
This column is submitted on behalf of the Tax Law Section, Joseph B. Schimmel, chair, and Christine Concepcion, Michael D. Miller, and Benjamin A. Jablow, editors.
