ACT 550 CSUGC Navigating Complexity of S Corporation Liquidation Essay

Option #2: S Corporation Article

Read Fall (2017) whose citation is below. Summarize the points in the article that explain factors to consider when liquidating an S corporation. Maintain a formal tone and support your analysis.

Fall, D. (2017). Disastrous tax consequences to avoid when liquidating an S Corporation. Links to an external site. Florida Bar Journal, 91(9).

by David Fall
T a x La w
Disastrous Tax Consequences to Avoid
When Liquidating an S Corporation
his article discusses the tax
consequences of liquidating
an S corporation that owns
certain assets and describes
three plans of liquidation.
P u rsu an t to I.R.C. §136l(a)( 1),1
an S corporation is a sm all busi­
ness 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 “sm all business corpora­
tion” 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 taxa­
tion (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 th at owns a warehouse, a
promissory note, and cash. The precise
tax consequences to the corporation
and its sole shareholder are not pos­
sible 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 liq­
uidating distributions. In a typical
transaction, the gain recognized, if
any, is the difference between the ba­
sis (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 rec­
ognized; if the basis exceeds the fair
m arket value, you recognize a loss.
Despite not knowing the fair m ar­
T
44
ket 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 dis­
tributes an asset to a shareholder, the
shareholder’s stock basis increases by
the gain recognized in that distribu­
tion and decreases by the fair market
value of the asset being distributed.
Liquidating Without Tax
Planning
In general, p u rs u a n t 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 m arket 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 liquidat­
ing distributions.
A fter all assets have been d is­
tributed, 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 dis­
tributions 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 nonliq­
uidating distribution, a distribution
THE FLORIDA BAR JOURNALVNOVEMBER 2017
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 distrib­
ute the warehouse in a liquidating
distribution, any gain recognized
would be ordinary gain pursuant tc
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 th at sale or
exchange as ordinary income. Pursu­
ant to I.R.C. §167, a warehouse is
depreciable property.
P u rs u a n t to I.R.C. §336(a), a
distribution in a complete liquidation
of a corporation is treated as if the dis­
tributed property were sold to the dis­
tributee. Pursuant to I.R.C. §1239(bt
(1) and §1239(c)(l)(A), a corporation
and a person are related persons if
the person owns more than 50 percen*
of the value of the outstanding stock
of the corporation. If the corporation
were to completely liquidate and
distribute the warehouse to a share­
holder, a “related person” because
the shareholder owns more than 50
percent of corporation, that liquidat­
ing distribution would be treated as
a sale, and I.R.C. §1239 would apply
so th at any gain recognized would be
taxed as ordinary income.
W hen app reciated, depreciable
real property is distributed, any gain
recognized is allocated between the
land and the property. P ursuant 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 de­
preciable nonresidential real property.
You also run the risk that the IRS will
challenge the disproportionate alloca­
tion of gain as an attem pt to game the
system.
sale or exchange by the corporation
during the 12-month period beginning
on the date a plan of complete liquida­
tion 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 share­
holder receives the note in exchange
for shareholder’s stock w ithin 12
m onths of the corporation adopt­
ing a plan of liquidation, and the
liquidation is completed within that
12-month period, then the sharehold­
er’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 share­
holder’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 share­
holder in the liquidation. If the cor­
poration 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
Distribution of Note
Pursuant to I.R.C. §331(a), amounts
received by a noncorporate sh are­
holder in a distribution in complete
liquidation of a corporation shall
be tre a te d as in-full paym ent in
exchange for the stock. Pursuant to
I.R.C. §453B(a)(l), 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 th at would be returnable
were the obligation satisfied in full.
Effectively, a liquidating distribu­
tion 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)(l), 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 re­
ceives (in exchange for shareholder’s
stock) a note acquired in respect of a
T h i s is h o w y o u s a y
i t ’s g o i n g t o b e o k a y .
Every 8 minutes the American
Red C ross responds to a
disaster and makes this promise.
You can help us keep it.
Donate today at redcross.org
A m e r ic a n R e d C ro s s
T H E F L O R ID A B A R JO U R N A L /N O V E M B E R 2 0 1 7
45
the note th at will have deferred gain,
which will cause the shareholder to
recognize more gain on the cash and
warehouse because less basis is al­
located to those assets.
If the shareholder has sufficient
stock basis, then a simple liquidating
distribution of all of corporation’s as­
sets will not result in a tax liability.
Every asset th at is distributed will
increase the shareholder’s stock basis
by the gain recognized in the distribu­
tion and decrease shareholder’s stock
basis by the fair m arket value of the
asset distributed.
The corporation can
then sell its LLC,
Inc., stock to the
shareholder.
Be aware, such
a transaction
is subject to
alternative minimum
Nonliquidating Distribution of Note
Due to the tax treatm ent of a non­
liquidating distribution of a note, it
may be advisable for the corporation
to distribute the note before it dis­
tributes the warehouse in a liquidat­
ing 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 re­
sulting 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
th a t 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 th at the fair market value
of the note at the time of distribu­
tion exceeds the difference between
the face value of the note and the
am ount of income the corporation
would receive if the note were satis­
fied 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 distri­
bution 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.
46
tax review.
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 distribu­
tions 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 m arket value of the prop­
erty 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 conse­
quences of I.R.C. §1239, we contribute
the warehouse to a newly formed lim­
ited 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 th a t no
gain is recognized on the distribution
of the cash and the note but does not
have enough basis to avoid recogni­
tion 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
THE FLORIDA BAR JOURNAUNOVEMBER 2017
Classification Election) and elect to
have the LLC treated as a C corpora­
tion.3The effective date of this election
will be the day before the effective
date of the deed transfer of the ware­
house 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 immedi­
ately 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
th e person(s) own m ore th a n 80
percent of the total combined voting
power of all classes of stock entitled
to vote and at least 80 percent of the
total num ber 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 th at 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 require­
ments for I.R.C. §351 nonrecognition.
N either the corporation nor LLC,
Inc., will have a tax liability from the
exchange. The corporation will effec­
tively contribute itself into LLC, Inc.
Because we are transferring an inter­
est 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 o f Property — P ursu an t
to I.R.C. §358(a)(l), 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 with­
out the recognition of gain or loss shall
be the same as th at of the property
exchanged decreased by the fair mar-
ket 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 th at 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 th at was recognized on
such exchange (not including any por­
tion 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 m ar­
ket value of any other property (except
money) received by corporation, the
am ount 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 — By
effectively contributing the corpora­
tion to LLC, Inc., solely in exchange
for LLC, Inc., stock, instead of just
distributing the warehouse to share­
holder 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
th at 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 th at owns the
warehouse, we can avoid I.R.C. §1239.
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…
Plan Two
In this plan, to avoid the tax con­
sequences of I.R.C. §453, we will con­
tribute 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 ben­
eficial 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 th at the
contribution can be treated as a I.R.C.
§351 contribution.
• Effect on I.R.C. §453 — As previ­
ously described, the contribution of
the note will not result in gain being
recognized by either LLC2, Inc., or
the corporation. After the contribu­
tion, 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. By having corpora­
tion contribute the note into LLC2,
Inc., instead of distributing the note
to the shareholder, we avoid the con­
sequences of I.R.C. §453 and §453B,
which would re su lt 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.5The corpo­
ration will then contribute all of its as­
sets 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 liqui­
dates 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
TRADEMARK
Copyright & Patent Searches
“Experienced Washington office
fo r attorneys worldwide ’’
FEDERAL SERVICES & RESEARCH:
Attorney directed projects at all Federal
agencies in Washington, DC, including:
USDA, TTB, EPA, Customs, FDA, INS,
FCC, ICC, SEC, USPTO, and many others.
Face-to-face meetings with Gov’t officials,
Freedom of Information Act requests,
copyright deposits, document legalization
@ State Dept. & Embassies, complete
trademark, copyright, patent and TTAB
files.
COMPREHENSIVE: U S. Federal,
State, Common Law and Design searches,
INTERNATIONAL SEARCHING
EXPERTS: Our professionals average
over 25 years experience each
FAST: Normal 2-day turnaround
with 24-hour and 4-hour service available
GOVERNMENT LIAISON SERVICES, INC.
200 N. Glebe Rd„ Suite 321
Arlington, VA 22203
Ph: 703-524-8200, Fax: 703-525-8451
Minutes from USPTO & Washington, DC
TOLL FREE: 1-800-642-6564
www.GovernmentLiaison.com
info@GovernmentLiaison.com
THE FLORIDA BAR JOURNAL/NOVEMBER 2017
47
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.
U nder I.R.C. §1361(b)(3)(A), a
QSUB must not be treated as a sepa­
rate 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. Ba­
sically, the QSUB election effectively
liquidates the corporation.
• I.R.C . §332: N onrecognition
o f Gain from Property Received in
Liquidation o f Subsidiary — Pursu­
ant 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 com­
pletely liquidated when the QSUB
election is made, and any assets or
liabilities then owned by the corpo­
ration will then be considered owned
by LLC3, Inc., no gain or loss shall be
recognized by LLC3, Inc., when the
corporation liquidates.
P u rsu a n t 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 th at 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.)6LLC3,
48
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.
Furtherm ore, 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 oc­
curs 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 th at if such a
transfer is not completed within such
period, or if the taxpayer does not con­
tinue 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 o f Gain from
Property Distributed in Liquidation
of Subsidiary — Pursuant to I.R.C.
§337(a), no gain or loss shall be rec­
ognized to the liquidating corporation
on the distribution to the 80-percent
distributee of any property in a com­
plete liquidation to which I.R.C. §332
applies. Pursuant to I.R.C. §337(c), the
term “80-percent distributee” means
only the corporation th at 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. W hen LLC3, Inc.,
makes the QSUB election and the
corporation liquidates, the corpora­
tion will not recognize any gain or loss
because LLC3, Inc., will own at least
THE FLORIDA BAR JOURNAL/NOVEMBER 2017
80 percent of the total voting power of
the stock of the corporation and have
a value of a t 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, ex­
ceeds 25 percent of the gross receipts
for three consecutive taxable years
and the corporation has accumulated
earnings and profits, the QSUB elec­
tion 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 corpo­
rations that used to be C corporations,
so it should not apply to corporation.
C o n c lu s io n
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 elimi­
nate 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).
D a vid 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 o f Alabama.
His primary areas o f 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.
Copyright of Florida Bar Journal is the property of Florida Bar and its content may not be
copied or emailed to multiple sites or posted to a listserv without the copyright holder’s
express written permission. However, users may print, download, or email articles for
individual use.