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Chapter 20
Corporations: Distributions in
Complete Liquidation and an
Overview of Reorganizations
Comprehensive Volume
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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The Big Picture (slide 1 of 2)
• Mr. and Mrs. Albert Smithson have built a
successful business, but they believe the time
has come for them to think seriously about
retirement.
• They own all of the stock in Orange, a C
corporation.
– Their stock investment has a basis of $200,000.
– The business, which is in the 34% income tax
bracket, owns net assets that are worth $4 million
and have a basis of $1.5 million.
The Big Picture (slide 2 of 2)
• Unfortunately, the Smithsons have no family
members who are interested in carrying on the
business, so they must resort to liquidating Orange
Corporation.
– Their strategy, in general, is to convert the value of their
business into a diversified portfolio of marketable securities
and to live off the earnings.
• The Smithsons realize that such a plan will be
taxable.
– They would like to know the amount that will be available
after paying all Federal taxes.
• Read the chapter and formulate your response.
Liquidations—In General
• Corporation winds up affairs, pays debts, and
distributes remaining assets to shareholders
– Produces sale or exchange treatment to shareholder
– Liquidating corporation recognizes gains and
losses upon distribution of its assets, with certain
exceptions
Liquidations—Effect on Corporation
(slide 1 of 3)
• Gain or loss is recognized by corporation on
distribution in complete liquidation
– Loss may be disallowed or limited if:
• Property distributed to related parties
• Property distributed has built-in losses
• A subsidiary’s liquidating distribution to its parent corporation or to
its minority shareholders
– Property treated as if sold for FMV
– Result: Liquidating distribution subject to corporate level
tax (gain), and shareholder level tax (receipt of proceeds)
Liquidations—Effect on Corporation
(slide 2 of 3)
• Limitations on losses—Related Party
Situations
– Losses are disallowed on liquidating distributions
to related parties if:
• Distribution is not pro rata
– In pro rata distributions, each shareholder receives their share
of each asset
• Property distributed is disqualified property
– Disqualified property is property acquired by corp in a §351
transaction during the five-year period ending on date of
distribution
Liquidations—Effect on Corporation
(slide 3 of 3)
• Limitations on losses—Built-in Loss
Situations
– Losses are disallowed when property distributed
was acquired in a §351 transaction and principal
purpose was to cause recognition of loss by corp
on liquidation
– Purpose is presumed if transfer occurs within two
years of adopting liquidation plan
The Big Picture – Example 4
Antistuffing Rules (slide 1 of 2)
• Return to the facts of The Big Picture on p. 20-2.
• Assume that the Smithsons transfer property to
Orange Corp. in exchange for additional stock.
– Property basis = $100,000, fair market value = $55,000.
– The exchange qualifies under § 351.
• Absent any exceptions, the general rule of carryover
basis would apply.
– Orange would take a carryover basis of $100,000 in the
property.
– Christina would take a $100,000 basis in the additional
stock.
The Big Picture – Example 4
Antistuffing Rules (slide 2 of 2)
• A sale or liquidating distribution of the
property by Orange Corp. would result in a
$45,000 loss.
– $55,000 (fair market value of property) - $100,000
(property basis).
• Similarly, a sale by the Smithsons of the stock
acquired in the § 351 exchange would also
result in a $45,000 loss.
– $55,000 (fair market value of stock) - $100,000
(stock basis).
Distribution of Loss Property in
Liquidation
Liquidations—Effect on Shareholder
(slide 1 of 2)
• Gain or loss recognized on receipt of property
from liquidating corporation
– Amount = FMV of property received - basis in
stock
• Generally, capital gain or loss
– Basis in assets received in liquidating distribution
= FMV on date of distribution
Liquidations—Effect on Shareholder
(slide 2 of 2)
– Special rule for installment obligations
• Shareholder may defer gain recognition to point of
collection
• Corporation must recognize all gain on distribution
The Big Picture – Example 13
Tax Paid On Net Gain (slide 1 of 2)
• Return to the facts of The Big Picture on p. 20-2.
• When the Smithsons are contemplating
retirement, their business, Orange Corp
has net assets worth $4 million.
– This valuation is after the payment of all of
Orange’s corporate debts except for taxes it
would pay on net gains recognized if it
liquidates.
The Big Picture – Example 13
Tax Paid On Net Gain (slide 2 of 2)
• Assume the Smithsons decide to liquidate
the corporation and the taxes the
corporation pays total $850,000.
– The amount realized by the Smithsons is
$3,150,000 ($4,000,000 - $850,000).
The Big Picture – Example 14
Tax Paid On Net Gain
• Return to the facts of The Big Picture on p. 20-2.
• Continuing with the preceding example, if
Orange Corporation liquidates and the
Smithsons receive a liquidating distribution of
$3,150,000.
– They will recognize a capital gain of $2,950,000
• $3,150,000 amount realized - $200,000 stock basis.
– The basis of any property the Smithsons receive
will be its fair market value.
Liquidations: Parent-Subsidiary
Situations (slide 1 of 4)
• Parent corporation does not recognize gain or
loss on liquidation of subsidiary
– Also, subsidiary recognizes no gain or loss on
property distributions to its parent
Liquidations: Parent-Subsidiary
Situations (slide 2 of 4)
• To qualify:
– Parent must own at least 80% of voting stock and
value of subsidiary’s stock
– Subsidiary must distribute all property in complete
cancellation of all its stock within the taxable year
or within 3 years from close of tax year in which
first distribution occurred
– Subsidiary must be solvent
Liquidations: Parent-Subsidiary
Situations (slide 3 of 4)
• Liquidating distributions to minority
shareholders
– Subsidiary corporation treated same way as in
nonliquidating distribution
• Distributing corp recognizes gain but not loss
– Minority shareholders recognize gain or loss
• Amount = FMV of property received-basis in stock
Liquidations: Parent-Subsidiary
Situations (slide 4 of 4)
• Basis of property received by parent
– Has same basis as subsidiary’s basis (unless
election is made under §338)
• Parent’s basis in subsidiary’s stock disappears
• Parent acquires tax attributes of subsidiary
– e.g., NOLs, business credit carryovers, capital loss carryovers,
subsidiary’s E & P
• May result in some inequities
Election Under §338
(slide 1 of 4)
• Parent may elect to treat acquisition of stock in
acquired corp as a purchase of the acquired
corp.’s assets if:
– Election is made by fifteenth day of ninth month
following qualified stock purchase
• Qualified stock purchase occurs when corp acquires
stock representing at least 80% of voting power and
value within a 12-month period
• Must be acquired in taxable transaction
– Stock purchases by affiliated group members count
Election Under §338
(slide 2 of 4)
• Tax Consequences
– Parent corp has basis in subsidiary’s assets = basis
in subsidiary’s stock
• Subsidiary may, but need not, be liquidated
Election Under §338
(slide 3 of 4)
• Tax Consequences (cont’d)
– Subsidiary is deemed to have sold its assets for an
amount determined with reference to parent’s basis
in subsidiary’s stock, adjusted for liabilities of
subsidiary
Election Under §338
(slide 4 of 4)
• Tax Consequences (cont’d)
– Gain or loss is recognized by subsidiary
– Subsidiary is treated as a new corporation that
purchased all of its assets on the day after the
qualified stock purchase date
Reorganizations—In General
• Refers to any corporate restructuring that may
be tax-free under §368
– To qualify, must meet certain general
requirements:
• Must be a plan of reorganization
• Must meet continuity of interest and continuity of
business enterprise tests
• Must have a sound business purpose
• Tax-free status can be denied under step transaction
doctrine
Summary of Different Types
of Reorganizations
• The term reorganization includes:
–
–
–
–
–
–
–
Statutory merger or consolidation
Stock for stock exchange
Stock for assets exchange
Divisive exchange
Recapitalization
Change in identity, form, or place of organization
Transfers in bankruptcy or receivership
Tax Free Reorganization
Consequences, in General (slide 1 of 3)
• Consequences to Acquiring Corporation
– No gain or loss recognized unless it transfers
property to the Target corporation as part of the
transaction
• Then gain, but not loss, may be recognized
– Basis of property received retains basis it had in
hands of Target corp plus any gain recognized by
the target
Tax Free Reorganization
Consequences, in General (slide 2 of 3)
• Consequences to Target Corporation
– No gain or loss unless it retains “other property”
received in the exchange or it distributes its own
property to shareholders
• Other property is defined as anything received other
than stock or securities
– Treated as boot
• Gain, but not loss, may be recognized
Tax Free Reorganization
Consequences, in General (slide 3 of 3)
• Consequences to Target or Acquiring Co.
Shareholders
– No gain or loss unless shareholders receive cash or
other property in addition to stock
• Cash or other property is considered boot
– Gain recognized by the stockholder is the lesser of the boot
received or the realized gain
– Basis of shares received is same as basis of those
surrendered, decreased by boot received, increased
by gain and dividend income, if any, recognized in
the transaction
Comparison of Reorganization Types
(slide 1 of 5)
Comparison of Reorganization Types
(slide 2 of 5)
Comparison of Reorganization Types
(slide 3 of 5)
Comparison of Reorganization Types
(slide 4 of 5)
Comparison of Reorganization Types
(slide 5 of 5)
Refocus On The Big Picture (slide 1 of 7)
• The Smithsons are wise to evaluate the
affordability of their retirement plan
before they sell or liquidate their
business.
• Nonetheless, after payment of income tax
at both the corporate and shareholder
levels, they will net only $2,707,500 from
the sale of their $4 million business.
Refocus On The Big Picture (slide 2 of 7)
• Specifically, in the event the corporation is
able to sell the business assets for $4 million,
the realized gain of $2.5 million will give rise
to Federal income tax of $850,000 ($2,500,000
X 34%).
• Following the payment of the corporate
income tax, the net proceeds to the Smithsons
will be $3,150,000.
Refocus On The Big Picture (slide 3 of 7)
• After offsetting the amount realized from the
liquidation by their stock basis of $200,000, their
capital gain of $2,950,000 will be subject to capital
gains tax of $442,500($2,950,000 X 15%).
• Therefore, the net after-tax cash available for
investment will be $2,707,500
– $3,150,000 proceeds – capital gains tax of $442,500.
• Now, the question for the Smithsons is whether this
amount will likely be sufficient to fund the type of
retirement they desire.
Refocus On The Big Picture (slide 4 of 7)
What If?
• Instead of the complete liquidation transaction
just described, the Smithsons should consider
alternatives that could produce a better tax
result such as the following.
Refocus On The Big Picture (slide 5 of 7)
What If?
– If the Smithsons are able to find a buyer who is interested
in maintaining the business in the current corporate form,
they should try to sell their stock in the business rather than
selling the business assets in liquidation.
• If the buyer is willing to pay $4 million for the corporation’s stock,
the Smithsons would recognize a capital gain of $3.8 million and
have$3,430,000 after tax ($4 million proceeds – capital gains tax of
$570,000).
– This approach would increase the net after-tax amount
available to fund their retirement portfolio by $722,500 due
to the fact that the corporate level tax is avoided.
Refocus On The Big Picture (slide 6 of 7)
What If?
• Another approach would be to attempt to market the
corporation as a potential takeover target in a tax-free
reorganization.
– With this approach, the Smithsons would receive stock in
the acquiring corporation without having to recognize any
gain from the transaction.
– This strategy could enable the Smithsons to live off the
subsequent dividend distributions made by the acquiring
corporation.
• Further, if they needed additional cash flow to meet living
expenses, they could sell shares of stock in the acquiring
corporation as needed, and any resulting gain would be subject to
the capital gains rates at that time.
Refocus On The Big Picture (slide 7 of 7)
What If?
• An obvious advantage of this approach is that gain
from the disposition of their stock would be deferred
until the stock in the acquiring corporation is sold in a
taxable transaction.
• However, a disadvantage the Smithsons would need
to evaluate is that they would not be able to build a
diversified portfolio.
– Given that their investment holdings would largely, if not
completely, consist of the stock of the acquiring
corporation.
If you have any comments or suggestions concerning this
PowerPoint Presentation for South-Western Federal
Taxation, please contact:
Dr. Donald R. Trippeer, CPA
[email protected]
SUNY Oneonta
© 2012 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part.
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