Print this article | Return to Article | Return to CFO.com
An anomaly described in a recent IRS ruling says there is a big, but subtle, difference.
Robert Willens, CFO.com | US
February 20, 2008
A fine line exists between definitions of a corporate liquidation and dissolution. But for tax purposes, the defining line can make a big difference. Witness the situation described in recent letter from the Internal Revenue Service (LTR 200806006, November 7, 2007), which addresses a seeming anomaly related to the tax code.
The anomaly is corporate dissolution without liquidation. In the ruling, a corporate taxpayer had been incorporated in a state on a particular date, let's say January 19, 2007. The company was "administratively dissolved" some time after, for example, effective January 25, 2008, due to its failure to timely pay state franchise taxes.
Company management, however, was blissfully unaware of this development and continued to file the business's federal corporate income tax return and pay all federal income taxes. Eventually, company officers learned of their plight and reincorporated the business in the same state. At issue is whether the company's status as a corporation had been terminated by the administrative dissolution.
If it is considered terminated, the company would have been viewed as having completely liquidated, and both it and its shareholders would have experienced the tax consequences attendant to the situation. However, in some cases, complete liquidation need not be accompanied by a formal or legal dissolution of the corporation. Witness the two scenarios.
When a corporation is completely liquidated, it transfers all of its assets to its shareholders—whether the assets are cash or property—and the shareholders assume the corporation's remaining liabilities. The tax treatment of the shareholders is governed by the tax code's Section 331(a), which provides that amounts distributed in complete liquidation, "shall be treated as in full payment in exchange for the stock."
Generally, stockholders record a gain (usually capital in nature), if the net distributions of the surrendered stock is greater than the shareholder's adjusted basis in the stock. Conversely, the stockholders record a loss (also, almost always a capital loss), if the net distribution is less than their adjusted basis in the stock surrendered in the transaction.
The transaction is treated somewhat differently if a shareholder owns more than one block of stock, and receives a series of distributions in complete liquidation. In that case, each distribution is allocated ratably among the several blocks. That's done in the same proportion that the number of shares within a block bears to the total number of shares owned by the shareholder. Further, shareholders are permitted to recover their entire basis in a block before reporting gain.
A loss from the liquidation, garners different treatment. It can be recognized only after the corporation has made its final distribution, or at least its last substantial distribution. The last substantial distribution can be used only if, at that time, the amount of the final distribution is both de minimis and determinable with "reasonable certainty." (See in this regard Rev. Rul. 68-348, 1968-2 C.B. 141, Rev. Rul. 69-334, 1969-1 C.B. 98 and Rev. Rul. 85-48, 1985-1 C.B. 126).
Something else to consider is that under Section 336(a) of the tax code, a gain or loss is recognized by a liquidating corporation on the distribution of its property in complete liquidation, as if such property were sold to the distributee at its fair market value. In other words, in most cases, the liquidation of a corporation commonly engenders two levels of taxation: tax will be imposed at both the corporate and distributee shareholder levels.*
The De Facto Company Closure
A complete liquidation is not always accompanied by a formal or legal company shutdown. According to Section 1.332-2(c) of the tax code, "...legal dissolution is not required..." What's more, a related revenue rule (Rev. Rul. 54-518, 1954-2 C.B. 142 ) states that "...where a corporation ceases business operations, has retained no assets, has no income, and has actually liquidated, there is in effect a de facto dissolution, even though the corporation has not been formally dissolved..."
In addition, it is entirely possible for the corporation to continue in existence even though it has been, as a matter of state law, dissolved.
Thus, unless dissolution brings about an automatic transfer of the corporation's assets to its shareholders, the corporation, even though dissolved, continues its existence. Accordingly, the continuation of existence, after dissolution, may well depend on whether the governing state law provides that a dissolved corporation can still own assets.
If state law allows a dissolved company to own assets, the dissolution, unless accompanied by an actual conveyance of the entity's assets to its shareholders, will not give rise to a liquidation. Indeed, in that situation, the tax consequences spelled out in ( Section 331(a) and Section 336(a) will not be visited on the shareholders and the corporation, respectively.**
Federal Law Governs
The ruling concludes that the "core test of corporate existence," for purposes of federal income taxation, is always, a matter of federal law. To be sure, since the state law in the IRS example brought about an automatic transfer (to its shareholders) of a dissolved corporation's assets, it followed that the company's dissolution did not give rise to a complete liquidation.
So, the ruling concludes that the dissolution and reincorporation did not result, respectively, in a distribution or transfer of the corporation's properties. In addition, the dissolution and reincorporation will not affect its shareholders' bases and holding period in its stock. More to the point, notwithstanding the dissolution and reincorporation, no new corporation is deemed to come into existence so the corporate taxpayer is not required to apply for a new Employer Identification Number.
For that reason, it is well-settled that a liquidation can occur without a formal or legal dissolution and, now, thanks to LTR 200806006, we also know that a dissolution—which does not give rise to an automatic transfer of the dissolved corporation's assets to its shareholders—also does not give rise to, in and of itself, a complete liquidation.
Contributor Robert Willens, founder and principle of Robert Willens LLC, writes a regular tax column for CFO.com.
*Except in instances where the liquidation is governed by Section 332(a), and Section 337(a). In that case, the distributee shareholder is another corporation which owns at least 80 percent of the voting power and value of the liquidating entity's stock on the date of the planned complete liquidation is adopted and all times thereafter until the receipt of the property.)
**When a complete liquidation is followed by a pre-arranged transfer of all or part of its essential operating assets to a second (almost always newly-created) controlled corporation, the steps may be "collapsed" and treated as a single, unitary transaction which bears an unmistakable resemblance to a reorganization. Such a transaction is popularly known as a liquidation/reincorporation. (See Bittker and Eustice, Federal Income Taxation of Corporations and Shareholders at Para. 12.64. See also Reg. Sec. 1.331-1(c) "...a liquidation which is followed by a transfer to another corporation of all or part of the assets of the liquidating corporation...may have the effect of...a transaction in which no loss is recognized and gain is recognized only to the extent of other property...") In LTR 200806006, however, it is highly unlikely that, if the dissolution had caused a liquidation, such liquidation would have been "stepped together" with the reincorporation (to find a reorganization). In the instant case, the corporate taxpayer would have been unaware of the fact that it had been completely liquidated and, thus, its eventual reincorporation, in belated response to such liquidation, could not be seen as part of a unitary transaction which encompassed both the liquidation and reincorporation. (See in this regard William C. Kind v. Commissioner, 54 T.C. 600 (1970) (Acq.))