Liquidation Without Tax Consequences

The IRS determined that transactions completed within the same year allowed a company to avoid the typical tax hit triggered when it rescinds its i...
Robert WillensDecember 20, 2010

Thinking about year-end tax planning? Consider a case examined by the Internal Revenue Service last year that provides insight into a useful tool for companies that expect to liquidate assets.

When a corporation completely liquidates and distributes its assets (subject to its liabilities) to shareholders in complete cancellation and redemption of their stock, the corporation recognizes a gain or loss as if such property were sold to the distributee shareholders at its fair-market value.1

However, the shareholders do not escape unscathed: Under Section 331(a) of the Internal Revenue Code, amounts received by a shareholder in a distribution in complete liquidation of a corporation are treated as if the transaction were payment in full in an exchange for stock.

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Accordingly, the shareholders recognize gain on the liquidation, measured by the excess of the net value of the property received over the basis of the stock surrendered in the transaction.2 However, in a private letter ruling issued by the IRS late last year, both the corporation and the distributee shareholders were absolved of any tax consequences arising from the liquidation of the corporation. The reason: the entity’s brief stint as a corporation was, in the final analysis, disregarded for tax purposes.

In the ruling, a partnership required access to “new capital and equity” for the purpose of making acquisitions in its expansion efforts. Accordingly, a corporation was formed based on a “plan of conversion” that transformed a partnership to a corporation. In the conversion, partners holding Class A interests in the partnership received Class A common stock in the corporation, while partners holding Class B interests received either Class B or Class C common stock in the corporation.

A month later, the corporation made a distribution to its shareholders in their capacity as former partners. In its ruling, the IRS stated that the distribution would have been made, in the same amounts, whether or not the partnership had converted into a corporation.

Willens 12-20-2010

The Snag
After the conversion, the corporation found that it could not raise the desired capital at an acceptable cost as long as its operations included a particular business unit. Accordingly, the corporation planned to engage in a “rescission transaction,” consisting of filing a “certificate of conversion” with the state to convert the corporation into a limited liability corporation (LLC). The plan also assured that all affected parties would be restored to the relative economic positions they would have occupied had the conversion of partnership into corporation not occurred.

The IRS ruling observed that the LLC should be taxed as a partnership. Further, while the corporation could first convert into a partnership and then into an LLC, it would incur greater expense than if the corporation converted directly into an LLC. Moreover, the IRS pointed out that the proposed transaction would be completed by the end of the 2009 taxable year, which would be within the same taxable year as the conversion of the partnership into a corporation.

It was represented that there is no material difference in the ultimate economic outcome and tax consequences between the two-step conversion (from a corporation to a partnership and then to an LLC) and the one-step conversion (from a corporation to an LLC) that was to be undertaken in this case. The IRS concluded that the LLC should be treated as a partnership at all times during the 2009 taxable year. As a result, for tax purposes, the corporation never existed.

It follows that the conversion of a corporation into a LLC is not treated as a liquidation of a corporation for purposes of determining the taxable income of a company and its equity holders. Therefore, by restoring the status quo ante within a single taxable year, the transaction is not treated as an incorporation followed by a separate liquidation. Instead, it is treated as if incorporation had never occurred, with the felicitous result that the tax consequences that ordinarily attend a corporate liquidation (as depicted in Section 336(a) and Section 331(a), supra) are avoided.

Contributor Robert Willens, founder and principal of Robert Willens LLC, writes a weekly tax column for

1 See Section 336(a) of the Internal Revenue Code.
2 See Section 1001 of the Internal Revenue Code.