1. Liquidating Distributions to Shareholders.
    1. General Rule.
      1. Section 331 provides the general rule with regard to corporate liquidations that amounts distributed in complete liquidation are treated as full payment in exchange for the stock. If the stock is a capital asset in the hands of the shareholders, then such gain or loss will be capital gain or loss.
      2. Section 331 does not differentiate between corporate and non-corporate shareholders.
    1. Tax Consequences to Liquidating Corporation.
      1. General Rule - Section 336(a) generally requires a corporation to recognize gain or loss upon a distribution of property in liquidation, as if the property were sold to the distributee at its fair market value. However, no gain or loss is recognized by a liquidating corporation for certain distributions by liquidating subsidiaries to an 80% parent corporation and liquidating distributions in connection with tax-free reorganizations, but only if the distributee does not recognize gain or loss with respect to the distributed property ( 336(c)). This means that the liquidating corporation does not recognize gain or loss on the distribution of property in connection with a tax-free reorganization unless the distributed property is taxed as boot to the distributee/shareholder.
      1. Treatment of Liabilities - If a liability is assumed by the distributee, or the distributed property is subject to a liability, the fair market value of the property is deemed to be not less than the amount of the liability ( 336(b)).
      1. Limitations on the Recognition of Loss - Section 336(d) provides special limitations on the recognition of losses. These rules are generally designed to prevent the contribution of built-in loss assets to a corporation prior to its liquidation in order to generate a recognized loss.
        1. Distributions to Related Parties - No loss is recognized to a liquidating corporation on the distribution of property to a related person if the distribution is not pro rata or if the property is disqualified property ( 336(d)(1)).
          1. A related person is defined under 267 to include an individual that owns more than 50% in value of the liquidating corporation's stock directly or indirectly ( 267(b)(2)).
          1. Disqualified property includes (a) property acquired by the liquidating corporation in a 351 transaction or as a contribution to capital within the five-year period ending on the date of its distribution; or (b) property, the adjusted basis of which, is determined, in whole or in part, by reference to the adjusted basis of the property described in (a) above, e.g., property received by the liquidating corporation under 1031 in exchange for disqualified property ( 336(d)(1)(B)).
        1. Contributed Property - For purposes of computing a liquidating corporation's loss on the sale, exchange, or distribution of property acquired by the corporation in a 351 exchange or contribution to capital (or from the sale or exchange of property having an adjusted basis determined by reference to such property), the adjusted basis of the property is reduced (but not below 0) by the excess of the adjusted basis of the property on the date of its contribution over its fair market value at such time, if one of the principal purposes of the acquisition was to generate a loss in connection with the liquidation ( 336(d)(2)).
          1. Except as provided in the regulations, contributions within two years of adoption of a plan of liquidation are presumed to be part of a loss recognition plan, even if the property was sold before the plan was formally adopted ( 336(d)(2)(B)(ii)).
          1. Although a contribution more than two years prior to a liquidation plan can have a prohibitive purpose, the basis adjustment rule is expected to be applied in such a case only in the most rare and unusual circumstance.
          1. In cases where a plan of complete liquidation is adopted in a taxable year following the date on which the tax return including the disallowed loss is filed, regulations may provide that such loss is recaptured in the year of liquidation, rather than requiring an amended return to be filed with respect to the year in which the loss was taken (See 336(d)(2)(C)).
      1. Treatment of Liquidation Expenses - Expenses incurred by the corporation in carrying out a complete liquidation are deductible. This rule applies only to expenses related to the liquidation. Expenses related to the sales of property should be treated as selling expenses, which serve to reduce the gain or loss realized upon the sale (Woodward v. Comm'r, 397 U.S. 572 (1970)).
      1. Organizational Expenses - Organization expenses which have been capitalized may be deducted upon liquidation pursuant to 165.
      1. Examples.
        Example 1: X Co. purchased a Whiteacre (unimproved land) in 1990 at a cost of $30,000. In 2003, X Co. was liquidated and distributed its assets among its three shareholders. X Co. had 100 shares of stock outstanding. A owns 60 shares of X Co.'s stock. B and C each own 20 shares of X Co.'s stock. A, B, and C are unrelated individuals. At the time of X Co.'s liquidation, the fair market value of Whiteacre was $10,000, and X Co. had a basis of $30,000 in Whiteacre. Pursuant to its liquidation, X Co. distributed a 60% interest in Whiteacre to A, a 20% interest in Whiteacre to B, and a 20% interest in Whiteacre to C. The other assets of X Co. also were distributed pro rata among X Co.'s shareholders. On the liquidating distribution of Whiteacre, X Co. recognized a loss of $20,000 pursuant to 336(a). Since Whiteacre was not disqualified property and since Whiteacre was distributed pro rata among X Co.'s three shareholders, the limitations of 336(d) on a liquidating corporation's recognition of loss do not apply.
        Example 2: Assume the same facts as those in Example 1, except that 100% of Whiteacre was distributed to C and the remaining assets of X Co. were distributed among its three shareholders in such manner as to make the totality of its distributions pro rata. As noted in Example 1, Whiteacre is not disqualified property. Since C owned only 20% of X Co.'s outstanding stock, C is not a related person to X Co. within the meaning of 267. To be a related person, C would have had to have actual and constructive ownership of stock of X Co. constituting more than 50% of the value of X Co.'s outstanding stock ( 267(b)(2)). While Whiteacre was not distributed pro rata among X Co.'s shareholders, it was not distributed to a related person (within the meaning of 267). Consequently, the limitations imposed by 336(d) on a liquidating corporation's recognition of loss are not applicable. X Co. recognized a loss of $20,000 on making the liquidating distribution of Whiteacre to C.
        Example 3: Assume the same facts as in Example 1 above, except that 100% of Whiteacre was distributed to A and the remaining assets of X Co. were distributed among its three shareholders in such manner as to make the totality of its distributions pro rata. A is a related person to X Co. within the meaning of 267. Since the distribution of Whiteacre to A, a related person, was not pro rata, X Co. is precluded by 336(d)(1)(A)(i) from recognizing a loss on that distribution.
        Example 4: Assume the same facts as those stated in Example 1, except that Whiteacre was distributed among X Co.'s shareholders in the following proportions: a 20% interest in Whiteacre was distributed to A, and B and C each received a 40% interest. The remaining assets of X Co. were distributed among its three shareholders in such a manner as to make the totality of its distributions pro rata. As noted above, A is a related person to X Co. While the distribution of the 20% interest in Whiteacre to A was less than A's percentage interest in the corporation, it was not pro rata. Therefore, the $4,000 loss that X Co. realized on distributing a partial interest in Whiteacre to A is not recognized because of 336(d). X Co. realized a loss of $16,000 on making the distributions of partial interests in Whiteacre to B and C. Since neither B nor C is a related person, X Co. will recognize that $16,000 loss. (It is a somewhat strange result, however, to deny X Co. loss recognition for the distribution to A since the portion of Whiteacre distributed to A is less than its percentage interest in the corporation.)
        Example 5: Y Co. was created in 1985. Y Co. had 100 shares of stock outstanding. D owns 60 shares of Y Co.'s stock, and E owns the remaining 40 shares of Y Co.'s outstanding stock. D and E are unrelated individuals. In 2003, D contributed Whiteacre (unimproved land) to Y Co. At the time of contribution, D had a basis of $50,000 in Whiteacre, which had a fair market value at that date of $60,000 (i.e., Whiteacre was an appreciated asset). No gain or loss was recognized on that contribution, and Y Co.'s basis in Whiteacre was $50,000 (i.e., Y Co. took the same basis in Whiteacre that D had). At the same time, E contributed $40,000 cash to Y Co. In 2004, Y Co. was liquidated and distributed all of its assets, including Whiteacre, 60% to D and 40% to E. At the time of liquidation, Y Co.'s basis in Whiteacre was still $50,000; but the fair market value of Whiteacre had fallen to $40,000. While the distribution of Whiteacre was pro rata, Whiteacre was disqualified property within the meaning of 336(d)(1)(B). It does not matter that Whiteacre was appreciated property when it was contributed to Y Co.; it matters only that the land was contributed to Y Co. within five years of Y Co.'s liquidation and that Y Co.'s basis was determined by the basis that D had therein. Consequently, the $6,000 loss that Y Co. realized on the distribution of 60% of Y Co. Whiteacre to D (a related person) cannot be recognized. The $4,000 loss that Y Co. realized on the distribution of a 40% interest in Whiteacre to E is recognized. (Although the statute is clear, there appears to be no good reason for denying recognition of the loss realized on the distribution to D since the property was an appreciated asset at the time it was contributed to Y Co.)
        Example 6: Individual A owns 70 shares of X Co.'s outstanding stock, and individual B owns the remaining 30 shares of X Co.'s outstanding stock. A and B are not related. X Co. had only one class of stock outstanding, and it was voting, common stock. The fair market value of X Co.'s stock is $1,000 a share. A had a basis of $70,000 in her 70 shares of X Co.'s stock.
        In 2003, A transferred Whiteacre (unimproved land) to X Co. in exchange for ten additional shares of X Co.'s stock. After this exchange was completed, A owns 80 shares of X Co.'s stock comprising 80% of X Co.'s outstanding stock. A had a basis of $50,000 in Whiteacre, and the fair market value of Whiteacre at that time was $10,000. As a result, A's basis in Whiteacre was $40,000 greater than the property's value.
        While A realized a $40,000 loss on the exchange with Y Co., A did not recognized any amount of loss because of 351. X Co. acquired the same basis in Whiteacre that A had, - namely, $50,000. A's basis in the ten shares of X Co. stock that she received in exchange for Whiteacre is the same as the basis that she had in Whiteacre, - namely, $50,000. As a result, after the exchange, A held 80 shares of X Co.'s stock with an aggregate value of $80,000; and A had an aggregate basis in those 80 shares of $120,000 ($70,000 in 70 shares and $50,000 in ten shares).
        Thirteen months after the contribution in 2003 between A and X Co. took place, X Co. adopted a plan of liquidation. Two weeks later, X Co. made a liquidating distribution to B of Whiteacre plus $10,000 cash. At that time, Whiteacre had a value of $10,000, and X Co.'s basis in Whiteacre was $50,000. Therefore, X Co. realized a loss of $40,000 on making the liquidating distribution. On the same date, X Co. made a liquidating distribution to A of $80,000 cash. Since A had a basis of $120,000 in her 80 shares of X Co.'s stock, she recognized a loss of $40,000 on X Co.'s liquidation. (Note that 267 does not prevent A from deducting that loss because that provision does not apply to a loss recognized from a distribution received pursuant to the complete liquidation of a corporation.)
        As to X Co.'s recognition of loss on distributing Whiteacre to B, 336(d)(1) does not apply to prevent recognition of X Co.'s loss because Whiteacre was not distributed by X Co. to a related person. Therefore, unless 336(d)(2) applies, A's transfer of Whiteacre to X Co. will provide a double deduction for the amount of depreciation in Whiteacre's value - i.e., both A and X Co. would be allowed a $40,000 deduction. If 336(d)(2) is applicable, X Co.'s basis in Whiteacre for purposes of determining a loss on that property must be reduced by $40,000 (the difference between the basis that X Co. acquired in Whiteacre and its value at the time X Co. acquired it). So, X Co. would have a basis in Whiteacre of only $10,000 and X Co. therefore would not recognize a loss when it distributed Whiteacre to B.
        Since X Co. acquired Whiteacre in a 351 exchange less than two years prior to adopting a plan of liquidation, there is a presumption that the property was acquired as part of a plan, the principal purpose of which was to have X Co. recognize a loss in connection with its liquidation (see 336(d)(2)(B)(ii)). It is likely, therefore, that 336(d)(2) will apply and that X Co. will not recognize a loss.
        Example 7: Assume the same facts as those stated in Example 6 above, except that when X Co. distributed Whiteacre to B, the fair market value of Whiteacre was only $6,000; and X Co. distributed $14,000 cash to B. Assuming that 336(d)(2) is applicable, X Co. will recognize a loss of $4,000 on making the distribution to B. For loss purposes, X Co.'s basis in Whiteacre is $10,000; and so it will recognize a $4,000 loss.
        Example 8: Assume the same facts as those stated in Example 6 above, except that when X Co. distribution Whiteacre to B, the fair market value of Whiteacre was $20,000. Assuming that 336(d)(2) is applicable, X Co.'s loss basis in Whiteacre was $10,000; and so X Co. did not recognize a loss. For the purpose of measuring a gain, X Co.'s basis in Whiteacre is $50,000; and so X Co. did not recognize a gain. Thus, X Co. did not recognize either a gain or loss.
        Example 9: Assume the same facts as those stated in Example 6 above, except that instead of distributing Whiteacre to B, X Co. sold Whiteacre for its fair market value of $10,000, and X Co. distributed the proceeds of that sale to B. Assuming that 336(d)(2) is applicable, X Co.'s basis for Whiteacre was $10,000; and so X Co. did not recognize a loss on that sale. Since X Co.'s basis for computing a gain was $50,000, X Co. also did not recognize a gain on the sale.
        Example 10: Assume the same facts as those stated in Example 6 above, except that X Co. adopted a plan of liquidation three years after it acquired Whiteacre. Because of the time differential, it is unlikely that the Commissioner could establish that X Co. acquired Whiteacre as part of a plan, the principal purpose of which was to have X Co. recognize a loss in connection with its liquidation. The existence of such a principal purposes is an essential element of having 336(d)(2) apply. Therefore, it is likely that X Co. will be permitted to recognize a loss of $40,000 on making the distribution of Whiteacre to B.
    1. Tax Consequences to Shareholders Receiving Liquidating Distributions.
      1. Recognition of Gain or Loss - Each shareholder must recognize gain or loss on the distribution received in liquidation ( 331(a) and 1001). Gain or loss is measured by the difference between the fair market value of the liquidating distribution and the shareholder's adjusted basis (prior to such distribution) of the stock. Gain or loss will be capital gain or loss if the stock is a capital asset in the hands of the shareholders. A capital gain or loss will be long-term if the stock has been held for the required holding period.
        1. The amount realized must be adjusted to reflect liabilities assumed or property received subject to liabilities.
        1. Shareholder gain or loss is computed on a share-by-share basis (Reg. 1.331-1(e)). The amount of each distribution must be allocated pro rata over all shares of the distributing corporation held by the shareholder (Rev. Rul. 68-348, 1968-2 C.B. 141; Rev. Rul. 85-48, 1985-1 C.B. 126).
          Example 11: Shareholder A owns 20 shares of stock in X Co., ten of which were acquired in 1998 at a cost of $1,500 and ten of which were acquired in December, 2002 at a cost of $2,900. If A receives a distribution of $250 per share in April, 2003, he will have a long-term capital gain of $1,000 on the shares he acquired in 1998 ($2,500 less $1,500) and a short-term capital loss of $400 on the ten shares he acquired in December, 2002 ($2,900 less $2,500).
        1. In Rev. Rul. 79-10, 1979-1 C.B. 140, the IRS ruled that a non pro rata distribution under 331(a) made by a liquidating corporation with only one class of stock outstanding will be treated as a pro rata distribution for Federal income tax purposes. Any shareholder receiving excess amounts over his/her pro rata share will be deemed to have received such payment in a separate transaction from a shareholder receiving less than his/her pro rata share. The difference will be treated as a gift or compensation, depending on the underlying facts.
        1. The corporation, pursuant to a plan of complete liquidation, notifies its shareholders that they will be entitled to receive a distribution liquidation upon surrender of their shares of stock after a given date, a cash-basis individual shareholder may be in constructive receipt of the liquidating distribution as of the date the distribution first becomes available (Rev. Rul. 80-177, 1980-2 C.B. 109).
          1. This may prevent a cash basis individual from shifting the recognition of gain into the following year.
          1. A liquidating corporation should be able to legitimately delay some liquidating distributions until the following year if corporate business reasons exist for the delay (such as satisfying liabilities, attempting to sell assets, and generally winding up activities, including paperwork).
      1. Tax Basis to Shareholders of Property Received in Liquidation - The fair market value of property distributed in liquidation of a corporation under 331 becomes the shareholder's new tax basis if gain or loss is recognized on receipt of the property ( 334(a) and Reg. 1.334-1(a)).
      1. Shareholder's Use of Installment Method - If shareholders receive, in exchange for stock, certain installment obligations acquired by the corporation in respect of certain sales or exchanges of property, the receipt of payments under such obligation is treated as the receipt of payments for the stock ( 453(h)(1)(B)).
      1. Computing Gain on Series of Distributions.
        1. Where a shareholder who owns a single block of stock receives a series of distributions in a complete liquidation of the corporation, no gain is recognized until an amount equal to the redeemed shareholder's adjusted basis has been received. After the adjusted basis is recovered, later distributions are treated as gain in their full amount (Rev. Rul. 68-348, 1968-2 C.B. 141).
        1. However, where the shareholder owns more than one block of stock, the gain or loss is computed separately for each block. Thus, each distribution to the shareholder must be allocated ratably among the different blocks owned by the shareholder in the proportion that the number of shares in a particular block bears to the total number of shares held by that shareholder and gain with respect to a particular block will be recognized once the adjusted basis for that block has been recovered even if the adjusted basis for other blocks has not yet been recovered. Once the adjusted basis of a specific block has been recovered, all later distributions allocable to that block will be recognized as gain in their entirety (Rev. Rul. 68-348, 1968-2 C.B. 141, amplified by Rev. Rul. 85-48, 1985-1 C.B. 126).
        1. These rules apply without regard to whether or not there is a surrender of any stock before the final distribution (Rev. Rul. 68-348, 1968-2 C.B. 141; Rev. Rul. 85-48, 1985-1 C.B. 126). This means that a shareholder cannot surrender some of his shares and treat a distribution as made in exchange for the shares surrendered. Instead, the distribution is treated as made proportionately for all the shares held by the shareholder.
          Example 12: A owns 150 shares of the only class of stock of X Co. A purchased 50 shares in 1997 at a cost of $10,000, 50 shares in 1998 at a cost of $20,000, and 50 shares in 1999 at a cost of $30,000. X Co. makes a series of distributions to its shareholders in redemption of all of its outstanding stock. A receives $30,000 in 2002, $30,000 in 2003, and $45,000 in 2004.
          The distributions are allocated equally among the three blocks of stock A owns.
          A recognizes no gain in 2002, but his basis is reduced to $0 in his 1997 block, to $10,000 in his 1998 block, and to $20,000 in his 1999 block.
          In 2003, A recognizes gain of $10,000 with respect to his 1997 block, his basis in his 1998 block is reduced to $0, and his basis in his 1999 block is reduced to $10,000.
          In 2004, A recognizes gain of $15,000 with respect to his 1997 block, gain of $15,000 with respect to his 1998 block, and gain of $5,000 with respect to his 1999 block (Rev. Rul. 63-48, 1968-2 C.B. 141; and Rev. Rul. 85-48, 1985-1 C.B. 126).
      1. Computing Loss on Series of Distributions.
        1. A loss on a series of distributions may be claimed only in the year in which it is definitely sustained. Except as noted below, this is the year in which the last liquidating payment is received, even though court approval, which may be necessary, is not given until the following year (Braun v. Comm'r, 23 B.T.A. 536 (1931)). This means that the taxpayer must have received all that it is possible for him to receive before a deductible loss can be established (Rev. Rul. 68-348, 1968-2 C.B. 141). A mere estimate of the net assets is not sufficient (Northwest Bancorporation Corporation 32 B.T.A. 1218 (1935 aff'd 88 F2.d 293 (8th Cir. 1937)).
        1. However, the realization of loss may not be postponed indefinitely by withholding the final distribution until some inconsequential contingency is resolved. If in a taxable year substantially all of the corporate assets have been distributed, except for a small reserve to cover a contingent liability for a small and clearly determinable last distribution, the loss is sustained in that year, not in a later year when the contingency is settled or the last distribution is made (Rev. Rul. 69-334, 1969-1 C.B. 98).
      1. Distribution of Installment Obligation Under Liquidation Completed Within Twelve Months.
        1. If a shareholder receives a liquidating distribution of an installment obligation in exchange for the shareholder's stock in the liquidating corporation, then payments received under the installment obligation (and not the receipt of the obligation) by the shareholder are treated as payment for stock if the following conditions are met:
          1. The installment obligation must be received in a liquidation to which the rules of 331 for determining gain or loss to the shareholder apply.
          1. The liquidating corporation must have received the installment obligation in connection with the sale or exchange of property (other than property described below) by the corporation during the twelve-month period beginning on the date a plan of complete liquidation was adopted.
          1. The liquidation of the corporation must be completed during the twelve-month period beginning on the date the plan of complete liquidation is adopted ( 453(h)(1)(A)).
        1. The effect of this rule is that the shareholder may report any gain on the liquidation under 453, taking gain into account as payments are received on the installment obligation received as part of a liquidating distribution. However, the corporation will still recognize gain on the distribution of the installment obligations under 453B unless the corporation is an S corporation that is eligible for exception to the gain recognition rule (see 453B(h)).
        1. The above rule does not apply to installment obligations acquired by the liquidating corporation in respect of a sale or exchange of the following property unless the sale or exchange is to one person in one transaction, and involves substantially all of that property attributable to a trade or business of the corporation:
          1. Stock in trade of the corporation,
          1. Other property of a kind which would properly be included in the inventory of the corporation if on hand at the close of the taxable year, or
          1. Property held by the corporation primarily for sale to customers in the ordinary course of its trade or business ( 453(h)(1)(B)).
        1. If an installment obligation arises from both a sale or exchange of inventory that does not comply with the bulk-sale requirements, and a sale or exchange of other assets, the portion of the installment obligation that is attributable to the sale or exchange of other assets is a qualifying installment obligation. (Reg. 1.453-11).
        1. For purposes of the above rule treating payments on the installment obligation (and not the receipt of the obligation) as payment for the stock, an installment obligation acquired in respect of a sale or exchange by a selling corporation is treated as acquired in a sale or exchange by a controlling corporate shareholder of the selling corporation, and by each controlling corporate shareholder. This means that if a chain of controlled corporations is liquidated, the shareholders of the liquidating parent may report the receipt of any installment obligation resulting from the sale or exchange of property by any of the subsidiary corporations in the chain on the installment method. (A subsidiary corporation does not recognize the gain on the distribution of installment obligations in a subsidiary liquidation.)
        1. Reg. 1.453-11(a)(2) provides that, if the stock of a liquidating corporation is traded on an established securities market, an installment obligation received by a shareholder from that corporation as a liquidating distribution is not a qualifying installment obligation and does not qualify for installment reporting, regardless of whether the requirements of 453(h) are otherwise satisfied. However, if an installment obligation is received by a shareholder from a liquidating corporation whose stock is not publically traded, and the obligation arose from a sale by the corporation of stock or securities that are traded on an established market, then the obligation generally is a qualifying installment obligation in the hands of the transferor. An exception to the above rule applies if the liquidating corporation is formed or availed of for a principal purpose of avoiding limitations on the availability of installment sales treatment, such as 453(k), through the use of a related party.
          Example 13: A, an individual, owns all of the stock of T corporation, a C corporation. T has an operating division and three wholly-owned subsidiaries, S, Y, and Z. On February 1, 2003, T, Y, and Z all adopt plans of complete liquidation.
          On March 1, 2003, the following sales are made to unrelated purchasers: T sells the assets of its operating division to B for cash and an installment obligation. T sells the stock of X to C for an installment obligation. Y sells all of its assets to D for an installment obligation. Z sells all of its assets to E for cash. The B, C, and D installment obligations bear adequate stated interest and meet the requirements of 453.
          In June 2003, Y and Z completely liquidate, distributing their respective assets (the D installment obligation and cash) to T. In July 2003, T completely liquidates, distributing to A cash and the installment obligations respectively issued by B, C, and D. The liquidation of T is a liquidation to which 453(h) applies and the liquidations of Y and Z into T are liquidations to which 332 applies.
          Because T is in control of Y (within the meaning of 368(c)), the D obligation acquired by Y is treated as acquired by T pursuant to 453(h)(1)(E). A is a qualifying shareholder and the installment obligations issued by B, C, and D are qualifying installment obligations. Unless A elects otherwise, A reports the transaction on the installment method as if the cash and installment obligations had been received in an installment sale of the stock of T corporation. Under 453B(d), no gain or loss is recognized by Y on the distribution of the D installment obligation to T. Under 453B(a) and 336, T recognizes gain or loss on the distribution of the B, C, and D installment obligations to A in exchange for A's stock.
          Example 14: A, a cash-method individual taxpayer, owns all of the stock of P corporation, a C corporation. P owns 30% of the stock of Q corporation. The balance of the Q stock is owned by unrelated individuals. On February 1, 2003, P adopts a plan of complete liquidation and sells all of its property, other than its Q stock, to B, an unrelated purchaser for cash and an installment obligation bearing adequate stated interest. On March 1, 2003, Q adopts a plan of complete liquidation and sells all of its property to an unrelated purchaser, C, for cash and installment obligations. Q immediately distributes the cash and installment obligations to its shareholders in completion of its liquidation. Promptly thereafter, P liquidates, distributing to A cash, the B installment obligation, and a C installment obligation that P received in the liquidation of Q.
          In the hands of A, the B installment obligation is a qualifying installment obligation. In the hands of P, the C installment obligation was a qualifying installment obligation. However, in the hands of A, the C installment obligation is not treated as a qualifying installment obligation because P owned only 30% of the stock of Q. Because P did not own the requisite 80% stock interest in Q, P was not a controlling corporate shareholder of Q (within the meaning of 368(c)) immediately before the liquidation. Therefore, 453(h)(1)(E) does not apply. Thus, in the hands of A, the C obligation is considered to be a third-party note (not a purchaser's evidence of indebtedness) and is treated as a payment to A in the year of distribution. Accordingly, for 2003, A reports as payment the cash and the fair market value of the C obligation distributed to A in the liquidation of P.
          Because P held 30% of the stock of Q, 453B(d) is inapplicable to P. Under 453B(a) and 336, accordingly, Q recognizes gain or loss on the distribution of the C obligation. P also recognizes gain or loss on the distribution of the B and C installment obligations to A in exchange for A's stock. See 453B and 336.
      1. Distributions Received in More Than One Taxable Year.
        1. If a shareholder receives liquidating distributions to which 453(h) applies in more than one taxable year, the shareholder must reasonably estimate the gain attributable to distributions received in each taxable year (Reg. 1.453-11(d)). In allocating basis to calculate the gain for a taxable year, the shareholder must reasonably estimate the anticipated aggregate distributions. For this purpose, the shareholder must take into account distributions, and other relevant events or information that the shareholder knows or reasonably could know up to the date on which the federal income return for that year is filed. If the gain for a taxable year is properly taken into account on the basis of a reasonable estimate and the exact amount is subsequently determined, the difference, if any, must be taken into account for the taxable year in which the subsequent determination is made. However, the shareholder may file an amended return for the earlier year in lieu of taking the difference into account for the subsequent taxable year.
        1. This means that the taxpayer must recompute the gain reported from the liquidation by allocating basis in the stock pro rata over all payments received or to be received. This may require amended returns if the liquidating distributions are not all received during the same taxable year of the shareholder, and the shareholder elects to file an amended return.
          Example 15: A, a calendar-year taxpayer, is the sole shareholder of X Co. and has an adjusted basis in her stock of $200,000. All of the stock was acquired in the same transaction and at the same cost. X Co. adopts a plan of liquidation in July 2003 and sells all of its assets in August 2003 to an unrelated purchaser for $1 million, consisting of $250,000 in cash and an installment note for $750,000.
          Assume that A does not recognize gain on the distribution of the installment obligation under 453(h), but only recognizes gain when payments on the obligation are received.
          X Co. distributes the cash of $250,000 in November 2003 and the installment note in June 2004. For 2003, A reports a gain of $50,000 ($250,000 of cash received less her $200,000 basis in the stock).
          For 2004, under the installment method, A recomputes the gain reported in 2003 by allocated basis according to the installment sale rules. Thus, she allocated 75% of her basis to the installment note and 25% to the cash. This allocation is determined as follows:
          1. Divide $750,000 (face amount of installment note) by $1 million (total distribution),
          1. The percent in "1" above is 75%,
          1. 75% of $200,000 (basis) equals $150,000,
          1. Basis allocable to installment note is $150,000,
          1. Divide $250,000 (cash received) by $1 million (total distribution),
          1. The percent in "5" above is 25%,
          1. 25% of $200,000 (basis) equals $50,000, and
          1. Basis allocable to distribution of cash is $50,000.
            As a result of the distribution of the $750,000 installment note in 2004, A may file an amended return for 2003 to reflect an additional $150,000 of gain for 2003 (the recomputed gain for 2003 is $200,000, i.e., $250,000 of cash received less $50,000 of basis). Since she reported only a gain of $50,000 for 2003, she must now report the recomputed gain either in 2003 if an amended return is filed or in 2004 if no amended return is filed.
            A will report 80% of each payment under the installment note (other than interest) as gain. This is determined as follows:
            1) Face amount of obligation - $750,000,
            2) Less basis of allocable to obligation - $150,000; gain - $600,000; contract price - $750,000; gross profit percentage - 80%.
            A similar recomputation, increasing the portion of the installment note that is attributable to gain rather than recovery of basis, must be made if the installment note is distributed in an earlier year and the cash in a later year.
      1. Installment Obligations Attributable to Certain Sales of Inventory.
        1. An installment obligation acquired by a corporation in a liquidation that satisfies 453(h)(1)(A) in respect of a broken lot of inventory is not a qualifying installment obligation. If an installment obligation is acquired in respect of a broken lot of inventory and other assets, only the portion of the installment obligation acquired in respect of the broken lot of inventory is not a qualifying installment obligation. The portion of the installment obligation attributable to other assets is a qualifying installment obligation. (Reg. 1.453-11(c)(4)).
        1. The term "broken lot of inventory" means inventory property that is sold or exchanged other than in bulk to one person in one transaction involving substantially all of the inventory property attributable to a trade or business of the corporation.
        1. If a broken lot of inventory is sold to a purchaser together with other corporate assets for consideration consisting of an installment obligation and either cash or other property, the assumption of (or taking property subject to) corporate liabilities by the purchaser, or some combination thereof, the installment obligation is treated as having been acquired in respect of a broken lot of inventory only to the extent that the fair market value of the broken lot of inventory exceeds the sum of unsecured liabilities assumed by the purchaser, secured liabilities which encumber the broken lot of inventory and are assumed by the purchaser or to which the broken lot of inventory is subject, and the sum of the cash and fair market value of other property received.
        1. If a portion of the installment obligation is not a qualifying installment obligation, then for purposes of determining the amount of gain to be reported by the shareholder under 453, payments on the obligation (other than payments of qualified stated interest) are to be applied first to the portion of the obligation that is not a qualifying installment obligation.
          Example 16: P corporation has three operating divisions, X, Y, and Z, each engaged in a separate trade or business, and a minor amount of investment assets. On July 1, 2002, P adopts a plan of complete liquidation that meets the criteria of 453(h)(1)(A). The following sales are promptly made to purchasers unrelated to P: P sells all of the assets of the X division (including all of the inventory property) to B for $30,000 cash and installment obligations totalling $200,000. P sells substantially all of the inventory property of the Y division to C for a $100,000 installment obligation, and sells all of the other assets of the Y division (excluding cash but including installment receivables previously acquired in the ordinary course of the business of the Y division) to D for a $170,000 installment obligation. P sells a of the inventory property of the Z division to E for $100,000 cash, a of the inventory property of the Z division to F for a $100,000 installment obligation, and all of the other assets of the Z division (including the remaining a of the inventory property worth $100,000) to G for $60,000 cash, a $240,000 installment obligation, and the assumption by G of the liabilities of the Z division. The liabilities assumed by G, which are unsecured liabilities and liabilities encumbering the inventory property acquired by G, aggregate $30,000. Thus, the total purchase price G pays is $330,000.
          P immediately completes its liquidation, distributing the cash and installment obligations, which otherwise meet the requirements of 453, to A, an individual cash-method taxpayer who is its sole shareholder. In 2003, G makes a payment to A of $100,000 (exclusive of interest) on the $240,000 installment obligation.
          In the hands of A, the installment obligations issued by B, C, and D are qualifying installment obligations because they were timely acquired by P in a sale or exchange of its assets. In addition, the installment obligation issued by C is a qualifying installment obligation because it arose from a sale to one person in one transaction of substantially all of the inventory property of the trade or business engaged in by the Y division.
          The installment obligation issued by F is not a qualifying installment obligation because it is in respect of a broken lot of inventory. A portion of the installment obligation issued by G is a qualifying installment obligation and a portion is not a qualifying installment obligation, determined as follows: G purchased part of the inventory property (with a fair market value of $100,000) and all of the other assets of the Z division by paying cash ($60,000), issuing an installment obligation ($240,000), and assuming liabilities of the Z division ($30,000). The assumed liabilities ($30,000) and cash ($60,000) are attributed first to the inventory property. Therefore, only $10,000 of the $240,000 installment obligation is attributed to inventory property. Accordingly, in the hands of A, the G installment obligation is a qualifying installment obligation to the extent of $230,000, but is not a qualifying installment obligation to the extent of the $10,000 attributable to the inventory property.
          In the 2003 liquidation of P, a receives a liquidating distribution as follows:
Item Qualifying Installment
Obligations
Cash and
Other Property
Cash
$190,000
B note $200,000
C note $100,000
D note $170,000
F note
$100,000
G note $230,000 $10,000
Total $700,000 $300,000
          Assume that A's adjusted tax basis in the stock of P is $100,000. Under the installment method, A's selling price and the contract price are both $1 million, the gross profit is $900,000 (selling price of $1 million less adjusted tax basis of $100,000), and the gross profit ratio is 90% (gross profit of $900,000 divided by the contract price of $1 million). Accordingly, in 2003, A reports gain of $270,000 (90% of $300,000 payment in cash and other property). A's adjusted tax basis in each of the qualifying installment obligations is an amount equal to 10% of the obligation's respective face amount. A's adjusted tax basis in the F note, a nonqualifying installment obligation, is $100,000, i.e., the fair market value of the note when received by A. A's adjusted tax basis in the G note, a mixed obligation, is $33,000 (10% of the $230,000 qualifying installment obligation portion of the note, plus the $10,000 nonqualifying portion of the note).
          With respect to the $100,000 payment received from G in 2004, $10,000 is treated as the recovery of the adjusted tax basis of the nonqualifying portion of the G installment obligation and $9,000 (10% of the $90,000) is treated as the recovery of the adjusted tax basis of the portion of the note that is a qualifying installment obligation. The remaining $81,000 (90% of $90,000) is reported as gain from the sale of A's stock.
      1. Recognition of Gain or Loss to the Distributing Corporation Under 453B.
        1. Under 453B, the disposition of an installment obligation generally results in the recognition of gain or loss to the transferor. Thus, in accordance with 453B and 336, a C corporation generally recognizes gain or loss upon the distribution of an installment obligation to a shareholder in exchange for the shareholder's stock, including complete liquidations covered by 453(h). Section 453B(d) provides an exception to this general rule if the installment obligation is distributed in a liquidation to which 337(a) applies (regarding certain complete liquidations of 80% or more owned subsidiaries). However, that exception does not apply to liquidations under 331.
        1. In the case of a liquidating distribution by an S corporation, however, 453B(h) provides that if an S corporation distributes an installment obligation in exchange for a shareholder's stock, and payments under the obligation are treated as consideration for the stock pursuant to 453(h)(1), then the distribution generally is not treated as a disposition of the obligation by the S corporation. Thus, except for purposes of 1374 and 1375 (relating to certain built-in gains and passive investment income), the S corporation does not recognize gain or loss on the distribution of the installment obligation to a shareholder in a complete liquidation covered by 453(h).
      1. Assumption of Corporation's Liabilities in Connection With Liquidating Distribution.
        1. Where a shareholder of a liquidating corporation assume corporate liabilities such as taxes or received property upon liquidation subject to a corporation's liabilities, the liabilities are taken into account in computing the shareholder's gain or loss (Rev. Rul. 59-228, 1959-2 C.B. 59). This means that the shareholder's gain or loss is the difference between the basis of its stock and the market value of the property received less the assumed liabilities.
        1. In addition, the assumption of liabilities does not increase the shareholder's basis in the property received on liquidation. An increase in basis would give shareholders who assume the liabilities a double tax benefit and there is no provision authorizing this. The payments of the liabilities do not constitute deductions from the shareholder's gross income (Rev. Rul. 59-228, 1959-2 C.B. 59).
      1. Contingent Liabilities of Liquidated Corporation.
        1. At the time a corporation distributes its assets in complete liquidation, it may have liabilities that are so contingent that they cannot be taken into account in computing the shareholder's gain or loss on liquidation. An example would be tax liabilities that arise only after an IRS examination in a year which is both after the corporation's year which is examined and after the liquidation. In this situation, the shareholder may be compelled to pay the tax liability as a transferee of the corporation's assets. When the shareholder pays the liability of the liquidated corporation (whether a tax liability or otherwise) as a transferee of the corporation, it has a capital loss rather than an ordinary loss, since the later payment is viewed as a part of the original liquidating transaction. Thus, the nature of the loss is determined by the character of the original transaction (Arrowsmith v. Comm'r, 344 U.S. 6 (1952)).
        1. However, contingent liabilities, such as transferee liability for corporate taxes, do not affect the shareholder's gain or loss determined in accordance with their accounting method, if at the time of the distribution they receive the distribution under a claim of right. Thus, a shareholder is not entitled to go back to the year of the liquidation and reduce its capital gain for that year by reason of a payment made in a subsequent year. The "look back to the year of liquidation rule" is used only to determine the nature of the loss. This result is no different where the shareholder's return for the year of liquidation is still open.
        1. Where a liquidating trust (a distribution to a liquidating trust that is used to hold the assets of the corporation pending the determination of the amount of the liabilities is treated as a distribution to the shareholders (Rev. Rul. 72-137, 1972-1 C.B. 101)) is used to hold the assets of the corporation, the trust's payment of the corporation's liabilities after the year of the final distribution causes the shareholders to have a capital loss in the later years because they are the owners of the trust (Rev. Rul. 72-137, 1972-1 C.B. 101). However, deductible interest accrued after the liquidation may be deducted by the shareholders (Heiderich v. Comm'r, 19 T.C. 382 (1952)). In contrast, interest accrued on a corporate tax liability before the liquidating distribution is not deductible by the shareholders, but results in a capital loss (Ewing v. Comm'r, 27 T.C. 406 (1956, aff'd 254 F.2d 600 (6th Cir. 1958)).
        1. Before liquidating and dissolving a corporation, make sure that all corporate liabilities, including possible tax liabilities, are paid. The shareholders may have no use for the capital loss in a later year while reducing the proceeds of liquidation will result in a tax benefit in the year of liquidation.
      1. Goodwill Distributed in Liquidation.
        1. In most cases, shareholders have little problem in determining what assets they received in the liquidation. However, there are certain types of assets such as goodwill, that frequently cause trouble.
        2. Goodwill becomes a problem when the corporate business is carried on by the shareholders or their transferees. If the corporate business ends with the corporation, the shareholders do not receive goodwill because it does not exist apart from a going concern. However, when the business is continued by the shareholders, the IRS will usually try to increase their liquidating dividends or distributions by a sometimes substantial amount for goodwill. If the source of the corporate goodwill was a franchise or the like which was automatically lost on the dissolution, then no goodwill passes to the shareholders even if they can easily get a new franchise (Akers v. Comm'r, 6 T.C. 693 (1946)). On the other hand, if the very same business of the corporation is carried on by the shareholders as partners, the courts will probably sustain the IRS's finding of goodwill (Tucker v. Comm'r, 25 F.2d 425 (8th Cir. 1928)). Where the goodwill is solely attributable to the personal ability of the corporation's individual officers, shareholders, etc., and there is no non-competition agreement with those officers, the goodwill becomes worthless on the dissolution and thus does not pass to the shareholders (Longo v. Comm'r, T.C. Memo 1968-217).
          1. For example, the Tax Court in Martin Ice Cream v. Comm'r, 110 T.C. 189 (1998) and Norwalk v. Comm'r, T.C. Memo 1998-279, held that there is no salable goodwill where the business of a corporation is dependent upon its key employees, unless they enter into a covenant not to compete with the corporation or other agreement whereby their personal relationship with clients become property of the corporation.
          1. Neither the corporation nor the shareholder will recognize gain on the distribution of customer-based intangible assets if no employment and/or noncompete agreement exists when liquidation takes place. If the intangible value of client and customer relationships belongs to the individual providing the personal relationship, then the corporation's distributions of clients or customers and any contracts with these individuals are not taxable events.
          1. The key to avoiding income tax for both the corporation and the individual shareholder centers on this aspect. Before owners liquidate any business or professional practice, it is critical that they rescind or void any employment or noncompete agreements. A practitioner should advise a client to dissolve noncompete agreements with shareholders before liquidation.
      1. Shareholder as Creditor.
        1. Where a person is both a shareholder and a creditor of a liquidating corporation, distributions received by that person are applied to the indebtedness first, any amounts received in excess of the indebtedness is applied in computing his capital gain or loss on liquidation (Haden Co. v. Comm'r, 165 F.2d 588 (5th Cir. 1948)). Thus, a shareholder creditor cannot have the liquidating corporation first redeem its stock and later pay the debt with remaining assets so as to give the creditor a bad debt deduction rather than a capital loss (Haden Co. v. Comm'r, 165 F.2d 588 (5th Cir. 1948)).
        1. Where the claim is an ordinary income item, such as a claim for compensation, any gain realized on the collection of the claim is ordinary income, rather than capital gain (Bratton v. Comm'r, 283 F.2d 257 (6th Cir. 1960)).
      1. Distributing Assets With Unascertainable Value - Shareholders usually are able to determine (with the help of an appraiser) the value of assets received on liquidation of their corporation. However, a problem is presented by assets having an unascertainable value when distributed. If the asset, such as a royalty or contract right, is valued at less than the amount which it later brings into the shareholder, the excess is ordinary income. If the shareholder values it at more than it turns out to be worth, the shareholder pays a capital gain on liquidation, and receives only a capital loss in the later year. To avoid this dilemma, the courts allow the shareholder to keep the liquidation transaction open and report as capital gain each payment received after the shareholder's basis is recovered (Burnett v. Logan, 283 U.S. 404 (1931)). However, the IRS's position is that an asset will rarely be treated as having an unascertainable value (Rev. Rul. 58-402, 1958-2 C.B. 15).
    1. Liquidation - Reincorporations.
      1. Form of the Transaction - A typical liquidation reincorporation transaction involves an attempt by shareholders to liquidate their existing corporation, realize capital gain on the distribution of appreciated assets (and obtain a stepped-up basis in such assets to fair market value), and then reincorporate some portion of the distributed assets in another corporation that continues the business of the old corporation. Generally, this transaction is the economic equivalent of a reorganization and a dividend to the extent of the assets retained by the shareholders.
      1. Desired Tax Results Under Prior Law - Under prior law, i.e., before the elimination of the capital gains preference and the imposition of corporate level tax on distributions of appreciated property, the liquidation reincorporation transaction, if the liquidation were respected as a separate step, could accomplish the following tax results:
        1. Shareholders were taxed on the value of the distributed assets, less their basis in their stock, at capital gain rates.
        1. The appreciated assets were transferred to the new corporation with a stepped-up basis without any corporate level tax (except for depreciation recapture and similar items).
      1. IRS Arguments - The IRS had some success in arguing that liquidation reincorporation transactions are in substance reorganizations under 368(a)(1)(D).
        1. See, for example, James Armor, Inc. v. Comm'r, 43 T.C. 295 (1964) where the sale of all of the operating assets of one corporation to a sister corporation owned in the same proportions by the shareholders was held to be a type D reorganization coupled with the distribution of a dividend under 356(a)(2) for assets retained at the shareholder level.
        1. Prior to DRA 1984, if the shareholders of the liquidating corporation ended up with less than 80% of the stock of the acquiring corporation, the shareholders often were able to avoid reorganization treatment (See, for example, Gallagher v. Comm'r, 39 T.C. 144 (1962) and Bergahs v. Comm'r, 361 F.2d 257 (2nd Cir. 1966)).
        1. DRA 1984 lowered the percentage of ownership necessary to find a type D reorganization to 50% and applied more rigorous constructive ownership rules, making it easier for the IRS to find a reorganization in a liquidation reincorporation situation.
        1. With the repeal of General Utilities and the capital gains preference, potential tax advantages of a liquidation reincorporation transaction will no longer be available in many cases.
          1. Simply paying a dividend of cash or liquid assets will be preferable to the liquidation reincorporation transaction if:
            1. The cash or non-operating assets to be retained by shareholders is a small part of the value of the corporation's assets;
            1. The built-in gain (i.e., the appreciation in the corporation's assets) is substantial; or
            1. A stepped-up basis for operating assets would not generate significant tax benefits.
          1. On the other hand, the benefits of a complete liquidation may outweigh the costs of a corporate level tax on the built-in gain if:
            1. The amount of built-in gain is minimal;
            1. The liquidating corporation has NOLs or built-in losses that can shelter such gain; or
            1. The shareholders have a high basis for their stock in the liquidating corporation.
              Example 17: A, an individual, is the sole shareholder of X Co., which operates a jewelry business and also has acquired some investment assets over the years. A liquidates X Co., forms new corporation Y Co., and transfers the operating assets to Y Co. while retaining the investment assets. This is an example of a liquidation reincorporation in a simple form.
              Example 18: A, an individual, is the sole shareholder of X Co., which operates a jewelry business and has also acquired some investment assets over the years. X Co. forms a new subsidiary Y Co., transferring the operating assets of the jewelry business to Y Co. in exchange for Y Co. stock, and retaining the investment assets. A then liquidates X Co., acquiring the Y Co. stock together with the investment assets. This also is a simple form of a liquidation reincorporation.
    1. Liquidation of a Collapsible Corporation.
      1. Section 341 is generally designed to prevent the conversion of ordinary income into capital gains by transferring ordinary income property to a corporation and disposing of a corporation's stock or liquidating the corporation before a substantial part of the income to be realized by the property has been received. If a corporation is collapsible (and the exceptions under 341 do not apply), then gain realized from its liquidation is treated as ordinary income ( 341(a)).
      1. With the repeal of the capital gains preference, 341 has lost its principal purpose. The only effect of 341 in the case of a liquidation of a collapsible corporation is to characterize the gain as ordinary income rather than capital gain, although both types of income are taxed at 28%. Unlike capital gains, however, ordinary income may not be used in full to offset capital losses ( 1211(b)).
    1. Procedure.
      1. Rev. Proc. 86-16, 1986-1 C.B. 546, provides a checklist of the information that must be included in a request for an IRS ruling under 331.
      1. Legal counsel should draft a plan of liquidation, direct the necessary action of the directors and shareholders, and properly record such actions in the corporate minutes and with appropriate state authorities.
      1. The fair market value of the corporate properties to be distributed should be determined. Accordingly, consideration should be given to using qualified appraisers to establish fair market value.
      1. Form 966 (Return of Information) and other documents should be filed with the IRS within thirty days after the adoption of the resolution or plan of liquidation ( 6043 and Reg. 1.6043-1).
        1. A corporation's failure to file Form 966 or its late filing will not be used to deny the availability of 331(a) treatment to the shareholders, but under certain circumstances, could subject the corporation to criminal penalties for willful failure to supply information required by regulations (Rev. Rul. 65-80, 1965-1 C.B. 154).
      1. Forms 1096 and 1099-DIV, information returns, should be filed with the IRS on or before February 28 of the year following distribution to shareholders in liquidation ( 6043 and Reg 1.6043-2). Note that Form 1099-DIV now covers liquidation distributions as well as dividends.
      2. The final Federal corporate income tax return is to be filed within two and one-half months after the end of the month in which the corporation is liquidated ( 6072(b)).
        1. Prompt assessment of additional taxes, if any, may be requested ( 6501(d)). As a result of this request, the usual thirty-six month statute of limitations may be reduced to eighteen months from the date this request is received by the District Director.
    1. Planning Opportunities.
      1. The liquidating distributions may be planned to span more than one taxable year of the shareholder. As no gain is recognized until the shareholder's stock basis is recovered, some gain may be shifted into the next year (Rev. Rul. 85-48, 1985-1 C.B. 126).
      1. A gift of the liquidating corporation's stock may be made in a reasonable period of time prior to the adoption of the plan of complete liquidation. If the donor is in a higher tax bracket than the donee, the overall tax liability to the shareholders may be reduced.