2. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Principles of Taxation: Advanced Strategies Chapter 13 Chapter 13 Business Liquidations and Terminations Business Liquidations and Terminations Slide 13-1

3. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Bankruptcy Legal process through which a debtor restructures or discharges debts Legal process through which a debtor restructures or discharges debts Two types for business Two types for business  Chapter 11 reorganization  Debtors and creditors agree to debt restructuring  Chapter 7 liquidation  Assets sold and proceeds distributed to creditors Slide 13-2

4. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Discharge of Debt Income Slide 13-3 General rule: Any discharge results in taxable income General rule: Any discharge results in taxable income Exceptions: Exceptions:  Bankruptcy  Insolvency

5. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Bankruptcy Exception Discharge must occur in a Title 11 bankruptcy case Discharge must occur in a Title 11 bankruptcy case Entire debt relief excludable from income Entire debt relief excludable from income Slide 13-4

6. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Insolvency Exception Exclusion limited to amount of insolvency Exclusion limited to amount of insolvency Insolvency is amount of debts over fair market value of assets Insolvency is amount of debts over fair market value of assets Slide 13-5

7. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Reduction of Tax Attributes Business that utilize either exception must reduce in order the following tax attributes: Business that utilize either exception must reduce in order the following tax attributes:  Net operating loss carryforwards  General business credit carryforwards  Minimum tax credit carryforwards  Capital loss carryforwards  Basis in property  Passive activity loss carryforwards  Foreign tax credit carryforwards Slide 13-6

8. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Reduction of Tax Attributes Attributes that produces deductions and basis reduced dollar for dollar by amount of discharge excluded Attributes that produces deductions and basis reduced dollar for dollar by amount of discharge excluded Credits reduced by 33.3 ¢ for each dollar of exclusion Credits reduced by 33.3 ¢ for each dollar of exclusion Slide 13-7

9. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Reduction of Attributes for S Corporations Bankruptcy and insolvency exceptions apply at S corporation level but attributes reduced at shareholder level Bankruptcy and insolvency exceptions apply at S corporation level but attributes reduced at shareholder level Any suspended losses treated as a net operating loss and reduced by shareholder’s pro-rata share of discharge Any suspended losses treated as a net operating loss and reduced by shareholder’s pro-rata share of discharge Slide 13-8

10. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Reduction of Attributes by Partnerships Election to reduce attributes made at partner not partnership level Election to reduce attributes made at partner not partnership level Discharge is treated as a separately stated item allocated among the partners Discharge is treated as a separately stated item allocated among the partners Any discharge is taxable to partner unless he or she meets bankruptcy or insolvency exception Any discharge is taxable to partner unless he or she meets bankruptcy or insolvency exception Slide 13-9

11. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Tax Consequences to Creditors General rule: creditor allowed deduction for worthless or discharged debts Special rule for noncorporate creditors: debt discharged or worthless must be a business debt   Nonbusiness debts considered a short term capital loss Slide 13-10

12. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Business versus Nonbusiness Bad Debts Shareholder loans to corporation generally treated as nonbusiness debts Shareholder loans to corporation generally treated as nonbusiness debts  Result is capital loss if debt goes bad Shareholder employee who lends money to corporation may be able to claim ordinary loss but only if dominant motive is to protect employment Shareholder employee who lends money to corporation may be able to claim ordinary loss but only if dominant motive is to protect employment Slide 13-11

13. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Corporate Liquidations Corporation ceases activity Corporation ceases activity Sells assets Sells assets Pays liabilities Pays liabilities Distributes any excess of assets over liabilities to shareholders Distributes any excess of assets over liabilities to shareholders Dissolves under state law Dissolves under state law Slide 13-13

14. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Consequences of Liquidation to Corporation Slide 13-13 Any assets distributed to shareholder are deemed sold for their fair market value Any assets distributed to shareholder are deemed sold for their fair market value Unamortized intangible assets such as goodwill written off and deducted Unamortized intangible assets such as goodwill written off and deducted Corporate attributes vanish Corporate attributes vanish

15. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Shareholder Tax Consequences Shareholder recognizes capital gain or loss equal to difference between fair market value of liquidating distribution and his or her basis in stock Shareholder recognizes capital gain or loss equal to difference between fair market value of liquidating distribution and his or her basis in stock Shareholder takes fair market value basis in any property distributed as part of liquidation Shareholder takes fair market value basis in any property distributed as part of liquidation Slide 13-14

16. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Worthless Stock Stock treated as sold on last day of taxable year for nothing Stock treated as sold on last day of taxable year for nothing Exception: Section 1244 stock Exception: Section 1244 stock Slide 13-15

17. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc High Cost of Corporate Liquidations Tax imposed on both corporation and shareholder Tax imposed on both corporation and shareholder Can result in an effective tax rate of over 50% Can result in an effective tax rate of over 50% S corporation election may ameliorate result but potential built-in gains tax under section 1374 S corporation election may ameliorate result but potential built-in gains tax under section 1374 Slide 13-16

18. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Liquidation of Controlled Subsidiary Controlled subsidiary definition: Controlled subsidiary definition:  Parent corporation owns at least 80% of voting power and value of stock Subsidiary does not recognize any gain or loss on distributions to parent Subsidiary does not recognize any gain or loss on distributions to parent Parent recognizes no gain or loss Parent recognizes no gain or loss Subsidiary’s bases in assets carries over to parent Subsidiary’s bases in assets carries over to parent Subsidiary’s attributes carry over to parent Subsidiary’s attributes carry over to parent Slide 13-17

19. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Liquidation of Controlled Subsidiary Insolvent subsidiary Insolvent subsidiary  Parent recognizes loss equal to basis  If 90% of subsidiary’s gross receipts were from an active business, loss is ordinary Slide 13-18

20. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Liquidations of Controlled Subsidiaries Slide 13-19 Minority shareholders not protected by section 332 Minority shareholders not protected by section 332  Liquidating corporation recognizes gain but not loss on distribution of assets to minority shareholder  Shareholder recognizes capital gain or loss equal to difference between liquidating distribution and their basis in stock

21. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Partnership Terminations Two types: Two types:  Natural termination  Automatic termination Slide 13-20

22. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Natural Termination Partnership discontinues operations Partnership discontinues operations Assets sold Assets sold Liabilities paid Liabilities paid Excess of assets over liabilities distributed to partners Excess of assets over liabilities distributed to partners Slide 13-21

23. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Tax Consequences of Liquidation Generally nontaxable to both partners and partnership Generally nontaxable to both partners and partnership Partner reduces “outside” basis by an cash received and substitutes remaining “outside” basis as basis of property received Partner reduces “outside” basis by an cash received and substitutes remaining “outside” basis as basis of property received Slide 13-22

24. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Gain Recognition by Partner Slide 13-23 If cash distribution exceeds “outside” basis, partner must recognize the excess cash as gain If cash distribution exceeds “outside” basis, partner must recognize the excess cash as gain Basis of any other property received is zero Basis of any other property received is zero

25. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Distributions of Ordinary Income Property If unrealized receivables or inventory received by partner special rules apply If unrealized receivables or inventory received by partner special rules apply Partner’s bases in these items may never be more than partnership’s bases in these items Partner’s bases in these items may never be more than partnership’s bases in these items Partner recognizes ordinary income on disposition of unrealized receivable Partner recognizes ordinary income on disposition of unrealized receivable Partner who sells inventory within five years of distribution recognizes ordinary income or loss Partner who sells inventory within five years of distribution recognizes ordinary income or loss Slide 13-24

26. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Loss Recognition by a Partner Loss recognized only if partner receives only cash Loss recognized only if partner receives only cash Capital loss equal to difference between “outside” basis and cash received Capital loss equal to difference between “outside” basis and cash received Slide 13-25

27. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Insolvent Partnerships Results in partners making additional contributions to pay off partnership debts rather than receiving distributions Results in partners making additional contributions to pay off partnership debts rather than receiving distributions Slide 13-26

28. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Automatic Terminations If there is a sale or exchange or 50% or more of the profits or capital interest within a twelve month period, a termination occurs If there is a sale or exchange or 50% or more of the profits or capital interest within a twelve month period, a termination occurs  Buy-sell agreements can prevent this Partnership year ends on termination Partnership year ends on termination Slide 13-27

29. McGraw-Hill/Irwin Copyright (c) 2002 by the McGraw-Hill Companies Inc Automatic Terminations No effect on day to day operations No effect on day to day operations For tax purposes two step process: For tax purposes two step process:  Old partnership contributes all its assets and liabilities to new partnership in return for 100% interest in new partnership  Old partnership distributes interest in new partnership to its partners Slide 13-28