© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. Comprehensive Volume 1 Chapter 20 Corporations: Distributions in Complete Liquidation and an Overview of Reorganizations

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 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. –The Smithsons 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 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) Assuming 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 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 $2,560,000 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 $590,000($2,950,000 X 20%). Therefore, the net after-tax cash available for investment will be $2,560,000 –$3,150,000 proceeds – capital gains tax of $590,000. 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 $3,240,000 after tax ($4 million proceeds – capital gains tax of $760,000). –This approach would increase the net after-tax amount available to fund their retirement portfolio by $680,000 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. –Their investment holdings would largely, if not completely, consist of the stock of the acquiring corporation.

© 2014 Cengage Learning. All Rights Reserved. May not be scanned, copied or duplicated, or posted to a publicly accessible website, in whole or in part. 41 If you have any comments or suggestions concerning this PowerPoint Presentation for South-Western Federal Taxation, please contact: Dr. Donald R. Trippeer, CPA SUNY Oneonta