Under Sec. 331, a liquidating distribution is considered to be full payment in exchange for the shareholders stock, rather than a dividend distribution, to the extent of the corporations earnings and profits (E&P). The shareholders generally recognize gain (or loss) in an amount equal to the difference between the fair market value (FMV) of the assets received (whether they are cash, other property, or both) and the adjusted basis of the stock surrendered. If the stock is a capital asset in the shareholders hands, the transaction qualifies for c apital gain or loss treatment.
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If the corporation sells its assets and distributes the sales proceeds, shareholders recognize gain or loss under Sec. 331 when they receive the liquidation proceeds in exchange for their stock. If the corporation distributes its assets for later sale by the shareholders, the assets generally come out of the corporation with a basis equal to FMV (and with the related recognition of gain or loss under Sec. 331 for the difference between the FMV and the shareho lders basis in the stock). As a result, the tax consequences of a subsequent sale of the assets by the shareholder should be minimal. The result of these rules is double taxation. The corporation is treated as selling the distributed assets for FMV to its shareholders, with the resulting corporate-level tax consequences. Then, the shareholders are treated as exchanging their stock for the FMV of the assets distributed in complete liquidation, with the resulting gains or losses at the shareholder level.
Shareholders that assume corporate liabilities or receive property subject to corporate liabilities take the liabilities into account in computing their gain or loss. They do not increase their basis in the property received on liquidation because doing so would give them a double tax benefit. Instead, the liability reduces the amount realized by the shareholder. If the property distributed is worth less than the amount of the liability itself, the FMV of the property is treated as no less than the amount of the liability (Sec. 336(b)). The assumption of a contingent or unknown liability is disregarded in determining the propertys FMV. However, the IRS has stated that a shareholder that assumes such a liability will receive capital loss treatment when the liability is ultimately paid by the shareholder (Rev. Rul. 72-137).
A shareholder may claim a loss on a series of distributions only in the year the loss is definitely sustained. Generally, a loss cannot be recognized until the tax year in which the final distribution is received. However, there have been some exceptions to this rule (e.g., in the year the last substantial distribution was made because the amount of the final distribution was then determinable with reasonable certainty) (Rev. Ruls. 68-348 and 85-48).
EditorNotes
Albert Ellentuck is of counsel with King & Nordlinger LLP, in Arlington, Va.