A fine line exists between definitions of a corporate liquidation and dissolution. But for tax purposes, the defining line can make a big difference. Witness the situation described in recent letter from the Internal Revenue Service (LTR 200806006, November 7, 2007), which addresses a seeming anomaly related to the tax code.
The anomaly is corporate dissolution without liquidation. In the ruling, a corporate taxpayer had been incorporated in a state on a particular date, let’s say January 19, 2007. The company was “administratively dissolved” some time after, for example, effective January 25, 2008, due to its failure to timely pay state franchise taxes.
Company management, however, was blissfully unaware of this development and continued to file the business’s federal corporate income tax return and pay all federal income taxes. Eventually, company officers learned of their plight and reincorporated the business in the same state. At issue is whether the company’s status as a corporation had been terminated by the administrative dissolution.
If it is considered terminated, the company would have been viewed as having completely liquidated, and both it and its shareholders would have experienced the tax consequences attendant to the situation. However, in some cases, complete liquidation need not be accompanied by a formal or legal dissolution of the corporation. Witness the two scenarios.
When a corporation is completely liquidated, it transfers all of its assets to its shareholders—whether the assets are cash or property—and the shareholders assume the corporation’s remaining liabilities. The tax treatment of the shareholders is governed by the tax code’s Section 331(a), which provides that amounts distributed in complete liquidation, “shall be treated as in full payment in exchange for the stock.”
Generally, stockholders record a gain (usually capital in nature), if the net distributions of the surrendered stock is greater than the shareholder’s adjusted basis in the stock. Conversely, the stockholders record a loss (also, almost always a capital loss), if the net distribution is less than their adjusted basis in the stock surrendered in the transaction.
The transaction is treated somewhat differently if a shareholder owns more than one block of stock, and receives a series of distributions in complete liquidation. In that case, each distribution is allocated ratably among the several blocks. That’s done in the same proportion that the number of shares within a block bears to the total number of shares owned by the shareholder. Further, shareholders are permitted to recover their entire basis in a block before reporting gain.
A loss from the liquidation, garners different treatment. It can be recognized only after the corporation has made its final distribution, or at least its last substantial distribution. The last substantial distribution can be used only if, at that time, the amount of the final distribution is both de minimis and determinable with “reasonable certainty.” (See in this regard Rev. Rul. 68-348, 1968-2 C.B. 141, Rev. Rul. 69-334, 1969-1 C.B. 98 and Rev. Rul. 85-48, 1985-1 C.B. 126).