CaseStudy by gjjur4356



                                                                                                  Albert B. Ellentuck, Esq.

 Understanding the Effects of Nonliquidating
 Distributions on Corporations

                                       Nonliquidating corporate distri-               income, as is gain attributable to the dis-
                                       butions are distributions of cash and/or       tribution of inventory and unrealized re-
                                       property by a continuing corporation           ceivables. Gain attributable to capital as-
                                       to its shareholders. At the shareholder        sets and certain property used in a trade
                                       level, a nonliquidating corporate distribu-    or business (Sec. 1231 property) is capital
                                       tion can produce a variety of tax conse-       gain.
                                       quences, including taxable dividend treat-         Practice tip: Corporations generally
                                       ment, capital gain or loss, or a reduction     report nonliquidating distributions to
                                       in stock basis.                                shareholders on Form 1099-DIV, Divi-
                                           At the corporate level, a nonliquidat-     dends and Distributions (Sec. 6042(c);
                                       ing corporate distribution can also have       Regs. Sec. 1.6042-4). The form breaks
                                       varying tax consequences. The distribu-        total distributions down into taxable and
                                       tion may have no tax effect, or it may         nontaxable categories. Form 5452, Cor-
                                       trigger corporate-level capital gain and/or    porate Report of Nondividend Distribu-
                                       ordinary income. The corporate-level tax       tions, is used to report nondividend distri-
                                       consequences of a nonliquidating corpo-        butions to shareholders.
                                       rate distribution depend on whether the
                                       distribution consists of cash or property         Example 1: A, B, C, and D each own
                                       (other than cash). The corporation does           2,500 shares of J Corp., a C corpora-
                                       not recognize gain or loss when it dis-           tion real estate development company.
                                       tributes cash to shareholders or when it          A disagrees with the other sharehold-
                                       redeems stock in exchange for cash pay-           ers and wants the corporation to re-
                                       ments (Sec. 311(a)).                              deem his stock for $60,000. A has held
                                                                                         his stock for three years, and his stock
                                       Avoiding Corporate-Level Gain                     basis is $59,000. A is not related to the
                                       When a corporation makes a nonliqui-              other shareholders. The corporation
                                       dating distribution of corporate property         cannot afford to redeem the stock en-
                                       other than cash (including a distribution         tirely for cash because its cash balance
                                       to redeem stock), the corporation recog-          of $75,000 must be used primarily to
                                       nizes gain if the property’s fair market          service real estate debt. However, the
                                       value (FMV) exceeds its adjusted tax              shareholders agree that J can distribute
 This case study has been adapted      basis in the corporation’s hands (Sec.            one of the tracts of land to A (see the
 from PPC’s Tax Planning Guide—        311(b)(1)). Specifically, the corporation         exhibit). A does not care which tract of
 Closely Held Corporations, 21st
                                       recognizes gain as if it had sold the appre-      land he receives in redemption of his
 Edition, by Albert L. Grasso, Joan
                                       ciated property for FMV to the recipient          stock because he plans to sell the land
 Wilson Gray, R. Barry Johnson,
 Lewis A. Siegel, Richard L. Burris,   shareholder. When multiple properties             immediately. The other shareholders
 Mary C. Danylak, Timothy Fontenot,    are distributed, the corporation computes         feel that the tracts will appreciate at
 James A. Keller, and Michael E.       gain on an asset-by-asset basis (Rev. Rul.        about the same rate, so they are willing
 Mares, published by Thomson Tax       80-283). The portion of the corporation’s         to distribute any of the tracts. How-
 & Accounting, Ft. Worth, TX, 2008     gain attributable to recapture items              ever, they want to avoid corporate-
 ((800) 323-8724;    (e.g., depreciation recapture) is ordinary        level gain.

5 8 t he tax adviser   January 2009
       Exhibit: Tracts of land owned by J Corp.

                              Basis              FMV             Debt        Net Equity
       Tract 1               $700,000          $750,000        $690,000       $60,000
       Tract 2                300,000           350,000         300,000        50,000
       Tract 3                600,000           600,000         545,000        55,000

    If J distributes Tract 1 or Tract 2 to A          H does not have enough cash to
to redeem his stock, the corporation must         redeem the stock. However, the share-
recognize a $50,000 gain. However, if the         holders have agreed to distribute a par-
corporation distributes Tract 3, it will not      cel of land held for investment purposes
recognize any gain.                               and stock in a publicly traded company,
    J could distribute $5,000 in cash and         I, Inc., to redeem E’s shares. The land
Tract 3 to redeem A’s stock without               has an FMV of $175,000 and basis of
recognizing any corporate-level gain.             $150,000, while the stock has an FMV
This strategy would provide A with the            of $20,000 and basis of $40,000.
$60,000 he wants in exchange for his
stock ($5,000 cash + $55,000 net equity            H cannot deduct a loss on a nonliqui-
in Tract 3). Since all of A’s shares would     dating distribution of depreciated prop-
be redeemed, and because he is unre-           erty. Conversely, if it distributes appreci-
lated to the remaining shareholders, the       ated property it must recognize gain as if
redemption would qualify for stock sale        it had sold the property to the shareholder
(capital gain) treatment as a complete ter-    for its FMV. Since the corporation must
mination of a shareholder’s interest under     compute its gains and losses on an asset-
Sec. 302(b)(3).                                by-asset basis, H would have a recognized
    A’s basis in the stock is $59,000, so      gain of $25,000 from the land and an
he would recognize a $1,000 long-term          unrecognized loss of $20,000 from the I
capital gain from the redemption. His          stock, if those assets were transferred to
basis in the land would equal its FMV          redeem E’s shares.
on the date of distribution, or $600,000.          Instead of distributing the I stock, the
A’s holding period would also begin on         corporation should sell it and distribute
that date.                                     the resulting sales proceeds to E. This
                                               would allow H to recognize a $20,000 tax
Recognizing Corporate-Level                    loss that would mostly offset the $25,000
Loss                                           taxable gain from distributing the appre-
Unfortunately, a corporation cannot            ciated land. Structuring the redemption in
recognize a tax loss on a nonliquidating       this fashion would not cause any adverse
distribution of depreciated property (i.e.,    tax effects for E. She would recognize a
where the property’s FMV is less than the      gain of $45,000 ($195,000 FMV of assets
adjusted basis). A corporation is generally    distributed to her less $150,000 basis in
allowed to recognize tax losses when de-       her redeemed shares) regardless of which
preciated property is distributed to share-    corporate assets she receives.
holders in complete liquidation of the cor-
poration (Sec. 311(a)).                                                              TTA

   Example 2: Assume that H, Inc., is a
   C corporation that is equally owned
   by E, F, and G, who are not related in
   any way. F and G actively manage H.
   Because of disputes regarding F’s and
   G’s salaries, E wants the corporation to
   redeem her stock (which has a basis of
                                                     Albert B. Ellentuck is of coun-
   $150,000). E does not care what assets
                                                     sel with King & Nordlinger,
   she receives as long as they have a total              .,
                                                     L.L.P in Arlington, VA.
   value of $195,000.

                                                                                              t h e ta x a d v i s e r   J a n u a ry 2 0 0 9 5 9

To top