Many business owners and shareholders of corporations will ask their tax attorney and/or business attorney, “what is a complete liquidation, and what are the tax implications to the C Corporation and the shareholders upon a complete liquidation?” I always find it interesting, maybe even ironic that the term “Complete Liquidation” is not defined in the Internal Revenue Code, and nor is it defined in the applicable Section 331 regulations. However, Federal Tax Regulations § 1.332-2(c) holds:
A status of liquidation exists when the corporation ceases to be a going concern and its activities are merely for the purpose of winding up its affairs, paying its debts, and distributing any remaining balance to its shareholders. A liquidation may be completed prior to the actual dissolution of the liquidating corporation. However, legal dissolution of the corporation is not required. Nor will there mere retention of a nominal amount of assets for the sole purpose of preserving the corporation’s legal existence disqualify the transaction.
IRC § 346(a) also allows for a series of distributions that are pursuant to a plan of liquidation to constitute a formal liquidation of the corporation. Therefore, it is apparent that a complete liquidation can occur without a formal dissolution and through a series of distributions. The United States Tax Court generally applies a three part test in determining whether there was a plan to liquidate: 1) Was there a manifest intent to liquidate; 2) Was there a continuing purpose to terminate corporate affairs and dissolve; and, 3) Were the corporate affairs confined and directed to the purpose of liquidation.
Substance over form will control the analysis of whether a corporation has completely liquidated, and the facts will control this analysis. If distributions are made to shareholders of the corporation before there is sufficient evidence to prove there was actual intent to liquidate the corporation, these distributions are likely to be treated as dividends in the eyes of the Internal Revenue Service as opposed to capital gain.
Shareholders receive a benefit through the complete liquidation because under IRC § 331(a), the amounts received by the shareholders are considered full payment in exchange for their stock, and therefore the shareholder receives capital gain treatment as opposed to a dividend distribution. As a capital gain, the shareholder is able to use their basis in the stock to offset or lower the capital gain. Further, this capital gain realized by the shareholder can be offset or lowered if the shareholder has other capital losses.
The earnings and profits of the corporation vanish when the corporation completely liquidates, whereas prior to the liquidation, the amount of the corporate earnings & profits was a figure that would have measured dividend distributions to the shareholders and had thus far, not been taxed at the individual level. Therefore, when a corporation completely liquidates, the earnings and profits of the corporation “escape” taxation as dividend distributions to shareholders.
As a Denver tax attorney and business attorney, John McGuire of The McGuire Law Firm can assist corporations and shareholders regarding complete liquidations and the tax implications to the corporation & shareholders.