Code Section 331: Shareholder Tax on Corporate Liquidations

A complete corporate liquidation marks the end of a company’s existence, where the business ceases operations, settles debts, and distributes remaining assets to its shareholders. This final distribution has direct tax consequences for those who own stock. The Internal Revenue Code governs how shareholders must treat the receipt of these assets, whether in the form of cash, property, or both. Understanding these rules is necessary for any shareholder involved in a corporate dissolution.

Shareholder Tax Treatment in a Complete Liquidation

Under Internal Revenue Code Section 331, distributions from a complete liquidation are treated as a payment in exchange for the shareholder’s stock. This “sale or exchange” treatment means the shareholder recognizes a capital gain or loss, not a dividend taxed as ordinary income. The nature of the gain or loss depends on the stock’s holding period.

If the stock was held for more than one year, the result is a long-term capital gain or loss. If held for one year or less, it results in a short-term capital gain or loss, which is taxed at higher ordinary income rates. If a shareholder owns different blocks of stock acquired at various times, the gain or loss must be calculated separately for each block.

Calculating Shareholder Gain or Loss

A shareholder’s capital gain or loss is calculated by subtracting their adjusted basis in the stock from the amount realized in the distribution. The “amount realized” is the total value received, which includes any cash plus the Fair Market Value (FMV) of all other property. FMV is the price that property would sell for on the open market. The amount realized is reduced by any corporate liabilities the shareholder assumes.

A shareholder’s “adjusted basis” is their original purchase price, adjusted for subsequent events like non-dividend distributions that reduce basis. For most investors, the basis is what they paid for the shares.

For example, a shareholder with an adjusted stock basis of $50,000 receives $80,000 in cash and land with an FMV of $120,000. The amount realized is $200,000 ($80,000 + $120,000). Subtracting the $50,000 basis results in a $150,000 capital gain.

Shareholder Basis in Distributed Property

Under Internal Revenue Code Section 334, a shareholder’s basis in any non-cash property received in a liquidation is its Fair Market Value (FMV) on the distribution date. This new basis is used to calculate gain or loss on a future sale of that property. For instance, if a shareholder receives property with an FMV of $120,000, their basis in that property becomes $120,000.

This “stepped-up” or “stepped-down” basis is a direct consequence of the shareholder recognizing a gain or loss on the property’s value during the liquidation. Establishing the basis at its market value prevents double taxation. It ensures that only future changes in the property’s value are taxed when the shareholder later sells it.

Reporting Liquidating Distributions

Shareholders must report the transaction to the IRS. The process begins when the liquidating corporation issues Form 1099-DIV, “Dividends and Distributions.” Cash liquidating distributions are reported in Box 9, and non-cash distributions are noted in Box 10.

The shareholder uses this information to complete Form 8949, “Sales and Other Dispositions of Capital Assets.” On this form, the shareholder details the transaction by listing the proceeds received, their cost basis in the stock, and the dates of acquisition and sale.

Finally, the totals from Form 8949 are transferred to Schedule D, “Capital Gains and Losses.” This schedule is filed with the shareholder’s Form 1040 tax return and consolidates all capital gains and losses for the year to determine the final tax liability.

Related Tax Considerations

The rules under Section 331 do not apply to every corporate liquidation. An exception exists for the liquidation of a controlled subsidiary into its parent company. If a parent corporation owns at least 80% of a subsidiary’s stock, the liquidation is governed by Internal Revenue Code Section 332. Under this section, the parent corporation does not recognize a gain or loss on the receipt of the subsidiary’s assets.

Another consideration arises when a shareholder receives an installment obligation, which is a promissory note from a third party. Under Internal Revenue Code Section 453, if the corporation acquired this note from a sale of its assets within 12 months of the liquidation, the shareholder may defer gain. This allows the shareholder to report the gain proportionally as they receive payments on the note, rather than all at once.