Partial Liquidation: Tax Treatment and Requirements

A partial liquidation is a distribution a C corporation makes to its non-corporate shareholders by redeeming a portion of its stock. The transaction must be part of a significant contraction of the corporation’s business. For shareholders, the distribution is treated as a sale of their stock, not as a dividend. This allows for a more favorable tax outcome, as the proceeds are taxed at lower capital gains rates instead of higher ordinary income rates.

Qualifying as a Partial Liquidation

For a distribution to be recognized as a partial liquidation, it must not be “essentially equivalent to a dividend.” This is determined by the distribution’s effect on the corporation’s business, not a shareholder’s ownership. The distribution must also follow a formal plan and occur within the taxable year the plan is adopted or the following year.

This standard is met under the corporate contraction doctrine, which requires a significant reduction in business activities. For example, if a fire destroys a factory and the company ceases that business line, distributing the insurance proceeds could qualify. The corporation must discontinue a distinct operation, not just distribute funds from a canceled expansion.

The tax code also provides a safe harbor rule. This rule applies if the distribution is from the corporation ceasing a “qualified trade or business” while continuing to operate at least one other business. Both the terminated and continuing businesses must have been actively conducted for the five-year period ending on the date of the distribution, and neither can have been acquired in a taxable transaction during that time.

Tax Consequences for Shareholders and the Corporation

For a non-corporate shareholder, a qualifying distribution is treated as a payment for their stock. This allows the shareholder to recover their tax basis in the redeemed shares. Gain or loss is calculated by subtracting the stock’s basis from the fair market value of the distribution received.

Any resulting gain is classified as a capital gain, subject to lower tax rates than ordinary income if the stock was held for more than one year. This differs from a dividend, which is taxed as ordinary income without any reduction for the shareholder’s stock basis.

From the corporation’s perspective, distributing appreciated property is a taxable event. The corporation must recognize a gain as if it sold the property at its fair market value. However, if the distributed property’s value is less than its tax basis, the corporation cannot recognize a loss on the distribution.

Information and Reporting Requirements

Properly documenting a partial liquidation requires a formal plan adopted by the corporation’s board of directors. This plan must outline the intent to partially liquidate, identify the assets to be distributed, and establish a clear timeline for the distribution. The corporation must then notify the IRS of its plan by filing Form 966, Corporate Dissolution or Liquidation.

The corporation is also responsible for reporting the distribution to shareholders using Form 1099-DIV, Dividends and Distributions. The total amount of cash and the fair market value of any property distributed is reported in Box 9 of this form. This provides shareholders with the necessary information for their own tax returns.

Executing the Partial Liquidation

The execution phase involves a series of time-sensitive actions. The corporation must file Form 966 with the IRS within 30 days after the plan of partial liquidation is adopted. The distribution of assets to shareholders must occur within the taxable year the plan is adopted or the following year.

The corporation must issue Form 1099-DIV to each shareholder and file copies with the IRS by the annual deadline, January 31 of the year following the distribution. Upon receiving this form, each shareholder reports the transaction on their personal income tax return. The capital gain or loss is reported on Schedule D of Form 1040.