Revenue Ruling 83-55: Applying the Cost Recovery Method

When a corporation sells its assets and distributes the proceeds to its shareholders over several years, a specific tax treatment may be available. This situation arises during a complete corporate liquidation. The structure of these payments, particularly when the total amount is not immediately known, creates a unique circumstance for shareholders. Understanding the tax implications is necessary for proper financial planning and reporting.

Qualifying for Special Tax Treatment

For a shareholder to use this special tax treatment, the corporation must first adopt a formal plan of complete liquidation. The distributions made to shareholders must be part of a series of payments, not a single lump-sum distribution. This series of distributions must also span more than one taxable year for the shareholder.

A defining condition for this treatment is that the total value of all liquidating distributions cannot be reasonably determined in the year the first payment is made. This uncertainty often occurs when the corporation’s assets are sold for contingent payments, such as royalties or earn-outs. If the total payout is fixed and known from the beginning, this specific cost recovery approach does not apply, and other tax rules, like the installment method, might be required.

Applying the Cost Recovery Method

The cost recovery method dictates how a shareholder treats the series of liquidating distributions. The first step is to determine the shareholder’s adjusted basis in their stock. This basis is typically what the shareholder originally paid for the stock, adjusted for certain corporate actions like stock dividends or non-taxable distributions.

Under this method, any distributions received are first treated as a non-taxable return of this basis. This means the shareholder does not report any income or gain from the distributions until their entire stock basis has been recovered. Each payment received reduces the remaining basis dollar-for-dollar. Once the cumulative distributions equal the shareholder’s basis, reducing it to zero, any subsequent payments received are treated as a taxable capital gain.

Consider a shareholder with a stock basis of $20,000. In year one, the corporation distributes $10,000. This amount is not taxable; it reduces the shareholder’s basis to $10,000. In year two, another $15,000 is distributed. The first $10,000 of this payment is a non-taxable recovery of the remaining basis, while the excess $5,000 is reported as a capital gain in year two. Any further distributions in subsequent years would be fully taxable as capital gains.

Shareholder Tax Filing Requirements

Once a capital gain is recognized under the cost recovery method, it must be properly reported to the IRS on Form 8949, Sales and Other Dispositions of Capital Assets. This form is used to detail the specifics of the capital gain, including the amount received that exceeds the stock’s basis.

The totals from Form 8949 are then carried over to Schedule D (Form 1040), Capital Gains and Losses. It is important for the shareholder to maintain records throughout the liquidation period. These records should document the original stock basis and track every distribution received from the corporation to accurately determine when the basis is fully recovered and a taxable gain is realized.