Section 334: Basis of Property Received in Liquidations

A corporate liquidation is the process by which a company ceases operations and distributes its assets to shareholders. For shareholders, a key question is how to determine the tax basis of the property they receive. This basis is used for future tax calculations, such as determining gain or loss on a subsequent sale or calculating annual depreciation deductions.

Determining Asset Basis in Taxable Liquidations

The general rule for determining the basis of assets received in a corporate liquidation is found in Internal Revenue Code Section 334. This rule applies to taxable liquidations, where the shareholder’s receipt of the assets is a taxable event. In this scenario, the shareholder must recognize a capital gain or loss, calculated as the difference between the fair market value of the assets received and the shareholder’s adjusted basis in their stock.

The shareholder’s new basis in the property received is its fair market value (FMV) at the time of the distribution. Fair market value is the price that property would sell for on the open market. The corporation’s own tax basis in the asset is irrelevant, as the asset’s basis is “stepped-up” or “stepped-down” to its current market value.

For example, a shareholder receives equipment with an FMV of $50,000, even though the corporation’s adjusted basis was only $10,000. The shareholder’s basis in that equipment is now $50,000, which would result in smaller taxable gains on a future sale.

This FMV basis rule is a consequence of the transaction being taxable. Because the shareholder recognizes a gain or loss on the receipt of the property, the tax code treats the shareholder as if they had purchased the asset for its full market value. This principle applies to individual shareholders and corporate shareholders that do not qualify for tax-free treatment.

Asset Basis in Tax-Free Subsidiary Liquidations

An exception to the fair market value basis rule exists for the tax-free liquidation of a subsidiary into its parent corporation. These transactions are governed by IRC Section 332, which allows a parent to absorb a subsidiary without immediate tax consequences. To qualify, the parent corporation must own at least 80% of the total voting power and 80% of the total value of the subsidiary’s stock. The property distribution must also occur within a single taxable year or be part of a series of distributions completed within three years under a formal plan of liquidation.

When a liquidation qualifies as tax-free, a “carryover basis” rule applies. This is a direct contrast to the FMV basis rule for taxable liquidations. A carryover basis means the parent corporation’s basis in the distributed assets is the same as the subsidiary’s basis in those assets immediately before the liquidation.

For example, a parent corporation liquidates a subsidiary it controls and receives a building with an FMV of $1 million. If the subsidiary’s own adjusted basis in the building was only $200,000, the parent corporation’s basis is the subsidiary’s $200,000 basis, not the $1 million FMV.

This carryover basis approach aligns with the tax-free nature of the transaction. Since the parent corporation does not recognize any gain or loss, the tax system defers the potential gain. The built-in gain is preserved in the hands of the parent company, which it will recognize if it later sells the building for $1 million.

Tax Consequences for the Liquidating Corporation

The liquidating corporation itself also faces tax consequences. The general rule, found in IRC Section 336, is that a liquidating corporation must recognize gain or loss as if it had sold its assets to the shareholders at fair market value. This treatment ensures that the appreciation of corporate assets is taxed at the corporate level before those assets are distributed to shareholders.

For instance, if a corporation distributes land with an FMV of $750,000 and a basis of $150,000, it must recognize a gain of $600,000. If the distributed property is subject to a liability, the FMV is treated as being not less than the amount of that liability for purposes of calculating the gain.

A major exception to this rule applies in the context of the tax-free subsidiary liquidations discussed previously. When a subsidiary liquidates into its controlling parent, the subsidiary generally does not recognize gain or loss on the assets it distributes to the parent company. This non-recognition treatment at the corporate level mirrors the tax-free treatment for the parent shareholder.

This parallel treatment highlights the different outcomes of the liquidation structures. In a standard taxable liquidation, tax may be incurred at both the corporate level and the shareholder level. In a qualifying parent-subsidiary liquidation, the tax is generally deferred for both the liquidating subsidiary and the parent corporation, preserving the asset’s underlying tax attributes through the carryover basis mechanism.