Tax Consequences of a Section 331 Liquidation

A corporate liquidation signifies the complete termination of a company’s operations. In this process, the corporation settles its debts and distributes its remaining assets to the shareholders. This distribution of assets, whether in cash or property, is a taxable event for both the corporation and its shareholders, requiring careful calculation and reporting of specific tax consequences.

Shareholder Tax Consequences

Under Internal Revenue Code Section 331, distributions in a complete corporate liquidation are treated as full payment in exchange for the shareholder’s stock. This transaction is considered a sale or exchange, not a dividend. A shareholder must calculate their gain or loss, which is the fair market value (FMV) of the assets received, less any corporate liabilities the shareholder assumes, minus the shareholder’s adjusted basis in their stock.

For example, a shareholder owns stock with an adjusted basis of $50,000. In a complete liquidation, they receive land with an FMV of $150,000 and assume a $20,000 mortgage on that land. The amount realized by the shareholder is $130,000 ($150,000 FMV – $20,000 liability). The taxable gain is then calculated by subtracting the stock basis from the amount realized, resulting in an $80,000 gain ($130,000 – $50,000).

The character of this gain or loss is capital. Whether it is a short-term or long-term capital gain or loss depends on how long the shareholder held the stock. If a shareholder owns multiple blocks of stock acquired at different times and for different prices, the gain or loss must be calculated separately for each block, which can result in both gains and losses from the same distribution.

If the liquidation involves a series of distributions over multiple tax years, the shareholder can first recover their entire stock basis before recognizing any gain. Once cumulative distributions exceed their basis, subsequent distributions are treated as capital gain. A shareholder cannot recognize a loss until the final distribution is received, as the total amount is not known until that point.

Corporate Tax Consequences

From the corporation’s perspective, a liquidation is also a taxable event. Under Internal Revenue Code Section 336, the corporation is treated as if it sold all of its assets at their fair market value (FMV). The corporation’s gain or loss is calculated for each asset by subtracting its adjusted basis from the asset’s FMV at the time of distribution.

This corporate-level tax leads to “double taxation.” The corporation first pays income tax on any appreciation in its assets’ value. For instance, if a corporation distributes a building with an FMV of $1 million and an adjusted basis of $400,000, it must recognize a $600,000 gain and pay corporate income tax on it.

After the corporate-level tax, shareholders pay tax on the liquidating distribution they receive. This two-tiered tax structure, where the same economic gain is taxed at both the corporate and shareholder levels, is a primary consideration. This treatment distinguishes C-corporations from pass-through entities like S-corporations, which avoid the corporate-level tax on liquidation.

Shareholder’s Basis in Distributed Property

A shareholder who receives property in a liquidation must establish a new tax basis for those assets. Under Internal Revenue Code Section 334, the shareholder’s basis in any property received is its fair market value (FMV) at the time of the distribution. This is often referred to as a “stepped-up” basis.

Since the shareholder has already recognized a gain or loss on the property’s receipt based on its FMV, their new basis becomes that same FMV. This prevents the same appreciation from being taxed again when the shareholder later disposes of the asset. For example, if a shareholder receives equipment with an FMV of $75,000, their basis for that equipment is $75,000.

This new basis is used for the shareholder’s future tax obligations. If an asset is depreciable, the shareholder will use this new FMV basis to calculate depreciation deductions. This basis will also be used to determine gain or loss on a subsequent sale of the asset.

Reporting and Procedural Requirements

Both the corporation and its shareholders must meet specific reporting requirements. The liquidating corporation must file Form 966, Corporate Dissolution or Liquidation, with the IRS within 30 days after adopting the plan to liquidate.

The corporation must also file a final federal income tax return for the year of its completed liquidation. This return will report the gain or loss recognized on the sale of its assets. The corporation must mark the return as its final one to signal to the IRS that it has ceased operations.

The corporation must issue Form 1099-DIV to each shareholder, reporting the cash and fair market value of property distributed. Shareholders use this information to calculate their capital gain or loss. This gain or loss is then reported on their personal income tax return on Schedule D (Form 1040).