U.S. Tax Consequences of Liquidating a CFC

A Controlled Foreign Corporation, or CFC, is a foreign-based company where U.S. shareholders own more than 50% of the stock. The process of corporate liquidation involves formally closing down the business and distributing its assets to shareholders. When a CFC is liquidated, it creates a complex series of U.S. tax implications for its American shareholders. This event requires navigating specific Internal Revenue Code sections that govern how both the shareholders and the corporation are taxed.

Shareholder-Level Tax Consequences of a Taxable Liquidation

The default tax treatment for a shareholder receiving a distribution from a liquidating corporation falls under Internal Revenue Code (IRC) Section 331. This rule treats the assets received as full payment for their stock, requiring the shareholder to recognize a capital gain or loss. This gain or loss is calculated as the difference between the fair market value of the distributed assets and the shareholder’s adjusted basis in the stock.

A modification to this rule comes from IRC Section 1248, which can recharacterize what would otherwise be a long-term capital gain into ordinary income taxed at higher rates. The amount recharacterized as a dividend is limited to the shareholder’s share of the CFC’s post-1962 earnings and profits (E&P) not already subject to U.S. tax. This rule prevents shareholders from converting deferred foreign earnings into lower-taxed capital gains through liquidation.

To prevent double taxation on income already taxed in the U.S., IRC Section 959 provides an exception. Under the Subpart F and GILTI regimes, U.S. shareholders often include a portion of a CFC’s income in their own taxable income annually, even if no cash is distributed. This is known as Previously Taxed Income (PTI). When a CFC liquidates, distributions of PTI are received tax-free and increase the shareholder’s stock basis, which reduces the total capital gain.

For the portion of the gain treated as a dividend, U.S. corporate shareholders may be able to claim deemed-paid foreign tax credits under IRC Section 960. This allows the shareholder to receive a credit for foreign income taxes paid by the CFC on those earnings. This credit mechanism is designed to mitigate double taxation on the same income by both a foreign country and the United States.

Corporation-Level Tax Consequences of a Taxable Liquidation

The liquidation process also triggers a taxable event for the CFC itself, governed by Internal Revenue Code (IRC) Section 336. This rule treats the CFC as if it sold all of its assets to its shareholders at fair market value (FMV) on the liquidation date. This deemed sale occurs at the corporate level and is separate from the tax consequences faced by shareholders. The CFC must then recognize a gain or loss on each asset, calculated as the difference between its FMV and the CFC’s adjusted basis. For example, if a CFC holds property with an adjusted basis of $1 million and an FMV of $3 million, it would recognize a $2 million gain.

This deemed sale applies to all corporate assets, including tangible property, intellectual property, and goodwill. The resulting gains and losses adjust the CFC’s earnings and profits (E&P). An increase in E&P from these gains can expand the amount of income recharacterized as a dividend to the U.S. shareholder, directly linking the corporate-level event to the shareholder’s tax liability.

Tax-Free Liquidation into a U.S. Corporate Parent

An alternative is a tax-free liquidation under Internal Revenue Code (IRC) Section 332, which allows for the tax-free dissolution of a subsidiary into its parent. This option requires the U.S. parent corporation to own at least 80% of the CFC’s total voting power and stock value. The distribution must be in complete cancellation of the subsidiary’s stock and occur within a single taxable year or pursuant to a plan of liquidation completed within three years.

If these conditions are met, neither the U.S. parent nor the liquidating CFC recognizes gain or loss on the asset transfer, a departure from a taxable liquidation where both parties recognize gains. Under IRC Section 381, the U.S. parent corporation also inherits the tax attributes of the liquidating CFC. This includes its historical earnings and profits (E&P) or any deficit in E&P. The parent also assumes the CFC’s accounts for Previously Taxed Income (PTI), ensuring this income can still be distributed tax-free in the future.

While the liquidation itself may be tax-free, IRC Section 367(b) acts as a gatekeeper to prevent the permanent avoidance of U.S. tax on a CFC’s deferred foreign earnings. This regulation requires the U.S. parent shareholder to include in its income, as a deemed dividend, the “all earnings and profits amount” of the CFC, which represents all of its untaxed E&P. This income inclusion ensures that the deferred earnings are subject to U.S. tax upon repatriation.

Alternative Structures Resulting in Deemed Liquidation

A formal legal liquidation is not the only path to trigger these tax consequences. A U.S. shareholder can achieve a similar outcome through a “check-the-box” election, which allows an eligible foreign entity to choose its classification for U.S. tax purposes. For instance, a foreign corporation with a single owner can elect to be treated as a disregarded entity, which is ignored as separate from its owner.

When a shareholder files this election to change a CFC’s classification from a corporation to a disregarded entity or partnership, the IRS treats it as a deemed liquidation. Regulations specify that the foreign corporation is treated as distributing all of its assets and liabilities to its shareholders in a complete liquidation on the day before the election’s effective date. This administrative action mirrors the economic reality of a legal liquidation without requiring formal dissolution of the entity under foreign law. This deemed event triggers the tax rules for a taxable liquidation, resulting in gain recognition at both the corporate and shareholder levels.

Shareholders use this strategy to simplify their international structure and future tax compliance. By converting a CFC into a disregarded entity, the U.S. owner can treat the foreign operations as a branch for U.S. tax purposes, eliminating complex CFC reporting in subsequent years. This can also be advantageous for preparing for a future sale of the foreign business, as the transaction would then be treated as a direct asset sale by the U.S. owner.

U.S. Tax Reporting and Compliance

The liquidation of a CFC is a reportable event requiring specific disclosures to the IRS. The primary compliance document is Form 5471, Information Return of U.S. Persons With Respect to Certain Foreign Corporations. A U.S. shareholder must file a final Form 5471 for the CFC’s last taxable year, providing information on its final financial state.

On this final form, the shareholder must report the CFC’s closing balance sheet and a final income statement reflecting gains and losses from the deemed asset sale. A part of this filing is Schedule P, which tracks the CFC’s Previously Taxed Income (PTI). The shareholder must accurately report the final PTI balances to substantiate any tax-free distributions and provide a detailed reconciliation of the CFC’s E&P.

If a “check-the-box” election is used for a deemed liquidation, the entity must also file Form 8832, Entity Classification Election. This form notifies the IRS of the classification change and establishes its effective date, and it must include a valid Employer Identification Number (EIN) for the foreign entity. Failure to file required forms can result in penalties starting at $10,000 per annual accounting period.