What Happens to NOL in Corporate Liquidation?
When a corporation dissolves, its Net Operating Loss is a key financial consideration. Explore the factors that determine if this tax asset is preserved or lost.
A net operating loss (NOL) occurs when a company’s tax-deductible expenses exceed its taxable income for the year. This situation often arises during a company’s early years or in cyclical industries. An NOL is a valuable tax attribute because it can be used to reduce taxes in more profitable years. The process of corporate liquidation involves winding up a company’s affairs, selling assets, paying debts, and distributing any remaining assets to shareholders.
NOL Utilization by the Liquidating Corporation
A corporation in the process of liquidating can use its existing Net Operating Losses (NOLs) to offset income generated during the winding-down period. For instance, if the corporation sells assets like buildings or equipment at a gain, the NOL can be applied to reduce the tax on that gain. The corporation can also use losses from its final year of operation, along with any NOLs carried forward from previous years.
For NOLs that arose in tax years after 2020, a carryback is not permitted. These NOLs can be carried forward indefinitely, though their use may be limited to 80% of taxable income in the carryforward year.
Transfer of NOLs in Parent-Subsidiary Liquidations
While a corporation’s Net Operating Loss (NOL) usually disappears with the company, an exception exists when a subsidiary is liquidated into its parent. Under specific Internal Revenue Code (IRC) provisions, the parent corporation can inherit the subsidiary’s NOLs. This transfer is governed by IRC Section 332, which outlines the requirements for a tax-free liquidation.
To qualify, the parent must own at least 80% of the subsidiary’s stock and receive all its property in complete cancellation of its stock within a set timeframe. If the liquidation qualifies as tax-free, IRC Section 381 allows the parent to inherit the subsidiary’s tax attributes, including NOL carryovers. The parent can begin using the inherited NOLs in its first taxable year ending after the subsidiary’s final distribution.
However, the use of these inherited NOLs may be restricted. If the subsidiary had a significant ownership change, an annual limit applies to how much of the NOL can be used. This limit is based on the subsidiary’s value and an IRS-published rate.
Consequences for Shareholders
When a C corporation liquidates and its Net Operating Losses (NOLs) are not transferred to a parent company, they are extinguished and do not pass through to individual shareholders. For shareholders, the liquidation is treated as if they sold their stock back to the corporation for the cash or property distributed. A shareholder must calculate a capital gain or loss by comparing the fair market value of the assets received against their adjusted basis in the stock. If the value of the distributed property exceeds the stock basis, the shareholder has a capital gain; if the basis is greater, they have a capital loss.
This shareholder-level capital loss is distinct from the corporation’s NOL. A shareholder’s capital loss can be used to offset their capital gains from other investments. If capital losses exceed capital gains, an individual can deduct up to $3,000 of the excess loss against other income annually, with any remainder carried forward to future tax years.
The treatment differs for S corporations, where income and losses are passed through to shareholders annually. Because of this structure, large corporate-level NOLs are less common. The liquidation of an S corporation is also treated as an exchange of stock for assets, but the shareholder’s gain or loss is adjusted for any income or loss passed through during the final year.
Final Tax Reporting Requirements
Finalizing a corporate liquidation involves specific tax reporting to formally notify the IRS and close the company’s accounts. A corporation must file a final income tax return for the year it ceases operations, using either Form 1120 for a C corporation or Form 1120-S for an S corporation. The box indicating it is a “final return” must be checked on the form.
The corporation must also file Form 966, Corporate Dissolution or Liquidation, within 30 days of adopting the plan to dissolve. A certified copy of the liquidation plan should be attached to this form.
Finally, the corporation reports distributions to shareholders using Form 1099-DIV. For each shareholder, this form must show any cash distributions in Box 9 and the fair market value of non-cash property in Box 10. This information allows shareholders to accurately calculate their capital gain or loss.