What Happens to NOL in Corporate Liquidation?

A net operating loss (NOL) occurs when a company’s allowable tax deductions exceed its taxable income in a given year. Corporate liquidation is the structured process of winding down a business, selling its assets, and distributing proceeds to shareholders. This article explores how NOLs are treated when a corporation undergoes liquidation, which is important for understanding the tax implications for both the dissolving corporation and its investors.

Understanding Net Operating Losses

A net operating loss arises when a corporation’s ordinary and necessary business expenses and other deductions surpass its gross income during a tax year. The Internal Revenue Code allows corporations to use these losses to offset taxable income in other years, providing a mechanism to balance the tax burden over time.

Historically, NOLs could be carried back to offset income in prior years, potentially resulting in tax refunds, and carried forward to reduce future taxable income. However, current rules, largely influenced by the Tax Cuts and Jobs Act of 2017, generally eliminated the ability to carry back losses for NOLs generated after December 31, 2017. Instead, these NOLs can be carried forward indefinitely.

A notable limitation for post-2017 NOLs is that they can only offset up to 80% of a corporation’s taxable income in any given future year. This means a corporation cannot reduce its taxable income to zero using only post-2017 NOLs. For example, if a corporation has a $100,000 NOL and $50,000 in taxable income, it can only use $40,000 of the NOL to reduce its taxable income to $10,000. Any remaining NOL can then be carried forward.

Corporate Liquidation Basics

From a tax perspective, corporate liquidation involves a series of steps culminating in the termination of the corporation’s tax existence. When a corporation liquidates, it typically distributes its assets to its shareholders in exchange for their stock. Under Section 336 of the Internal Revenue Code, the liquidating corporation generally recognizes gain or loss on the distribution of its assets to shareholders. This recognition occurs as if the corporation had sold these assets at their fair market value immediately before the distribution.

The fair market value of the assets distributed determines the amount of gain or loss recognized by the corporation. This “as if sold” rule can trigger a corporate-level tax liability, even if no actual sale to an outside party occurs. For instance, if a corporation distributes property with a fair market value exceeding its tax basis, the corporation must report a taxable gain.

Once all assets are distributed and any corporate tax liabilities are settled, the corporation’s tax existence generally ceases. This cessation is formally reported to the Internal Revenue Service (IRS) by filing the corporation’s final income tax return, marking the end of the corporate entity for federal tax purposes.

NOL Treatment During Corporate Liquidation

The treatment of a corporation’s existing net operating losses during liquidation is specific and generally restrictive. As a corporation proceeds with liquidation, any NOLs it possesses can be used to offset taxable income generated in its final tax year. This includes income from the sale of assets during the winding-up period or any operating income earned before the final distributions. For instance, if asset sales during liquidation generate significant taxable gains, existing NOLs can reduce or eliminate the corporate-level tax on these gains.

However, any unused NOLs generally expire when the corporation ceases to exist. Once the corporate entity is dissolved, there is no ongoing taxable income against which to apply the remaining NOLs. These unused tax attributes cannot be carried forward to any subsequent period because the taxpayer no longer exists to utilize them.

There are specific scenarios where NOLs might survive a corporate transaction that resembles a liquidation but is part of a larger restructuring. Under Section 381 of the Internal Revenue Code, NOLs and other tax attributes can carry over to an acquiring corporation in specific types of tax-free reorganizations or liquidations of a subsidiary into its parent. In such cases, the acquiring corporation succeeds to the NOLs of the target corporation, subject to various limitations.

Even when NOLs can carry over in a Section 381 transaction, their utilization may be significantly limited by Section 382 of the Internal Revenue Code. Section 382 imposes an annual limitation on the use of a corporation’s pre-change NOLs if there has been an “ownership change.” An ownership change typically occurs when the percentage of stock owned by one or more 5-percent shareholders increases by more than 50 percentage points over a rolling three-year period. If triggered, this limitation restricts the amount of pre-change NOLs that can be used each year to offset post-change taxable income.

If a liquidation is part of a transaction that causes such an ownership change, or if a change already occurred prior to liquidation, the ability to use the NOLs, even in the corporation’s final year or if transferred to an acquirer, could be severely constrained. These complex rules emphasize that while some exceptions exist, the general rule remains that NOLs are vulnerable during corporate dissolution.

Shareholder Tax Consequences of Corporate Liquidation

When a corporation liquidates, the tax implications for its shareholders are distinct. Shareholders generally treat distributions received in complete liquidation as full payment in exchange for their stock, under Section 331 of the Internal Revenue Code, resulting in a capital gain or loss. The amount of this gain or loss is determined by the difference between the fair market value of the assets received and the shareholder’s adjusted tax basis in their stock.

For example, if a shareholder receives $10,000 in cash and property with a fair market value of $15,000 for stock that had a $12,000 basis, they would recognize a capital gain of $13,000. This gain is usually taxed at capital gains rates, which can vary based on the holding period of the stock and the shareholder’s individual income tax bracket. If the fair market value of assets received is less than the stock basis, the shareholder may recognize a capital loss.

The corporation’s net operating losses do not directly pass through to its shareholders. Shareholders cannot use the corporation’s unused NOLs on their personal income tax returns to offset their own taxable income. Corporate tax attributes generally remain at the corporate level, as the corporation and its shareholders are considered separate legal and tax entities.

However, a corporation’s NOLs can have an indirect impact on shareholders. If a corporation had significant taxable income during its existence but also sufficient NOLs to offset that income, it would have paid less corporate-level tax. This reduction in tax liability would leave more assets within the corporation available for distribution to shareholders during liquidation. Consequently, higher distributions could lead to larger capital gains for shareholders, as the fair market value of received assets would be greater. Conversely, if the corporation did not have NOLs to offset its income, the corporate-level tax burden would reduce the assets available for distribution, potentially leading to smaller capital gains or even capital losses for shareholders.