What Is the Liquidation-Reincorporation Doctrine?

The liquidation-reincorporation doctrine is a principle the Internal Revenue Service (IRS) uses to address corporate transactions where shareholders dissolve a corporation and then transfer its operating assets to a new corporation they also control. The doctrine’s purpose is to prevent a “bailout” of corporate earnings at favorable tax rates. Shareholders might attempt this to withdraw cash from the business and have it taxed as long-term capital gains instead of ordinary income. The IRS looks past the transaction’s form to its underlying substance, ensuring the tax consequences match the economic reality of a continuing business.

Core Elements of the Doctrine

For the doctrine to be invoked, the IRS and courts look for two main conditions. The first is shareholder continuity, which requires that the shareholders of the old corporation retain a significant ownership interest in the new one. A common benchmark used by courts and the IRS is a 50% or greater interest in the new corporation by the shareholders of the old one. This analysis focuses on the substance of the ownership rather than just formal titles.

The second element is the continuity of the business enterprise. This condition is met if the essential business activities of the liquidated corporation are carried on by the new entity. It is not necessary for the new business to be an exact replica; the test is met if the new corporation continues the core operations, uses the same assets, or serves the same customer base. A mere change in name or location is not enough to defeat this test if the fundamental business purpose remains intact.

Beyond these two tests, there is often an analysis of whether an overall plan of reorganization existed. The IRS may apply the step-transaction doctrine, which integrates a series of formally separate steps into a single transaction for tax purposes. If the liquidation and reincorporation are interdependent and prearranged, they may be treated as one integrated plan.

Recharacterization as a Type D Reorganization

When the IRS successfully applies the doctrine, it recharacterizes the events as a specific type of corporate reorganization, most commonly a Type D reorganization under Internal Revenue Code Section 368. A Type D reorganization requires a corporation to transfer all or part of its assets to another corporation. Immediately after the transfer, the transferring corporation or its shareholders must be in control of the corporation that received the assets.

For these purposes, the law defines control as owning stock that possesses at least 50% of the total voting power and 50% of the total value of all classes of stock. The facts of a liquidation-reincorporation map onto these requirements, with the old corporation’s dissolution treated as the asset transfer and the shareholders’ ownership of the new entity satisfying the control test. This recharacterization allows the IRS to apply the tax rules governing reorganizations rather than liquidations.

Tax Consequences of Recharacterization

Once a transaction is reclassified as a Type D reorganization, the tax implications change significantly. The most impactful consequence is the treatment of any cash or property that shareholders withdrew. Instead of being treated as a payment for stock in a liquidation generating capital gains, these distributions are considered “boot.”

Under Internal Revenue Code Section 356, boot is taxed as ordinary income to the extent of the shareholder’s share of the corporation’s accumulated earnings and profits (E&P). Since these schemes are designed to distribute E&P, the entire distribution will likely be taxed at higher ordinary income rates, negating the transaction’s intended tax benefit.

The corporate-level tax consequences are also altered. The new corporation must take a “carryover basis” in the assets received, meaning its basis in the assets is the same as the old entity’s basis. This prevents shareholders from receiving a “stepped-up” basis to fair market value, which would have led to larger depreciation deductions. Other tax attributes, such as the E&P account and net operating losses, also carry over from the old corporation to the new one, though the use of losses may be subject to limitations under Section 382.

Key Judicial Precedents

The liquidation-reincorporation doctrine developed through a series of court decisions that affirmed the IRS’s ability to look beyond a transaction’s formal steps. In Bazley v. Commissioner, the Supreme Court held that a transaction that was in substance a distribution of earnings should be taxed as a dividend, even if it met the literal definition of a reorganization. The court established that the net effect of a transaction, rather than its form, dictates the tax treatment.

In Davant v. Commissioner, two corporations were controlled by the same shareholders, and the assets of one were sold to the other before the first was liquidated. The court found the transaction was a reorganization and held that the earnings and profits of both corporations could be aggregated to determine the amount of the dividend. This case reinforced the “substance over form” principle in this context.

The case of James Armour, Inc. v. Commissioner involved one corporation selling its operating assets to a sister corporation owned by the same shareholders, followed by a liquidation. The Tax Court held that this constituted a Type D reorganization even though no new stock was formally issued. The court reasoned that issuing stock would have been a “meaningless gesture” since the shareholders already owned 100% of the acquiring company, establishing a key precedent for applying the doctrine.