WHO TO CONTACT For Additional Registrations: -Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10) For Assistance During the Program: -On the web, use the chat box at the bottom left of the screen If you get disconnected during the program, you can simply log in using your original instructions and PIN. IMPORTANT INFORMATION This program is approved for 2 CPE credit hours. To earn credit you must: • Participate in the program on your own computer connection (no sharing) – if you need to register additional people, please call customer service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford accepts American Express, Visa, MasterCard, Discover . • Listen on-line via your computer speakers. • Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the attestation form, which will be emailed to registered attendees. • To earn full credit, you must remain connected for the entire program. Liquidation of S Corporations: Mastering Tax Implications of Liquidating Distributions Case Study on Planning, Calculations, and Property Dispositions THURSDAY, OCTOBER 22, 2015, 1:00-2:50 pm Eastern
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WHO TO CONTACT
For Additional Registrations:
-Call Strafford Customer Service 1-800-926-7926 x10 (or 404-881-1141 x10)
For Assistance During the Program:
-On the web, use the chat box at the bottom left of the screen
If you get disconnected during the program, you can simply log in using your original instructions and PIN.
IMPORTANT INFORMATION
This program is approved for 2 CPE credit hours. To earn credit you must:
• Participate in the program on your own computer connection (no sharing) – if you need to register additional people, please call customer
service at 1-800-926-7926 x10 (or 404-881-1141 x10). Strafford accepts American Express, Visa, MasterCard, Discover.
• Listen on-line via your computer speakers.
• Respond to five prompts during the program plus a single verification code. You will have to write down only the final verification code on the
attestation form, which will be emailed to registered attendees.
• To earn full credit, you must remain connected for the entire program.
Liquidation of S Corporations:
Mastering Tax Implications of Liquidating Distributions Case Study on Planning, Calculations, and Property Dispositions
THURSDAY, OCTOBER 22, 2015, 1:00-2:50 pm Eastern
Tips for Optimal Quality
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• “Except as otherwise provided in this title, and except to the extent inconsistent with this
subchapter, subchapter C shall apply to an S corporation and its shareholders.”
• As a result, the liquidation provisions of subchapter C apply to S corporations.
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Section 336
• Section 336 provides that a corporation will recognize gain or loss on the distribution of
property in complete liquidation of the corporation as if the property were sold at fair market
value.
• Consequences of (i) sale of assets by S corporation with distribution of cash proceeds to
shareholders, or (ii) in-kind distribution of S corporation assets to shareholders are therefore
generally the same. Any appreciation in the S corporation will be triggered and recognized
as a result of a liquidation.
• This is a significant difference from partnerships.
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Example
• ABC Inc., an S corporation, owns a building with a basis of $500. ABC sells the building for
$1000. ABC recognizes $500 of gain [$1000 amount realized less $500 basis] under
Section 1001(a).
• Assume instead that ABC distributes the building to its three shareholders - A, B, and C.
ABC is treated as selling the building for $1000, its fair market value, under Section 336. As
a result, ABC recognizes $500 of gain.
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Rules to Watch Out For
• If property taken subject liability, the fair market value is treated as no less than the amount
of the liability.
• No loss recognized under Section 336(d) on distributions to related person (within meaning
of section 267) if (i) not pro rata or (ii) disqualified property (property acquired in certain
Section 351 transactions within 5 years of the distribution).
• Ordinary income on Sections 1245 or 1250 depreciation recapture.
• Ordinary income under Section 1239 if depreciable property distributed to related person.
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Shareholder’s Treatment of Corporate Items
• Section 1366 generally provides that S corporation shareholders report their pro rata share
of the S corporation’s tax items on their personal returns (Schedule K-1).
• Section 1367 provides that the S corporation shareholders get a basis adjustment for their
pro rata share of the S corporation’s tax items.
• The result is that S corporations are generally pass-through entities like partnerships, with a
single layer of tax.
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Built-in Gains Tax
• Built-in gains tax is an important exception to the pass-through treatment for S corporations.
The concern was that C corporations could otherwise convert to an S corporation shortly
before it planned to sell assets, thereby avoiding the double layer of tax.
• In most general terms, the tax is imposed on any gains built-in at the time of the S election if
recognized by the S corporation within ten years of the conversion.
• The tax is imposed at the highest corporate tax rate (35%).
• Schedule D (1120-S), Part III.
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Recognition Period
• The built-in gains tax applies to any taxable year that begins during the recognition period.
Section 1374(a).
• The recognition period is the ten year period beginning with the first day of the first taxable
year for which the corporation was an S corporation. Section 1374(d)(7).
º Special shorter periods for 2009 -2010 (seven years) and for 2011-2014 (five years).
º S Corporation Modernization Act of 2015 (H.R. 2788) proposes reducing recognition
period to five years.
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Net Recognized Built-In Gain
• The tax is 35% of “net recognized built-in gain.” Section 1374(b).
• Net recognized built-in gain is the lesser of:
º The amount of taxable income that the S corporation would have in a taxable year if only
recognized built-in gains and recognized built-in losses were taken into account, or
º The S corporation’s taxable income for such taxable year.
• If recognized built-in gain exceeds taxable income, the excess built-in gain is carried over
and treated as recognized built-in gain in the next taxable year.
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Recognized Built-in Gain
or Loss
• Recognized built-in gain or loss is the gain or loss recognized during the recognition period
on the disposition of any asset except to the extent that the S corporation can establish:
º the asset was not held on first day that the corporation elected S status, or
º such gain exceeds the excess (if any) of the FMV of the asset on the first day of the
corporation’s first S status year over the adjusted basis of the asset on that day (or
converse for losses).
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Example
• ABC, Inc. was formed as a C corporation in 2005.
• On January 1, 2013, ABC Inc. elects S corporation status.
• At the time of conversion to S status, ABC holds a building with a basis on $500 and a fair
market value of $1000 (i.e., $500 built-in gain).
• ABC sells the building on December 1, 2014 for $1200 when it has a basis of $400.
• ABC has taxable income for 2014 is $900.
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Example
• Recognized built-in gain is $500.
º $800 gain on building [$1200 AR - $400 basis], reduced to
º $500 [$1000 FMV on 1/1/13 - $500 basis on 1/1/13].
• Net recognized built-in gain is $500. This is the lesser of
º $500 recognized built-in gain, or
º $900 taxable income.
• ABC pays built-in gains tax of $175 [35% tax rate on $500].
• Shareholders receive K-1s for their shares of ABC tax items. 17
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Example
• Assume instead ABC only has taxable income of $400.
• Net recognized built-in gain is $400. This is the lesser of
º $500 recognized built-in gain, or
º $400 taxable income.
• ABC pays built-in gains tax of $140 [35% tax rate on $400].
• ABC has $100 of recognized built-in gain in 2015 (issue if ABC is not liquidating).
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Built-in Gains Tax –
Miscellaneous
• Note that the burden of establishing that not all of the gain is built-in gain is on the S
corporation.
º Practical tip: If a client is going to make an S election, include appraisals as part of the
conversion planning.
• There are special rules in place to capture assets acquired by an S corporation from a C
corporation or an S corporation subject to Section 1374 in a basis carryover transaction.
• Built-in gain does not get reduced ratably over the recognition period.
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Treatment of Liquidating Distribution
at Shareholder Level
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Section 331
• Section 331(a) provides that “amounts received by a shareholder in a distribution in complete
liquidation of a corporation shall be treated as in full payment in exchange for the stock.”
• Section 331(b) specifically denies Section 301 from applying to liquidating distributions.
º As a result, Section 301(c) does not apply, and thus Section 1368 (provision that
normally governs distributions by S corporations) does not apply.
• Shareholders recognize gain or loss to extent of difference between amount received and
their basis in their S corporation stock.
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Stock Sale
• Each shareholder recognizes gain or loss to extent of difference between fair market value of
property received and his basis in his S corporation stock.
• What is the shareholder’s basis in his S stock?
• Generally, initial basis equals the cost paid for the stock. If property was contributed for
stock, then basis equals basis of property contributed, adjusted for gain recognized and boot
distributed.
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Stock Basis
• Basis increased by:
º Additional capital contributions,
º Share of S corporation income (including exempt income), and
º Excess of depletion deductions over basis.
• Basis decreased by:
º Share of S corporation losses, deductions, and depletion,
º Share of noncapital, nondeductible expenses (e.g. penalties or bribes), and
º Distributions not includible in shareholder’s income under Section 1368.
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Debt Basis
• General rule
º Initial basis equals the cost of the debt.
º Decreased by the repayment of principal.
º Reduced to zero if the debt becomes worthless.
• Basis adjustments are generally made to the shareholder’s stock basis, not its debt basis.
However, stock basis can only be reduced to zero. If there are additional decreasing
adjustments to be made, the adjustments will then be made to reduce debt basis. If this
occurs, when the S corporation later has income items, the basis increase will first restore
the debt basis before increasing stock basis.
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Calculating Shareholder Basis at Time of
Liquidation
• When determining a shareholder’s basis in his S stock, under Treasury Regulation Section
1.1367-1, basis is adjusted:
º First, for current year S corporation items, and
º Then, for S corporation items resulting from liquidation.
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Stock Sale Treatment
• To the extent that the fair market value of the distributed assets exceeds his basis, the
shareholder recognizes gain on the liquidation. If basis exceeds fair market value, the
shareholder recognizes a loss (if Section 336(d) does not apply).
• The gain or loss is capital. There is no Section 751-like provision for S corporations.
• Shareholder takes a basis in the distributed assets equal to fair market value under Section
334(a).
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Example
• ABC Inc., an S corporation since formation, makes a liquidating distribution of a building with
a $1000 FMV and basis of $500 to A, its sole shareholder. A has a basis in his stock of $200
at start of the year. ABC has taxable income for the year, prior to distribution, of $100.
• ABC recognizes $500 of gain on the liquidating distribution.
• A’s stock basis is $800 [$200 basis plus $100 taxable income for year plus $500 gain on
liquidating distribution].
• A’s gain on liquidating distribution is $200 [$1000 FMV - $800 basis]. Gain is capital gain.
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Example
• A receives K-1 from ABC showing $500 of gain from liquidating distribution and $100 of
income from final tax year.
• A has $300 capital gain from “stock sale” to ABC.
• A takes a basis in the building of $1000.
• A starts a new holding period for the building – no tacking.
º Significant difference from partnerships.
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Mismatched Tax Years
• Treasury Regulation Section 1.1367-1(d) provides that the adjustments to a shareholder’s
basis in his stock are determined as of the close of the corporation’s taxable year, and the
adjustments are generally effective as of that date.
• As a result, if the S corporation and its shareholders have different tax years, there is the
potential for a mismatch of gains and losses.
• Gains and losses may offset each other, but in different tax years.
• As an adviser, it is important to consider this and avoid making distributions in separate
taxable years, if possible.
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Example
• ABC Inc. is an S corporation with a January 31 year end.
• During the year ending 1/31/15, ABC sells its building for $2500, resulting in $2000 gain.
ABC also has $500 of other taxable income.
• ABC distributes $2500 to A, its sole shareholder, on December 31, 2014. Assume no AAA.
• A has a basis in his stock at start of 2014 tax year of $500.
• Escrow period for building sale expires, and ABC distributes remaining $500 in liquidating
distribution on January 31, 2015.
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Example
• If same tax year, A would recognize no gain or loss on the distributions [$3000 cash less
$3000 basis [$500 + $2000 + $500].
• However, because of Treasury Regulation Section 1.1367-1(d)(1), A’s $2500 basis increase
does not occur until 1/31/15.
• On his 2014 return, A recognizes $2000 gain from the 12/31/14 distribution [$2500 cash less
$500 basis].
• On his 2015 return, A recognizes $2000 loss from 1/31/15 distribution [$500 cash less $2500
basis].
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Liquidation of S Corporations LESLIE ELLEN BOYD
CLIFTONLARSONALLEN
Character and Timing of Gain Recognition
• General Financial Considerations o Seller: Cash sale of seller’s stock with complete relief of corporate debts
o Buyer: Use as little cash as possible;
Acquire only the assets required for continuation of the business;
Limit responsibility of assuming liabilities
•General Tax Considerations – Adverse motivations o Seller
Prefer capital gain recognition (generally stock sale)
Potential for gain deferral – installment sale
o Buyer Wants a cost basis in the assets, especially inventory and depreciable assets
Specific Tax Considerations o Gain or loss recognized by selling corporation (Built-In Gains)
o Gain or Loss recognized by selling shareholders Amount of gain or loss
Character of gain or loss
Timing of recognition of gain or loss
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Comparison of Tax Effects – Asset vs. Stock Sale
- Buyer contemplating purchase from business of Sellco
- Sellco is an S corporation
- Sellco’s business enterprise is valued at $1,000,000
- Sellco’s assets are valued at $500,000
- Sellco’s shareholder’s basis in Sellco’s stock is $500,000
- Sellco’s assets would produce ordinary income and built-in gains if sold by Sellco
- Both Sellco’s shareholder and Buyer would be in the 35% tax bracket for ordinary income and 15% tax bracket for capital gains
- Compare and contrast the after tax cash flow to Sellco’s shareholders under each structure
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Asset Sale
Asset Sale
Taxable Income Cash Flow
Cash Received by Sellco $1,000,000
Corporate Gain $500,000
Built in Gain Tax (175,000) (175,000)
Corporate Income to Shareholder $325,000
Shareholder’s Basis Prior to Asset Sale $500,000
Shareholder’s Basis After Asset Sale $825,000
Net Cash to Shareholder $825,000 $825,000
Gain on distribution 0
Shareholder’s tax on corporation’s income ($325,000 x 35%) (113,750)
Cash to Shareholder After Tax $711,250 35
Stock Sale
Asset Sale
Taxable Income Cash Flow
Cash Received by Shareholder $1,000,000 $1,000,000
Less: Basis in Shares (500,000)
Capital Gain $500,000
Tax on Capital Gain (75,000)
Cash to Shareholder After Tax $925,000
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Observations • If buyer pays $1,000,000 for the assets, it will have a cost basis of $1,000,000 in those assets.
•If buyer pays $1,000,000 for stock and then liquidates the corporation, it would need to pay an additional $175,000 in built in gains tax when Sellco distributes the assets, because Sellco would retain its basis of $500,000.
•Compare Results
Asset Sale Stock Sale
Cash paid by buyer, including tax liquidation
$1,000,000 $1,175,000
After-tax cash to selling shareholder
(711,250) (925,000)
Combined Tax Burdens $288,750 $250,000
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Other Variations
• Employment Agreement: one or more sellers remain employed by buyer, who pays seller certain amount for services
• Covenant not to Compete: seller has no right to re-open business in general vicinity for set period of time • Benefits
o Single level of tax for Sellco • Drawback
o Generally results in Ordinary Gain to Sellco • Comparison of results on next slide
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Variation – Asset Sale with Covenant - Buyer will pay Sellco $800,000 for all of its assets
- Buyer will also pay Sellco’s Shareholder $250,000 as covenant not to compete Taxable Income Cash Flow
Cash Received by Sellco $800,000
Corporate Gain $300,000
Built In Gain Tax (35%) (105,000) (105,000)
Corporate Income to Shareholder 195,000
Shareholder Basis Prior to Asset Sale 500,000
Shareholder’s Basis after sale 695,000
Net Cash to Shareholder 695,000 695,000
Gain on Distribution 0
Shareholder’s Tax on Corporations Income (35% of $195,000) (68,250)
Cash to Shareholder After Tax $626,750
Cash Received Directly as Covenant $250,000
Tax on Value of Covenant (35% of $250,000) (87,500)
$789,250 39
Benefits of Variation •Selling shareholder ends up with additional cash of $78,000
•Buyer takes assets with basis of $800,000, with no tax burden of liquidating the corporation
•Buyer also receives amortizable intangible of $250,000
•Buyer and seller have compromised equally
40
Allocation of Consideration • Seller preference o Allocate to capital assets for favorable rate
•Buyer’s preference o Allocate to inventory, which is sold shortly
o Allocate to depreciable assets with short recovery periods
o Creates ordinary income for seller!
•Goodwill o Taxed as capital gain to seller
o Amortizable over 15 years to buyer
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Rules for Allocation of Consideration • IRC 1060 Allocation Rules – applies to asset sales meeting the following conditions: o The transaction must constitute the sale of a trade or business Goodwill or going concern value may indicate a sale of a trade or business
o Buyer’s basis is determined by reference to the purchase price (transfer must be taxable)
•Implications o Buyer and seller must each use residual method of allocating cost and sales price of individual
properties transferred
o Amount allocated = total consideration or identifiable FMV, whichever is less
o Seven classes, listed on the following slide
o Each party reports allocation of the consideration on Form 8594
Classes of Assets Class Description
I Cash and demand deposits
II CD, government, marketable securities
III Accounts receivable (trade receivables)
IV Inventory
V All assets not included in other classes
VI Intangible assets other than goodwill
VII Goodwill
Built In Gains Tax Consideration • Corporation should carefully review its history o Did the corporation convert from a C Corporation to S Corporation within the past 10 years? o Did the Corporation acquire any assets in a tax-free manner within 10 years prior to the sale Such assets might be subject to the built-in gains tax
o Corporation has burden in both instances of establishing that any gains are not built-in gains
• Planning Strategies o Devalue Property Subject to Built-in-Gain and ascribe to other assets
o IRC §1031 Exchange
o Identify Covenant Not to Compete
Can be Purchased from Selling Corporation, Shareholders or Both
Does not exist until effective date of sale
Ordinary Income to Seller
Make sure seller is realistically in a position to compete
o Is there an opportunity to identify personal goodwill
Not a corporate asset
Also considered a capital asset
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Installment Sale •General principal: Seller does not recognize gain except to the extent it receives payments on obligation o Losses are recognized in year of sale o Certain gains not subject to deferred reporting Dispositions of inventory
Dispositions of depreciable property subject to recapture
Dispositions to related parties, if the buyer disposes of the property within two years
•Seller must allocate gain between ordinary, capital, and 1231 assets o Ordinary gains on sale of items other than inventory and depreciation recapture can be deferred o (ie cash basis accounts receivable)
•Built-in-gains are recognized ratably as the installment note is collected
•If selling corporation receives an installment obligation as part of its consideration, it can elect to report all gain in the year of sale
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Installment Sale Considerations – Corporation Continues
•If the corporation has substantial installment obligations received before sale of substantially all assets, liquidation will accelerate shareholder gain
•If corporation has installment receivables, immediate liquidation accelerates built in gains on any portion of deferred gain
•Installment obligation will likely generate investment income o Corporation may run afoul of passive investment income limit
o Subject to passive investment income tax for three years and lose S election in fourth year
o Note that gross profit from collection of installment note would not be passive income, except to the extent that it resulted from the sale of stock or securities
o Interest received on installment note is passive income
46
Installment Sale Consideration – Corporation Continues
•Generally, if selling corporation liquidates, gain or loss on assets is recognized in year of liquidating distribution o Receipt of property from distribution in complete liquidation is equivalent to sale of stock by shareholders
o Gain or loss recognized in full by year shareholder
o Basis of property received is FMV
•S Corporations escape immediate recognition on distribution of installment receivable If generated by a sale pursuant to a plan of complete liquidation
Postpones recognition at shareholder level upon receipt of installment obligation
Shareholder must allocate basis in stock between installment receivable and other property received in liquidation
Does NOT apply to BIG S Corporation would recognize taxable BIG on distribution of installment receivable in liquidation
Cause Immediate corporate tax
Flows through to shareholder as a loss
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Other Collateral Effects to Shareholder •Selling shareholders should determine if the asset disposition completely terminated an interest in a passive activity o Selling shareholder deducts suspended passive losses
•If selling shareholders' basis, after adjustment for items in year of sale > value of stock, liquidation might generate IRC 1244 ordinary loss deduction
•If selling shareholder is active in business, gain or loss on sale of S corporation stock is not subject to net investment income tax under IRC 1411.
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S Corporation Liquidations Case Study: Eagle Corporation and Swallow
Corporation
Eagle Corporation
• Eagle Corporation is an S corporation. It uses the calendar year. It filed an S election in November, 2013, which took effect on January 1, 2014.
• Eagle has two equal and unrelated shareholders, Gene and Vicki.
• Eagle intends to acquire all of the stock, or all of the assets, of Swallow Corporation.
• The note bears interest at an annual rate of 8%, which exceeds the AFR at the time of the deal.
• Principal payments are to be $200,000 plus interest per year for nine years, beginning in the year following the deal, with the balance due in the final year
• Eagle also agrees with Sally on a covenant not to compete. Eagle will pay Sally $100,000 per year for five years, with the first payment at closing.
• Carl has not been active in the business operation for several years, and Eagle will not pay him for a covenant not to compete.
What is Eagle’s basis in the assets immediately on completion of the purchase?
Class FMV Consideration (after
senior group)
Allocate to class (< of FMV or
consideration) Total $3,500,000
I Cash $48,000 3,500,000 48,000 II Marketable securities 152,000 3,452,000 152,000 III Accounts receivable 300,000 3,400,000 300,000 IV Inventory - 3,100,000 - V Other tangible 1,460,000 3,100,000 1,460,000 VI Intangible 500,000 1,540,000 500,000 VII Goodwill 1,040,000 1,040,000 1,040,000