Unit 14 - Corporate Distributions and Liquidations

Eastlake Manufacturing Corp. is closing down its operations. The corporation distributed inventory in the redemption of all its outstanding stock in a complete liquidation. On the date of the distribution, the inventory had a cost basis of $100,000 and a fair market value of $900,000. All the inventory was distributed to Michael, the sole shareholder of the company. What is the nature and the amount of the gain to Eastlake Corporation in this liquidating transaction?

A corporation must recognize gain or loss on the distribution of property in a complete liquidation. The distribution is treated as though the property was sold to the distributee at fair market value. The tax treatment depends on the type of property. In this case, the property distributed was inventory (not a capital asset), which would be treated as though the company sold the inventory to a buyer at Fair Market Value. Therefore, the company must recognize $800,000 of ordinary income ($900,000 FMV - $100,000 cost basis).

Madeline owns 2,000 shares of Parker Communications, Inc. She purchased the corporate stock three years ago for $40,000. She is not active in the management of the company, she is merely a passive investor. Parker Communications Inc. begins winding up its affairs and distributed $112,000 in two cash payments to Madeline. She received $32,000 on December 31, 2023 and $80,000 on January 10, 2024. The corporation officially liquidates a week later (on January 17) and permanently shuts its doors. How much gain or loss does Madeline recognize in these two liquidating distributions?

Liquidating distributions are treated differently than other types of corporate distributions. Liquidating distributions are not paid solely out of the profits of the corporation. A liquidating distribution is not taxable until the shareholder’s stock basis ($40,000) has been fully recovered. Madeline recovered $32,000 of her original basis in 2023, when she received the first distribution, and the remaining balance of her basis of $8,000 in 2024. Her recognized gain is therefore $72,000 ($112,000 total distribution - $40,000 basis). She will recognize no gain or loss in 2023, (her stock basis is reduced, instead) but must recognize $72,000 of capital gain in 2024, when she receives her final distribution.

Note: It is not unusual when a large corporation ceases operations for it to make a series of liquidating distributions before the corporation actually dissolves. 

Agilent Investments, Inc. is a C corporation that is going through a complete dissolution. Agilent Investments, Inc. has 25 equal shareholders, and each one receives an equal distribution of cash. For federal income tax purposes, each shareholder’s receipt of the liquidating corporate distribution amount is treated as: ___________________.

For federal income tax purposes, each shareholder’s receipt of the liquidating corporate distribution amount is treated as a sale of all the shareholder’s stock in exchange for the distribution.

In this example, each shareholder will receive a final cash distribution in exchange for their stock. Each shareholder then must recognize a capital gain (or loss) equal to the difference between the distribution amount (the cash, for example) and the shareholder’s basis in the stock relinquished in the liquidating transaction.

Stock Redemption

A stock redemption occurs when a corporation buys back its own stock from a shareholder in exchange for cash or property. A corporation can recognize a loss on a stock redemption, but only in the following circumstances:

• The redemption occurs in a complete liquidation of the corporation, or

• The redemption occurs on stock held by an estate.

For the last three years, Ansari Services Group, Inc., a calendar-year S corporation, earned passive investment income in excess of 25% of its gross receipts. Ansari Services Group has accumulated E&P from earlier years in which it was a C corporation. What is the effect of this accumulated E&P?

An S corporation that had been a C corporation previously and had accumulated E&P during that period may have to pay tax at the corporate level on excess net passive income (ENPI) if its passive investment income exceeds 25% of its gross receipts. If the corporation has accumulated E&P at the end of the tax year and has ENPI in excess of 25% of its gross receipts for three consecutive taxable years, the S election is terminated as of the beginning of the fourth year. Ansari Services Group's S election would be terminated and the corporation would revert to be taxed as a C corporation.

Note: An S corporation generally does not have accumulated E&P, because S corporations are pass-through entities. However, an S corporation can have accumulated E&P if the company was a C corporation in the past, and converted to an S corporation while it still had accumulated E&P. For more information about S corporations, see the IRS detail page on S Corporations.

Distributions coming from accumulated earnings and profits

Distributions from a C corporation are deducted first from current E&P, and then from any accumulated E&P. Any part of a distribution from current-year E&P or accumulated E&P is reported as dividend income to the shareholder.

the ratio used to calculate how much of the distribution comes from accumulated E&P is ….. (total current profit/total distribution X quarterly distribution )

Quarterly since the distributions are broken up to quarterly’s

What increases a corporation’s earning and profits?

Corporate dividends distributed to shareholders will decrease a corporation's earnings and profits. The amount of a C corporation’s earnings and profits determines the tax treatment of corporate distributions to shareholders. The starting point for determining corporate E&P is the corporation’s taxable income. The following transactions increase the amount of E&P:

• Long-term contracts reported on the completed contract method

• Intangible drilling costs deducted currently

• Mine exploration and development costs deducted currently

• Dividends-received deduction

What decreases a corporation’s earning and profits?

• Corporate federal income taxes

• Life insurance policy premiums on a corporate officer

• Excess charitable contributions (over the allowable limit)

• Expenses relating to tax-exempt income

• Excess of capital losses over capital gains

• Corporate dividends and other distributions

cash-basis C corporation that filed for Chapter 7 bankruptcy during the year. What happens with regards to the corporation's filing requirements after a bankruptcy filing?

A separate taxable estate isn't created when a partnership or corporation files a bankruptcy petition, and the corporation's normal tax return filing requirements don't change. In other words, if a C corporation files for bankruptcy, the court-appointed trustee, must file the entity's income tax returns on Form 1120 as normal.