Avoiding the Dangers of Using Liquidation-Reincorporation as a Planning Technique

Editor:
Albert B. Ellentuck, Esq.
Of Counsel
King & Nordlinger, L.L.P.
Potomac, MD
 

Editors note: This case study has been adapted from PPC Tax Planning GuideClosely Held Corporations, 16th Edition, by Albert L. Grasso, Joan Wilson Gray, R. Barry Johnson, Lewis A. Siegel, Richard L. Burris, James A. Keller, Gary W. Brown and James J. Mogelnicki, published by Practitioners Publishing Company, Fort Worth, TX, 2003 ((800) 3238724; www.ppcnet.com).

Facts: Sam Jones owns 100% of the stock of S Inc., with a $200,000 basis. Ss basis in its depreciable assets is $100,000, with a $200,000 fair market value (FMV). The corporation has an unused $100,000 net operating loss (NOL) carryover expiring at the end of the current tax year.

Sam has informed his tax adviser that his goals for S are to:

1. Depreciate its assets using a basis equal to FMV, instead of adjusted basis; and

2. Use the $100,000 NOL before it expires.

Sam is somewhat familiar with the tax laws and has devised a plan to meet these goals. Under the plan, Sam would liquidate the corporation in the current year and have it distribute the depreciable assets to him. The corporation would use its $100,000 NOL carryover to offset the $100,000 gain ($200,000 FMV of assets $100,000 basis) it would recognize on the liquidating distribution. Sam would not recognize any gain; his stock basis would equal the FMV of the assets distributed to him.

Sam would then transfer the assets to a new corporation for $200,000 of stock. Sam anticipates the new corporation would have a basis in the assets equal to the $200,000 FMV and would depreciate that higher basis. In effect, the transaction would be a liquidation-reincorporation. Issue: What advice should Sams tax adviser give him as to the use of a liquidation-reincorporation to attain his objectives?

Analysis

Taxpayers contemplating the use of liquidation-reincorporation as a planning technique should be aware that Regs. Sec. 1.331-1(c) may cause problems. That rule collapses the two transactions (the liquidation of the old corporation and the formation of the new one) into one transaction. If a liquidation is followed or preceded by a transfer to another corporation of all or part of the liquidating corporations assets, it may have the effect of a dividend distribution or a transaction in which gain recognition is limited (and no loss is recognized). Recharacterization as a dividend would trigger $200,000 ordinary income to Sam (limited by Ss earnings and profits). Sams $200,000 basis in his S stock would offset any dividend distribution not classified as ordinary income. Also, Ss $100,000 NOL carryforward would offset the $100,000 capital gain realized on the distribution of the appreciated property to Sam.

If the IRS recharacterizes the transaction as a D reorganization, S would not realize taxable gain (and, thus, could not use the carryover); the new corporation would not step-up the asset bases.

Ss liquidation-reincorporation will fulfill the D reorganization requirements that substantially all the S assets are transferred to the new corporation and the latters stock is distributed to Ss shareholders. S could easily avoid the D reorganization requirement of a formal plan of reorganization. However, the courts have recharacterized liquidation-reincorporations as D reorganizations when taxpayers deliberately failed a requirement to qualify as a D reorganization; see, e.g., S.B. Rose, 640 F2d 1030 (9th Cir. 1981). In Rose, the court held that the absence of a written plan did not prevent a liquidation-reincorporation from being reclassified as a D reorganization. Often, the substance of a liquidation-reincorporation, rather than the formalities, persuades the courts.

The tax adviser should tell Sam to consider the following alternative. The corporations sale of all of its assets results in a $100,000 gain at the corporate level. The corporation could then use its $100,000 NOL carryover to offset the gain on the sale and use the $200,000 sale proceeds to purchase new assets.

Conclusion

The tax adviser should tell Sam that the application of Regs. Sec. 1.331-1(c) could result in treating the transaction as a $200,000 dividend or a corporate reorganization. The practitioner might advise Sam to consider as an alternative the sale of the assets and use of the sale proceeds to purchase new assets. This would allow S to use its NOL carryover and have a $200,000 depreciable basis in its assets.

The tax adviser should also tell Sam that if S sells substantially all its assets, retains the proceeds without purchasing new assets and does not liquidate, it could be deemed a personal holding company (PHC) subject to the PHC tax.

Variation

Sam decides to form a new corporation, sell the assets of the old corporation to the new one, then liquidate the old corporation. Does this effectively accomplish Sams goals?

This strategy will not work. In Rev. Rul. 61-156, the IRS ruled that such a transaction was merely a device to withdraw corporate earnings at capital gain rates. It also stated that there was no reality to the sale of the corporate assets or the corporate liquidation; in essence, the transaction was a sham.