Category: Corporations; Sales & Exchanges; International
Subject: Corporate Liquidation
Title: Proper Corporate Level Treatment of Shareholder Loan
IRC Sections: 61(a)(12), 118, 108
Filename: 1195.html
Date Produced: 01/95

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Facts
Two C corporations are about to be liquidated. Corporation A is owned equally by two corporate shareholders, one domestic and the other foreign. Corporation A owes $450,000 plus accrued interest to its shareholders. Corporation B is owned 100% by a foreign individual. Corporation B owes $227,607 to its shareholder. The balance sheets of Corporation A and B are as per your memorandum to me of January 13, 1995 which is incorporated by reference into this document. Both corporations are accrual basis.

Issues
What is the proper corporate level treatment of the shareholder loans and accrued interest when the two corporations are liquidated?

Answer
Liquidation of corporate debt owed to shareholders amounts to cancellation of the indebtedness. In general, cancellation of debt (COD) results in income to the debtor; however, it is possible for the shareholders to contribute their debt to capital in order to avoid COD income at the corporate level with respect to the principal portion of the debt owed. Capitalization of the accrued interest, however, could result in COD income, depending on the shareholder's facts.

Discussion
Ordinarily, gross income includes cancellation of indebtedness. Internal Revenue Code (IRC) Section 61(a)(12). If the shareholders of Corporations A and B received insufficient assets in liquidation to satisfy the debts owed to them by their respective debtor corporations, it seems clear that the debts owed to them would in effect be canceled. Accordingly, income would result under the principle set forth in IRC Sec. 61(a)(12).

IRC Section 118 provides that the gross income of a corporation does not include contributions to its capital, but IRC Sec. 118(c)(2) refers the reader to Section 108(e)(6) for a special rule in the case of shareholder indebtedness contributed to corporate capital. Section 108(e)(6) provides that if a corporation acquires its own debt from a shareholder as a contribution to capital, Section 118 shall not apply and the debt is treated as having been satisfied with an amount of cash equal to the shareholder's basis in the indebtedness.

In effect, Section 108(e)(6) says if the shareholder contributes corporate debt to capital, it is as if the corporation paid an amount of cash in satisfaction of that debt equal the shareholder's basis in the debt. Accordingly, this provision frees the corporation from any COD income provided the shareholder's basis in the corporate debt is equal to the face of the debt. Presumably, the shareholders in this case have basis equal to the face of the debt with respect to the principal portion of the debt. If so, contribution of the debt would simply increase the shareholder's basis in his stock and increase the equity section of the corporate balance sheet.

In contrast, the accrued and unpaid interest may create an entirely different result depending on the individual circumstances of each shareholder-creditor. The question is whether the shareholder-creditor has basis in the accrued interest portion of the amount due from the corporation. Presumably, this is a method of accounting issue. If the creditors are cash basis, then they almost certainly have no basis in the accrued interest portion of the corporate debt. If so, the corporate debtor would recognize COD income to the extent of the accrued interest owed to such shareholders. See Revenue Ruling 76-316, 1976-2 CB 22.

Insolvent taxpayers are allowed by Section 108(a) to exclude COD income to the extent of their insolvency. However, in this case since the shareholder debt is relieved at the same time as the accrued interest, it seems clear that the corporation-debtor will not be insolvent after the contribution of corporate indebtedness. Accordingly, the exclusion under Section 108(a) would be unavailable.

If the shareholder-creditor is accrual basis, then he presumably recognized interest income for U.S. tax purposes equal to the accrued interest at the corporate level and would therefore have basis in the accrued interest portion of the debt. In that case, contribution of the accrued interest portion of the debt should not create COD income at the corporate level.

A word of caution is in order since some of the shareholders are non-U.S. persons or entities. It is not entirely clear what should happen if these non-U.S. persons or entities are accrual basis but excluded the interest income from U.S. taxation by reason of treaty or some other provision of law. I am willing to speculate that a contribution to capital of accrued interest in such a case would result in COD income at the corporate level.