Category: Corporations; Sales & Exchanges
Subject: Liquidations
Title: Installment Sale in Conjunction with Liquidation
IRC Sections: 336, 331, 453
Filename: 1265.html
Date Produced: 08/95

Copyright 1998, The Tax Resource Group. All rights reserved. Telephone 800-578-3498. Internet: www.taxresourcegroup.com

The liquidation of a corporation (either an S corporation or a C corporation) generally produces at least two major taxable events.

A) Section 336(a) provides that if a corporation is liquidated, gain or loss is recognized (at the corporate level) with respect to any assets distributed in liquidation as if those assets had been sold at fair market value. Section 336(b) further provides that the fair market value of liquidated assets for purposes of determining gain or loss cannot be less than any liabilities assumed by the shareholder in the liquidating transaction.

B) Section 331 provides that a shareholder in liquidation is treated as having sold his stock in exchange for the liquidating proceeds received from the corporation.

Hence, we have generally have two major taxable events, one at the corporate level and another at the shareholder level, associated with the liquidation of a corporation. This is the ultimate example of the principle of double taxation in the corporation environment: the corporation pays tax on any profits earned at the corporate level and the shareholder pays tax AGAIN when those profits are distributed either in liquidation or as dividends. An S corporation election in general avoids the second layer of tax, because any profits recognized at the corporation level increase the basis of the shareholder's stock and are thus not taxed again when distributed to the shareholder.

If the liquidating corporation actually sells its property prior to liquidation, the deemed sale rule of Section 336 does not generally apply. If there is an actual sale, the corporate level income event is controlled by the actual sale, not the deemed sale provision of Section 336.

What happens if a corporation sells its assets in exchange for an installment note and then liquidates? Absent any special rules, the following occurs.

-The corporation recognizes any gain from the installment sale resulting from payments in the year of sale or any gain attributable to depreciation recapture.

-Because distribution of an installment note is considered a disposition of the note [Section 453B(a)], any remaining gain inherent in the installment note is triggered when the note is distributed to the shareholder. In essence, all gain from the installment note would be recognized in the year of sale and liquidation (assuming the two events occur within the same tax year).

-If the corporation is an S corporation, any corporate level gain is passed through to the shareholder and increases the basis in his stock. Also, the S corporation itself would be required to recognize and pay corporation level tax on any built in gains.

-The shareholder has a gain (presumably a capital gain) measured by the fair market value of the all assets distributed in liquidation less any basis he has in his stock.

Notice that the shareholder is required to pay tax on a gain measured by receipt of a less-than-fully-liquid asset, the installment note, and the shareholder may not have sufficient cash to pay the tax owed.

The scenario set forth above was at one time the actual state of the law. Congress felt the result was too harsh and enacted two special rules, one for all corporations and the other just for S corporations.

Section 453(h) provides a special rule for all corporations which relaxes the general provision requiring immediate recognition of gain at the shareholder level resulting from receipt of an installment obligation. The shareholder is allowed to recognize gain from disposition of his stock as payments are received on the note. I essence, it is as if the shareholder sold his stock in exchange for the installment note and whatever else is distributed by the corporation in liquidation.

Section 453B(h) provides a special rule just for S corporations which relaxes the general provision requiring corporate level recognition of gain inherent in an installment note distributed in liquidation. This special rule does not apply to gains to which the special corporation-level built-in gains tax applies.

Corporation A has cash of $68,000 and a property with a fair market value of $1 million and basis of $800,000. There is no depreciation recapture potential with respect to this property. X, Corporation A's sole shareholder, has basis in his A stock of $100,000. Corporation A sells its property for a $1 million, ten-year installment note and immediately liquidates. No payments are received prior to liquidation.

If Corporation A is a C corporation, the $200,000 profit from the sale will be recognized on distribution of the installment note. Using a flat 34% tax rate, A pays corporation tax of $68,000. Corporation A uses the $68,000 it has on hand to pay the tax and then dissolves. Now X, the shareholder, will receive $1 million over ten years against his stock basis of $100,000. X's gross profit on the installment sale is $900,000 and his gross profit ratio for installment reporting purposes is 90%. Accordingly, X will recognize gain equal to 90% of each principal payment from the installment note.

On the other hand, if A is an S corporation, no gain is recognized at the corporate level on distribution of the installment note. Assume that A has always been an S corporation and there is no potential built in gains tax. X receives the $68,000 cash and the $1 million installment note. It is not entirely clear how to treat the $68,000 cash payment. I believe X's basis must be allocated as between the cash payment and the installment note such that the $68,000 payment is against basis of $6,367 for a gain of $61,633. ($100,000 x 68,000 ÷ 1,068,000 = $6,367). The remaining basis, $93,633 is used for the installment sale producing a gross profit percentage of 90.6367%.

Qualifying for the Special Rules
Both special rules, Section 453(h) applicable to all corporations and Section 453B(h) applicable only to S corporations, share the same set of qualifying requirements.

A) There must be a plan of liquidation adopted by the liquidating corporation.

B) The installment obligation must be received pursuant to a sale of corporate assets contemplated by the plan of liquidation.

C) The corporation must distribute the installment obligation and formally dissolve within 12 months after adoption of the plan of liquidation.

The special rule of Section 453(h) does not apply to any installment obligation or any portion thereof related to inventory unless the inventory was sold in bulk in one transaction to one buyer. Section 453(h)(1) flush language. Also, the special rule of Section 453(h) does not apply if the corporate assets are sold to certain related parties.

Practical Steps
1. The board of directors of the liquidating corporation should adopt a resolution to sell all the assets of the corporation and to completely liquidate within 12 months after the adoption of the resolution. See attached examples from BNA Portfolio 59-1. Clearly, the necessary resolutions must be drawn up by a competent attorney licensed to practice in the state in which the corporation is located. Also, the samples are for illustration only.

2. IRS Form 966 should be filed within 30 days after adoption of the resolution.

3. The sale of assets should take place in accordance with the plan.

4. The proceeds of the sale plus any other assets net of any liabilities not assumed by the shareholders should be distributed to the shareholders as directed by the corporate by-laws and applicable state law.

5. The corporation should be formally dissolved in accordance with state law.

6. The final return of the corporation is due within 2.5 months after the date of dissolution.Minutes of Directors Meeting of Christopher Corporation.

The regular meeting of the Board of Directors of Christopher Corporation was held in the corporate offices at 121 1/2 South Broad Street, Philadelphia, Pennsylvania on the fifteenth day of January, 1991 at 10:00 a.m. The following, constituting all of the directors, were present:

Able Baker
Conrad Christopher
Carl Christopher
Charlotte Christopher
Richard Roe

Also present by invitation of the Board of Directors was John Doe, Esquire, general counsel to the Corporation.

Conrad Christopher, the Chairman of the Board of Christopher Corporation called the meeting to order and informed the directors that the Corporation had received from Jilcy Enterprises, Inc. an offer of $825,000 plus an assumption of all of its liabilities for its inventory, machinery and equipment, and business land and building.

Mr. Doe, after reviewing the Corporation's financial statements and the purchase offer advised the Board of Directors that acceptance of the offer would, for federal income tax purposes, result in an ordinary loss of $225,000; a loss of $50,000 on the sale of the inventory and a loss under Section 1231 of $200,000 on the sale of the land and building, less ordinary income of $25,000 from depreciation recapture on the sale of the machinery and equipment. Mr. Doe further advised that the net ordinary loss available to the Corporation would be $225,000 which would result in a refund of federal income taxes of approximately $103,500, and that there would be an investment credit recapture of $26,666. After full discussion, the following preambles and resolutions were adopted:

WHEREAS: the Corporation has received an offer from Jilcy Enterprises, Inc. to purchase certain of its assets for $850,000 and the assumption of the Corporation's liabilities; and,

WHEREAS: the Board of Directors believe that it is in the best interest of the Corporation to accept the offer of Jilcy Enterprises, Inc., and,

WHEREAS: under the By-Laws of the Corporation all such asset sales must be approved by the shareholders;

be it,

RESOLVED: that the Board of Directors transmit the offer of Jilcy Enterprises, Inc. to the shareholders together with the recommendation of the Board of Directors that the offer be accepted.


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SecretaryMinutes of Special Meeting of Shareholders of Christopher Corporation.

Pursuant to the By-Laws of the Corporation, a Special Meeting of the Shareholders of Christopher Corporation was held in the corporate offices at 121 1/2 South Broad Street, Philadelphia, Pennsylvania on the fifteenth day of January, 1991 at 2:00 p.m. to consider the recommendation of the Board of Directors that the Corporation accept the offer of Jilcy Enterprises, Inc. to purchase certain of the assets and assume certain of the liabilities of the Corporation.

Present at the meeting, and owning all of the issued and outstanding shares were:

Conrad Christopher
Carl Christopher
Charlotte Christopher

After due deliberation the shareholders unanimously adopted the following resolutions:

RESOLVED: That the recommendation of the Board of Directors regarding the sale of certain of the Corporation's assets is hereby adopted and the Directors are authorized to take whatever steps necessary to carry out the proposals set forth in that recommendation.


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SecretaryMinutes of Special Meeting
of the Board of Directors
of Christopher Corporation

Pursuant to the Corporation's By-Laws, a Special Meeting of the Board of Directors of Christopher Corporation was held at the corporate offices at 121 1/2 South Broad Street, Philadelphia, Pennsylvania at 10:00 a.m. on the fifteenth of May, 1991. The following, constituting all of the Directors, were present:

Able Baker
Conrad Christopher
Carl Christopher
Charlotte Christopher
Richard Roe

Conrad Christopher, Chairman of the Board, reported that the sale of various assets to Jilcy Enterprises, Inc. had been consummated and that the Corporation had in its account cash of $850,000. He further recommended that the Corporation consider adopting a plan of complete liquidation and distributing its assets to its shareholders pursuant to such plan.

Able Baker pointed out that in any plan of liquidation consideration must be given to the Corporation's claims against Erik Enterprises, the claims against the Corporation by one of its suppliers, and the fact that the Corporation might not be able to collect the full amount of the net receivables.

After full discussion, the following preambles and resolutions were adopted:
WHEREAS: The Board of Directors believe it to be in the best interests of the Corporation and its shareholders that the Corporation be liquidated.

Now, therefore, be it

RESOLVED: That subject to the ratification of the shareholders the Corporation be completely liquidated in accordance with the provisions of Section 331 of the Internal Revenue Code of 1986, as amended, and be it

FURTHER RESOLVED: That in accordance with such plan of liquidation, the officers and directors, and counsel for the Corporation are authorized and directed to see:

1. That within thirty (30) days after the date of the meeting at which the shareholders adopt the plan of liquidation, counsel for the Corporation shall file Form 966 with the District Director of Internal Revenue, [wherever the return is normally filed], together with a certified copy of this resolution;

2. That after the plan of liquidation is adopted the Corporation make a cash distribution to its shareholders pursuant to such plan in the amount of $850,000, such distribution to be made not later than May 31, 1991;

3. That the services of a disinterested qualified appraiser be obtained to determine the fair market value of the undeveloped land;

4. That the Corporation shall proceed as far as possible to collect all accounts receivable and to settle any claims against it;

5. That the Corporation shall make no distribution of assets other than those set forth in Item 2 to its shareholders prior to February 2, 1992;

6. That thereafter, as soon as practical, the Corporation, by its duly authorized officers and directors, distribute all assets, subject to any unpaid liabilities, to the shareholders in redemption and cancellation of all the outstanding capital stock of the Corporation, using their discretion as to how the assets and liabilities will be apportioned among the shareholders, but in no event distributing to any shareholder net assets of a lesser value than is due him on a pro rata basis, using the appraisal values determined under Item 3 of this Resolution as the basis for determining the pro rata amount applicable to each share of stock;

7. That the proper officers of the Corporation shall file a Certificate of Dissolution pursuant to Section 1103 of the Pennsylvania Business Corporation Law with the Department of State, Corporation Bureau of the Commonwealth of Pennsylvania;

8. That the proper officers and Corporation counsel shall file all other forms and documents required by the Commonwealth of Pennsylvania and the Federal Government, including tax returns, as soon as possible after distribution of the corporate assets;

9. That specific authorization is given to John Doe, counsel for the Corporation, to prepare, sign and forward to the Commissioner of Internal Revenue, after the final tax return has been filed for the Corporation, a request for prompt assessment of all federal taxes due from the Corporation; Note: this is not a requirement, and not everyone decides to do this.

10. That the officers and directors of the Corporation are empowered, authorized, and directed to carry out the provisions of this resolution, and to adopt any further resolutions that may be necessary in liquidating and dissolving the Corporation in accordance with the expressed intent of the shareholders under the plan adopted.

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Secretary