What is a nonliquidating distribution
In our hypothetical, we have an S Corporation (“Corporation”) that owns a warehouse, a promissory note, and cash.The precise tax consequences to the Corporation and its sole shareholder (“Shareholder”) are not possible to know without knowing the fair market values and bases of the Corporation’s assets.Any gain or loss shall be considered as resulting from the sale or exchange of the property in which the note was received.Pursuant to §453B(b), the basis of the note shall be the excess of the face value of the note over an amount equal to the income which would be returnable were the obligation satisfied in full.
If Corporation distributes the note to Shareholder in a complete liquidating distribution and Shareholder receives the note in exchange for Shareholder’s stock within 12 months of Corporation adopting a plan of liquidation and the liquidation is completed within that 12-month period, then Shareholder’s receipt of the note is not treated as a receipt of payment for Shareholder’s stock; instead, Shareholder’s receipt of the payments on the note is treated as receipt of payment for Shareholder’s stock and he would not owe any taxes on the note until Shareholder actually receives each payment.
For purposes of Subchapter S of the IRC, a “small business corporation” is a domestic corporation that meets certain statutory criteria.
S Corporations are advantageous to small businesses because the business itself is not subject to federal taxation (although, some states subject S Corporations to taxation); only the S Corporation shareholders are subject to federal taxation.
However, according to §453(h)(2), if Shareholder receives an installment obligation in a complete liquidation, then Shareholder’s stock basis must be allocated among all the property received by Shareholder in the liquidation.
If Corporation liquidates and distributes the assets to Shareholder, then Shareholder will have to allocate Shareholder’s stock basis among all the assets received in the liquidation, including the note that will have deferred gain, which will cause Shareholder to recognize more gain on the cash and warehouse because less basis is allocated to those assets.
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However, if the stock basis is depleted before Corporation distributes all of its assets, then any subsequent distributions will result in taxable gain to the extent that there is gain recognized in those subsequent distributions.