McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved.

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Chapter Business Liquidations and Terminations 14

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 14-3 Bankruptcy Legal process through which a debtor restructures or discharges debts Two types for business Chapter 11 reorganization Debtors and creditors agree to debt restructuring Chapter 7 liquidation Assets sold and proceeds distributed to creditors

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 14-4 Discharge of Debt Income General rule: Any discharge results in taxable income Exceptions: Bankruptcy Insolvency

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 14-5 Bankruptcy Exception Discharge must occur in a Title 11 bankruptcy case Entire debt relief excludable from income

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 14-6 Insolvency Exception Exclusion limited to amount of insolvency Insolvency is amount of debts over fair market value of assets

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 14-7 Reduction of Tax Attributes Business that utilize either exception must reduce in order the following tax attributes: Net operating loss carryforwards General business credit carryforwards Minimum tax credit carryforwards Capital loss carryforwards Basis in property Passive activity loss carryforwards Foreign tax credit carryforwards

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 14-8 Reduction of Tax Attributes Attributes that produces deductions and basis reduced dollar for dollar by amount of discharge excluded Credits reduced by 33.3 ¢ for each dollar of exclusion

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide 14-9 Reduction of Attributes for S Corporations Bankruptcy and insolvency exceptions apply at S corporation level but attributes reduced at shareholder level Any suspended losses treated as a net operating loss and reduced by shareholder’s pro-rata share of discharge

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Reduction of Attributes by Partnerships Election to reduce attributes made at partner not partnership level Discharge is treated as a separately stated item allocated among the partners Any discharge is taxable to partner unless he or she meets bankruptcy or insolvency exception

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Tax Consequences to Creditors General rule: Creditor allowed deduction for worthless or discharged debts Special rule for noncorporate creditors: Debt discharged or worthless must be totally worthless to be deductible Must be a business debt to recognize ordinary loss Nonbusiness debts considered a short term capital loss

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Business versus Nonbusiness Bad Debts Shareholder loans to corporation generally treated as nonbusiness debts Result is capital loss if debt goes bad Shareholder employee who lends money to corporation may be able to claim ordinary loss but only if dominant motive is to protect employment

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Corporate Liquidations Corporation ceases activity Sells assets Pays liabilities Distributes any excess of assets over liabilities to shareholders Dissolves under state law

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Consequences of Liquidation to Corporation Any assets distributed to shareholder are deemed sold for their fair market value Unamortized intangible assets such as goodwill written off and deducted Corporate attributes vanish

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Shareholder Tax Consequences Shareholder recognizes capital gain or loss equal to difference between fair market value of liquidating distribution and his or her basis in stock Shareholder takes fair market value basis in any property distributed as part of liquidation

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Worthless Stock Stock treated as sold on last day of taxable year for nothing Capital Loss Exception: Section 1244 stock

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide High Cost of Corporate Liquidations Tax imposed on both corporation and shareholder Can result in an effective tax rate of almost 50% S corporation election may ameliorate result but potential built-in gains tax under section 1374

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Liquidation of Controlled Subsidiary Controlled subsidiary definition: Parent corporation owns at least 80% of voting power and value of stock Subsidiary does not recognize any gain or loss on distributions to parent Parent recognizes no gain or loss Subsidiary’s bases in assets carries over to parent Subsidiary’s attributes carry over to parent

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Liquidation of Controlled Subsidiary Insolvent subsidiary Parent recognizes loss equal to basis If 90% of subsidiary’s gross receipts were from an active business, loss is ordinary

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Liquidations of Controlled Subsidiaries Minority shareholders not protected by section 332 Liquidating corporation recognizes gain but not loss on distribution of assets to minority shareholder Shareholder recognizes capital gain or loss equal to difference between liquidating distribution and their basis in stock

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Partnership Terminations Two types: Natural termination Automatic termination

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Natural Termination Partnership discontinues operations Assets sold Liabilities paid Excess of assets over liabilities distributed to partners

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Tax Consequences of Liquidation Generally nontaxable to both partners and partnership Partner reduces “outside” basis by an cash received and substitutes remaining “outside” basis as basis of property received

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Gain Recognition by Partner If cash distribution exceeds “outside” basis, partner must recognize the excess cash as gain Basis of any other property received is zero

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Distributions of Ordinary Income Property If unrealized receivables or inventory received by partner special rules apply Partner’s bases in these items may never be more than partnership’s bases in these items Partner recognizes ordinary income on disposition of unrealized receivable Partner who sells inventory within five years of distribution recognizes ordinary income or loss

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Loss Recognition by a Partner Loss recognized only if partner receives only cash Capital loss equal to difference between “outside” basis and cash received

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Insolvent Partnerships Results in partners making additional contributions to pay off partnership debts rather than receiving distributions

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Automatic Terminations If there is a sale or exchange or 50% or more of the profits or capital interest within a twelve month period, a termination occurs Buy-sell agreements can prevent this Partnership year ends on termination

McGraw-Hill© 2005 The McGraw-Hill Companies, Inc. All rights reserved. Slide Automatic Terminations No effect on day to day operations For tax purposes two step process: Old partnership contributes all its assets and liabilities to new partnership in return for 100% interest in new partnership Old partnership distributes interest in new partnership to its partners