In setting up a business entity, the owners must decide what type corporation they intend to create: sole Proprietorship, Partnerships or Corporations. A sole Proprietorship is an entity where one person owns all the business assets and liabilities. The business is only separate from the owner on the basis of accounting purposes alone; it is not a unique legal entity from the owner. Partnership businesses are formed by two or more persons or corporations who take ownership for all the assets and liabilities of the business. It is similar to a sole Proprietorship in that it is not a separate legal entity. A Corporation is a legally recognized entity formed by law. It is distinctively separated from the owners; referred to as shareholders. Each of the three business entities attracts different types of taxations (Drake & Fabozzi, 2011). The owners of an entity must agree on corporation type that has most tax advantages for them. The corporation can change its legal status in due course to accommodate new business realities and take advantage of the different tax regimes. Corporations are of the two types: Regular and Electing Corporations. A regular corporation is liable to tax remittance separate from the owners – Corporation Income Tax Return. The incomes and expenses of regular corporations are reported in the return form for the purpose of tax calculation that ranges between 15 and 39% (Smith, Harmelink & Hasselback, 2009). An electing corporation is not a separate tax paying entity from the owners: it files Tax Income Return though does not pay income tax. Similar to Sole businesses and Partnerships, Electing Corporation file Tax Return through its individual shareholders.
In due course of the life of a Corporation, the shareholders may decide to liquidate the entity. This is preceded by the owners’ forfeiture of their shares in the corporation upon receiving their percentage share contribution following the payment to all the creditors. Corporations can be liquidated for various reasons: lack of business, to avoid heavy taxation of based on the ownership and due to losses (Drake & Fabozzi, 2011). The owners may also want to convert the assets of the corporation into cash of other ventures, or where a potential buyer is not willing to buy off the corporation’s shares. The owners benefit from liquidation in that they receive full compensation for the total value of their shares. The shareholders also have the opportunity to start a new business with a preferred share portfolio. They can also realize a capital loss if the stocks has a higher value than the fair market value of the distributed assets (Gaughan, 2010).
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A Corporation needs to meet certain conditions to qualify for status of liquidation before the rule of liquidation is applied to the entity and its shareholders. The liquidation status is characterized by the corporation’s cessation of being a going concern; conducts its business in a manner of winding up, clearing it financial obligations and subsequent distribution of the remaining assets to the shareholders (Smith, Harmelink & Hasselback, 2009). A successful liquidation process will lead to a total dissolution of the entity: a legal termination of the entity existence under the law. After meeting its financial obligations and allocation of remaining properties to owners, a gain or a loss accruing is determined. The law requires the shareholders to treat the proceeds from the distribution of assets as gains from the disposal of shares. The gain or loss is computed by deducting basis of the shareholder’s stock from the prevailing market value. The gain or loss is recognized as a capital gain or loss, since stocks are capital assets. In case of corporate shareholders, the assets received from distribution process of a liquidating subsidiary are neither recognized as gains or loss (Hoffman, Smith, Willis, Boyd & Dilley, 2011). Additionally, the liquidating subsidiary does not recognize gain or losses and any tax accruing thereof for the purpose of passing it over to its parent company. The gain or loss is recognized based on the nature of the property to the corporation and the duration the of the property’s ownership.
Liquidation Effects on Corporation
Whenever a Corporation enters the liquidation status, there are several tax consequences applying to the entity. The start of the liquidation process marks the end of the accounting period for the purpose of corporation tax. It also marks the start of a new accounting period that does not end until the 12 months are over or the liquidation process is complete; whichever comes first. There are several scenarios that determine the tax consequences of liquidating Corporations. A parent Corporation’s basis in the stock of its subsidiary under liquidation, and in accordance with section 332, disappears indefinitely after dissolution (Smith, Raabe & Malone, 2012). The shareholders should weigh the implications of whether recognizing losses of the subsidiary’s stocks or selling later of the subsidiary’s distributed assets will offer more taxable gain or less loss that arise when the internal asset basis is less than the external stock basis. Where a shareholder receive money or assets from a company under liquidation, he is liable to a capital gain tax in relation to the money received or the assets’ market value at the date of the distribution, less the amount deemed to be dividend (Smith, Raabe & Malone, 2012).
If the Corporation has a foreign subsidiary and liquidates in the United States, it qualifies under section 332, and the parent corporation is taxed all the proceeds of it liquidated subsidiary. Moreover, if a parent corporation from the United State liquidates in a foreign country, pursuant to section 332, the subsidiary will be taxed on the distribution of the appreciated property (Gaughan, 2010). Treating of Earnings and Profits (E&P) realized by the subsidiary, while it was a member of the parent group of companies, is already reflected in the Earning and Profit of the parent corporation and, hence, no further adjustment is required in E&P of the parent company. If the subsidiary had Earnings and Profits earned prior to being a member of the parent corporation, it will only be exempted from deductions upon successful liquidation of the subsidiary. The 80% control test must be performed to determine the share capital portfolio for a subsidiary owned by more than one consolidated group member. Member of the group will not recognize loss and gains on the subsidiary under liquidation; the subsidiary will recognize the gains but not losses on assets it distributes to its shareholder members that do not own it: at least 80% of the subsidiary (Smith, Harmelink & Hasselback, 2009).
If the subsidiary is liquidated under section 332, the parent corporation automatically succeeds in the subsidiary liquidation tax attributes. Exempt to this provision is given in section 269(b), which sets the criteria on the stock ownership and duration. The Inland Revenue Service invokes the section to disallow the parent company to use the subsidiary pre-acquisition tax attributes. Section 269(b) is essentially a check against liquidations aimed at avoiding the federal tax. Regardless of the tax eligibility of the liquidation subsidiary, uniting two separate corporations into one can have a remarkable impact on preceding state tax scheduling (Hoffman, Smith, Willis, Boyd & Dilley, 2011). If two entities had been operating in and justifying taxation of profits in a high-tax state and a low-tax state, after the liquidation, they would have lost such a previous benefit.
Internal Revenue Service recommends that liquidating corporations filing for tax return should exercise due diligence to ensure that all filing requirements are met. There should be conformation of whether form 1099 was successfully filed for all the shareholders receiving distribution in excess of $600 in a time of one calendar year (Hoffman, Smith, Willis, Boyd & Dilley, 2011). There are applicable penalties to non-compliance to this requirement. In case when dividends were paid to foreign entities, form 1042 must have been filed. Form 966 that governs the corporate liquidation should be a file. The Internal Revenue Service states that an entity that has successfully completed liquidation is often considered to be dissolved and, hence, must return files and pay tax, thereon soonest or on or before the fifteenth of the third month after dissolution.
Liquidation Effect on Liabilities
The expenses incurred in liquidation are determined for the purpose of filing a tax return. Expenses incurred can be categorized as costs of preparation and management of the liquidation and winding up of the business. Example of such costs includes, accountants’ and lawyers’ fee. These costs are treated as an ordinary operation business costs pursuant to Code section 162. Expenses incurred in disposing the assets are offset against the revenue realized from the transaction (Gaughan, 2010). Expenses incurred as a result of tax-free reorganization are not deductible from the tax net. Expenditures of a capital nature may be deducted upon liquidation. Shareholder expenses are not deducted, although they affect the final amount realized from distribution. Corporation Liquidation form 966 should be filed with the Inland Revenue Service in a time of 30 days of plan liquidation adoption. A separate 1099 form must be filed for each shareholder that received more than $600 of distribution liquidation in the year. The corporation tax year ends when the liquidation is completed (Gaughan, 2010).
Effect on the Shareholders
The shareholders are considered to have forfeited their rights of stock ownership in exchange for the money and assets received in liquidation distribution. This determines the loss or gain accrued, and a fair market basis for the property received. Shareholders receive the distribution either by the company selling the assets and distributing the proceeds or the corporation distributing the assets direct to the shareholders (Smith, Harmelink & Hasselback, 2009). The process results in shareholders realizing either a capital gains or loss depending on whether the shareholders’ stocks are of share capital nature. The gain or loss is the difference between the shareholder’s stock basis and the fair market value of the liquidation distribution received. There are exemptions to this general rule; section1224 is one of such exemptions (Smith, Harmelink & Hasselback, 2009). Whenever a shareholder assumes the liability to property of a liquidating corporation, or receives distribution property that is subject to liability; the liability reduces the total amount the shareholder receives, increasing the shareholder’s loss or reducing the shareholder’s gain.
There is a set of rules and guidelines that stipulate how corporation liquidation process is accomplished. Formal corporation liquidation involves the adoption of the plan of liquidation and important local law notifications to the different stakeholders; winding up of business activities; distribution of properties and the subsequent dissolution of the corporate legal entity. For United States’ federal income tax purposes, liquidation of corporations may be seen to operate under a different set of rules (Smith, Raabe & Malone, 2012). Tax authority scrutinizes liquidating corporations to discourage in practices that may lead to unlawful tax avoidance. The tax payer may also avoid tax liability by means of liquidating one or several entities and colluding with other entities. They may also engage in arrangements that may be intended to defeat the creditors and avoid the due liabilities. The business may liquidate with the intention of reorganizing and carrying on with the business using the same assets from the original entity; it may arrange distribution to be received by associates, affiliates or the taxpayer. These scenarios can lead to civil and criminal consequences against the shareholders.