Academic journal article Journal of Accountancy

Avoid Taxes in Liquidation

Academic journal article Journal of Accountancy

Avoid Taxes in Liquidation

Article excerpt

EXECUTIVE SUMMARY

* THE IRS SAYS DISTRIBUTIONS of customer-based intangibles to shareholders are taxable. When a firm or corporation distributes to its shareholders all of its assets, both tangible and intangible, and ceases doing business, the IRS says there is a taxable distribution of its intangible goodwill.

* THE CRITICAL ISSUE FOR TAX PLANNING is whether the assets distributed are considered property under IRC code section 336 and whether the corporation owns them.

* THE QUESTION OF WHO "OWNS" the clients and customer-based intangibles turns on whether there is an employment or noncompete agreement in effect at the time the intangibles are distributed. Without such an agreement, client goodwill attributable to the personal characteristics of a shareholder isn't a property right belonging to, or transferable by, a firm.

* A NONCOMPETE COVENANT, to be enforceable, must reasonably reflect an employer's protectable interest in both the nature and the scope of the restraint on the employee. Trade secrets, special processes, patents and proprietary information are among an employer's protectable interests, but how noncompete provisions create an employer property right isn't clear.

* THE PRACTITIONER SHOULD ADVISE the client to terminate employment and noncompete agreements with shareholders before liquidation.

* WHETHER PLANNING FOR A LIQUIDATION of their own professional practices or advising clients about the liquidation of a commercial organization, CPAs will find that the problems and the solutions associated with each are likely to be the same.

Proper planning requires CPAs to examine existing employment agreements with shareholder-employees.

Lawyers advise CPAs to have employment and noncompete agreements in their accounting practices. They recommend that all employees, including those who are shareholders, promise--in writing--not to take clients with them if they leave the firm. Such agreements can protect firms, the lawyers say. But what they might not say is that employment and noncompete agreements can create serious income tax consequences when a firm or corporation is liquidated and goodwill assets such as client relationships are distributed among the shareholders. There is the possibility of some relief, however: A CPA firm and its shareholders are in a better position to avoid serious tax consequences if such agreements are not in place when the professional corporation is dissolved.

The IRS asserts that distribution of "clients and customer-based intangibles" to shareholders is taxable, but the Tax Court has held that it isn't if a noncompete agreement between the shareholder or employee and the firm does not exist. This apparent contradiction presents some questions to which there are no black-and-white answers. In the cases discussed in this article, the Tax Court did not distinguish between personal service corporations, such as CPA firms, and commercial organizations, such as an ice cream distribution company, in identifying the individual ownership of customer-based intangibles. In planning for a liquidation of their professional practice or advising clients about the liquidation of a commercial organization, CPAs will find that the problems and the solutions are likely to be the same.

TANGIBLE OR INTANGIBLE, YOU STILL MAY OWE TAXES

In a firm or corporate liquidation, or when a shareholder redeems his or her interest, it's not uncommon for the business to distribute property as well as money in exchange for the capital stock a shareholder held.

When such a business distributes its property, it generally is deemed to have sold the property at fair market value, which requires it to recognize a gain (IRC section 336(a)). The shareholder, who treats the fair market value of the property as received in exchange for his or her stock, also recognizes a gain (IRC section 331(a)). The critical issue for tax planning is whether the assets distributed are considered property under IRC section 336 and whether the corporation owns them. …

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