Taxation of liquidating distributions
But a question arises when it distributes to its shareholders all its assets—both tangible and intangible—and ceases doing business: Is there a taxable distribution of its intangible goodwill? According to the Tax Court, on the other hand, the answer is that it depends.The question of who “owns” the client relationships and customer-based intangibles turns on whether an employment or noncompete agreement is in effect at the time of the distribution.
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)).Further, according to the IRS, when the firm transfers such intangibles to shareholders, they also realize taxable gain.There’s no doubt that a firm can distribute tangible property to its shareholders as a dividend, whether it liquidates or not.According to the IRS, when a corporation distributes “clients and customer-based intangibles” to its shareholders, IRC sections 331 and 336 apply; such intangibles include the corporation’s client base, client records, workpapers and goodwill (including going-concern value).The IRS position is that these intangibles are the firm’s assets and the firm realizes taxable gain when it distributes them to shareholders.The corporation recognizes income on the excess of fair market value over adjusted basis.
The shareholders recognize capital gains on the fair market value of the property received in excess of their basis in the stock.
This mainly occurs during voluntary liquidations of solvent corporations.
THE IRS SAYS DISTRIBUTIONS of customer-based intangibles to shareholders are taxable.
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.
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.