25.3 Distributions, Redemptions, and Liquidations

The Distribution Question Is an Ordering Question

Distribution problems reward a disciplined sequence: identify the entity, classify the payment, compute basis before the payment, then decide whether dividend income, return of capital, gain, or loss results. The same dollar can be a dividend in a C corporation, a tax-free recovery in an S corporation, a partnership basis recovery, or sale proceeds in a qualifying redemption.

Memorize that corporate distributions are measured against earnings and profits (E&P) - a tax concept - not financial-statement retained earnings. Current E&P is tested first (allocated pro rata across the year), then accumulated E&P (allocated chronologically).

C Corporation Distributions

Appreciated property (Sec. 311(b)). If the corporation distributes property worth more than its basis, the corporation recognizes gain as if it sold at FMV, which also increases E&P. The shareholder measures the distribution at FMV and takes an FMV basis in the property. A nonliquidating distribution of loss property does not let the corporation deduct the loss.

Worked example. A C corporation with ample E&P distributes land, FMV 70,000, basis 25,000. The corporation recognizes 45,000 gain; the shareholder reports a 70,000 dividend and takes a 70,000 basis in the land.

S Corporation and Partnership Distributions

S corporation. An always-S corporation generally has no E&P, so cash distributions are tax-free to the extent of stock basis, with the excess a capital gain. Increase basis for pass-through income before applying the distribution. A former C corporation can carry accumulated E&P, and the accumulated adjustments account (AAA) distinguishes S-era earnings (tax-free up to basis) from old C-corp E&P (potential dividend). An S corporation distributing appreciated property recognizes gain that passes through to shareholders, raising their basis.

Partnership. Distributions use a nonrecognition model. A current cash distribution reduces outside basis and creates gain only when cash exceeds outside basis. A property distribution generally triggers no gain; the partner's basis in distributed property is limited to remaining outside basis. Section 751 hot assets - unrealized receivables and substantially appreciated inventory - can convert what looks like capital gain into ordinary income.

• C-corp liquidation: gain/loss at entity and shareholder levels.
• S-corp liquidation: corporate gain/loss passes through first.
• Partnership liquidation: focus on outside basis, cash, property basis, hot assets.

Redemptions and Section 302

A redemption occurs when a corporation buys back its own stock. The question is whether it is a sale or exchange (capital gain, basis recovered) or a dividend-equivalent distribution (ordinary dividend, no basis recovery). Section 302 grants sale treatment if the redemption is:

1. Substantially disproportionate - after redemption the shareholder owns <50% of voting power and <80% of the prior percentage;
2. A complete termination of the shareholder's interest;
3. Not essentially equivalent to a dividend (a meaningful reduction); or
4. A partial liquidation for a noncorporate shareholder.

The exam trap is Section 318 constructive ownership: family attribution (spouse, children, grandchildren, parents), entity attribution, and option attribution can make a shareholder still "own" redeemed stock. If every Sec. 302 test fails, the payment is taxed under the dividend rules.

Exam Workflow

1. Classify: current distribution, redemption, or liquidation.
2. Compute entity-level gain first for corporate appreciated-property distributions.
3. Update owner basis for pass-through income before testing S-corp distributions.
4. For partnerships, compare cash to outside basis first, then property basis and Sec. 751.
5. For redemptions, run Sec. 302 with Sec. 318 attribution before assuming sale treatment.

Partnership Distributions in Detail

Partnership distributions deserve their own drill because the ordering rules differ from corporations. A current (nonliquidating) distribution reduces outside basis: cash first, then the partner takes the partnership's basis in distributed property (a carryover basis, capped at remaining outside basis). Gain arises only when cash exceeds outside basis; loss is never recognized on a current distribution.

Worked example. A partner with outside basis 40,000 receives 55,000 cash. Cash (55,000) exceeds basis (40,000), so the partner recognizes 15,000 capital gain and ending basis is 0 - basis cannot go negative.

Liquidating distributions are different: the partner zeroes out the interest. Here a loss can be recognized, but only when the partner receives solely money, unrealized receivables, and inventory and outside basis exceeds the total received. If any other property is distributed, no loss is allowed; the partner instead allocates remaining basis to that property.

Section 751 hot assets are the recurring trap. "Hot assets" are unrealized receivables and inventory items. When a distribution (or a sale of a partnership interest) effectively exchanges a partner's share of hot assets, the law recharacterizes what would be capital gain into ordinary income, preventing partners from converting ordinary income into capital gain through the partnership form.

Comparison with corporations: a corporation distributing appreciated property recognizes gain at the entity level (Sec. 311(b)); a partnership distributing property generally recognizes no gain at the entity level and the partner takes a carryover basis. This asymmetry is a favorite MCQ contrast - distributing appreciated property out of a C corporation is a taxable event, but out of a partnership it usually is not. Always identify the entity before deciding whether the distribution itself is a recognition event.