 Hello and welcome to this session. This is Professor Farhad and this session we would look at the complete corporate liquidation. Specifically, we're going to be covering the built-in laws. This topic is covered in corporate income tax course, the CPA exam regulation section. As always, I would like to remind you to connect with me only then, if you haven't done so yet. YouTube is where you would need to subscribe. I have over 1500 tax accounting and auditing lectures. It's all free. Please share them with others. If you like them, please click on the like button, put them in the playlist, let the world know about them. If you're benefiting from my lectures, it means others might benefit as well. This is my Instagram account. This is my Facebook account. And on my website, you can support the channel by making a donation. In the prior session, we look at related party losses. Then we ask ourselves the following question. What if you have some assets, some junk that you don't need, and rather than selling the asset at a loss because you cannot deduct, what if you contribute this asset to the corporation? Simply put, what we are discussing here is contributing built-in loss. Simply put, the asset that you are contributing, it's already at a loss and you're contributing it. We talked about the benefit for you. It will increase your equity. It would also increase it and decrease the minority position if they are present. It also allowed the corporation to sell it at a loss. It's a win-win situation. Then we talked about, well, Congress already know about this and corporate losses not gained are this allowed on property, which is called disqualified. So this property, because it has a built-in loss, it's disqualified. If it's contributed in the past five years prior to the corporate liquidation, we're going to go a little bit more into this rule and talk about what do we mean by built-in losses. So this is what we did in the prior session. In the prior session, we looked at losses that are related party losses and we said we cannot take those. In this session, we're going to focus on number two. In the following session, we'll cover number three and number four. So what are we talking about here? We're talking about the built-in loss limitation. Simply put, you have a loss but you cannot take it. So losses are disallowed on the distribution or sale of built-in loss property, even if a distribution or sale involved unrelated party. Even though you're going to sell them to somebody unrelated to somebody who's not related to the company, they don't own 50 plus, you would still, those losses will be disallowed. How do we define built-in property losses? It's a property acquired in a section 351. So it's very important to know it's section 351. If section 351 is not there, the built-in losses do not apply or contribution to a capital transaction as part of a plan. So basically you are contributing this asset as part of your contribution and the principal purpose of which is to recognize a loss by the liquidating corporation and you are contributing this property and with the aim of eventually the corporation disposing of it at loss. So there is no business purpose for it. So transfer occurring, always transfer occurring within the past two years of adopting the plan are treated as acquired for tax avoidance plan. So any asset acquired, not acquired, contributed to the company in the past two years, basically they are flagged for the built-in loss limitation. Also this presumptive rule does not apply to the following situation. Now we said it's always a few if you contributed within the past two years. However, when there is a clear and substantial relationship between the property and the conduct of a corporation, current and future business, if the asset has a use, if you need a warehouse and you contributed a warehouse, if we need a vehicle like a truck and you contribute the vehicle, well there is there is a business use for it. If that exists then this will not apply. When the property contributed in the first two years of the corporation existence, also this rule here will not apply because the corporation just started and losses this allowed by this provision are limited to the built-in loss determined at the date when the property was acquired by the corporation. So the losses that we disallowed is the built-in losses and we're going to see what does that mean in a moment when we work an example. The basis step-down rule limit the built-in losses limitation reach. So you're going to see when we look at the base step-down rules limit which we talked about in the prior chapter I believe in chapter 18. So we're going to revisit this again and it limits that the amount of losses that you can take. You can take some losses but not all of it. So the best way to illustrate this is to actually work an example. So in the current year B company acquired two properties from the shareholder in a transaction that qualify under section 351. What does that mean? It automatically trigger in your mind that we could have a built-in loss and if there's a built-in loss at section 351 we could have a built-in loss limitation. So here's what we contributed. Land basis of 100,000 fair market value of 50 there's a built-in loss of 50,000. Securities basis of a 10,000 fair value of 35 we have a built-in gain. We net them this is the net built-in loss. So the net built-in loss is 25,000 results in a step-down basis of $75,000 in the land for Brown corporation. So simply put we're going to look at the land with the basis now we're going to reduce the basis of the land to 75 to 75,000. Later in that year Brown adopted plan of liquidation and distributed the land to unrelated shareholder when the land is worth 30,000. Now we distributed the land and we already know the land has a built-in loss but the fair value of the land just kept going down and now it's at 30,000. So how do we compute the loss? How do we compute the loss exactly? Well the proceeds we're going to be receiving is 30,000 this is the we're going to be receiving the fair market value the basis 75,000 remember the basis the built-in basis is 75,000. Okay fair market value 30 basis 75 what is our total loss? Our total loss is 45,000 total loss is 45,000 that's the loss realized. Now how much of that loss of the realized is actually recognized? Well what we have to understand is some of the losses occur after occurred after we contributed the asset remember the fair market value was 50 then a drop down to 30 but that drop down and 30 that additional 20,000 occur after we contributed the asset. Okay what does that mean? It means of the 45,000 loss realized which is that's how much we realized by Brown on the distribution 25,000 is is this allowed by the built-in loss and the remaining the 20,000 is recognized so notice of the 45,000 20,000 happen after the contribution that's allowed and 25,000 is not allowed because that's considered as prior to the contribution of the asset. Now let's change the example a little bit let's assume the fair market value rather than 50 it's 120 what does that mean? It means we don't have a built-in loss now we have a gain and let's assume now we liquidated and we sold the property the fair market value of the property is 30,000 basis of 100,000 we have a loss of 70,000. Now if we distribute this property to unrelated party in a liquidation that's fine we can count the loss of 70,000 so the loss will be recognized okay however if we distribute this property to a related party okay under the related party loss limitation we cannot recognize any loss okay we cannot recognize any loss so the loss is this allowed although notice the decline happened after after we acquired the property so notice when we when they gave us the property it was again it does not matter when we distributed when we distribute the property we had a loss when you distribute the property we had a loss so if it's a related party but it's a related party although the decline happened after it would still be this allowed okay so let's assume the fair market value is 120 there is no built-in loss on the transfer brown will have a basis of 100,000 if the distribution to unrelated party we would recognize the entire loss of 70,000 if the distribution to a related party brown cannot recognize any of the loss under the related party loss limitation because the property is a disqualified property it's section 351 within the past five years when the distribution to related party the loss is this allowed even though the decline happened after even though the decline happened after it would still be a loss now let's talk about the presumption of tax avoidance purpose now what you did is you contributed an asset for the and we are making the presumption there is no business need for it to avoid taxes let's see how this works cardinal corporation stock is held by two unrelated individual 60 by m and 40 by jack one year before cardinal liquidation m which is the majority shareholder majority it's a related party transfer a land with a basis of 150 fair market value of 100 so what does that mean well if we have a basis fair market let's start with a fair market value if we have a fair market value of 100 and the basis of 150 we have a loss of 50,000 so we are contributing an asset with a built-in loss and equipment the equipment has a basis of 10 and fair market value of 70 so fair market value of 70 basis of 10 we have a gain of 60,000 notice when we net those out overall we have a net gain of 10,000 so we don't have a net built-in loss we have a net gain we have a net gain okay as there is no built-in loss on the transfer cardinal will have the basis 150 in the land so now we're going to pick up the basis so in the land so the land will have a basis the land will have a basis of 150 and obviously the equipment will have a basis of 10 because it's already again in the liquidation cardinal distributed the land and now the land has a fair market value of 90 so now we distribute the land the land has a fair market value of 90 the basis is 150 what is our total realized loss hopefully you can do the math the total realized loss is 60 now the total realized loss is obviously you can see this 60 even though the distribution is let's assume to an unrelated party the built-in loss of 50,000 is not recognized so 60 is the total loss 60 of the total loss but we have a built-in loss right from the get go of 50 therefore what we do we're gonna say well 50,000 cannot be counted and what's left in the losses is 10,000 so the remaining losses the remaining losses will be allowed okay so only a loss of 10,000 can be recognized now instead let's assume we distribute it to Manuel who's a related party because he owns 60 percent then there we go we stop right there we say none of it is allowed because he's a 60 owner okay so hopefully you can follow this example assume that the land and equipment are transferred to cardinal corporation because a bank required the additional capital investment as a condition to make a loan to the corporation now what we do is we have a business purpose for the transfer in that situation all of the 60,000 dollar is recognized if the land is distributed to Jack in a liquidation Jack is what Jack is not the related party Jack is the 40 percent owner if instead the land is distributed to Manuel a related party the entire loss is this allowed okay so bear in mind Jack is 40 percent Manuel is 60 percent Manuel is a related party Jack is not so if we if there is a business purpose then we have to make that distinction between related party and non-related party let's take a look at this example our corporation stock is owned by Pedro and Pedro who are unrelated Pedro and Pedro each own 50 percent of the stock of the corporation now before we proceed to be related party you have to be 50 plus okay 50 plus all has the following asset none of which were acquired in section 351 or a contribution to capital transaction so these are assets are not section 351 nor the are contributed to the company and there are distributed in complete liquidation so cash is the fair market value the same land 200,000 dollar basis fair market value of 440 we have a gain of we have a gain of 240 here equipment adjusted basis up to 50 a loss of 90 this is before we look at the question we can we can we have we have that much information assume that the corporation distributed the land to Pedro and the cash and equipment to Pedro so the land the land to one of them so 440 so notice the distribution is 50 percent and 50 440 and the other two is 440 determine the recognized determine the corporation recognized gain or loss on the distribution of the land well there's a gain good there's a gain we recognize the gain there's no if and buts about it we recognize the gain determine our recognize gain or loss for the distribution of the equipment now notice the equipment has a loss actually not the loss is 110 on the on the equipment sorry my math was wrong 110 this is the loss okay now we're going to recognize the loss of 110 okay why because this is a liquidating distribution liquidating distribution liquidating distribution means what it means we are going to in the absence of related party in the absence of the in the absence of related party we can we can recognize the loss and this asset was not section 351 and was not a capital contribution so notice they told us in the problem this asset here both of them are not section 351 and both of these shareholders are not related party okay why because it has to be more than 50 percent so two two reasons we're going to recognize the loss we're going to recognize the gain the gain should be easy we always recognize the gain why do we recognize the loss it's exactly 50 percent oops it's exactly 50 percent and the other reason is the art it's not disqualified asset not disqualified asset it means not section 351 and it's not asset contributed to as a capital transaction let's take a look at this example on january 4th 2018 m company acquired two properties from a shareholder solely in exchange of stocks in a transaction that qualifies under section 351 now we're looking at a transaction that is section 351 the shareholder basis the fair market value and the built-in loss for each property are as follow so property one there's a gain property two we have a loss so overall we have a built-in loss of 50 000 and the company adopt the plan of liquidation later in the year and distribute property two to a 30 percent shareholder so it's not related party when the property is worth 350 okay compute the company basis and property one and property two as of january 4th 2018 first they want us the basis for the corporation well for property one it's pretty straightforward property one there's a built-in gain well if it's a built-in gain we the basis transfer so 300 000 is for property one property two notice in property two we have a loss we have we have a built-in loss we have to do we have to take this 50 000 the net loss and reduce the property so 525 we have to reduce 525 by 50 000 the net loss therefore the basis in the property for the corporation for for property two is 475 as much if my math is right and it should be right 475 okay this is this is the basis in property two now compute the company realized and recognize loss on liquidating distribution of property two so property one is pretty straightforward let's look at property two why property two is why are they looking for property two because it has it because it has a built-in loss okay so first let's determine the realized loss before you proceed just what's my realized loss and then you determine how much am i going to recognize or not well if my basis is 475 that's my basis 475 and the value is 350 so four four well let's start with the value 350 minus 475 is my basis so i have a realized loss so my loss is 125 and that's my realized loss now i have to be very careful here and how much loss am i going to recognize okay because there was a built-in loss to start with all right now remember the fair market value of acquisition was 400 000 okay and we stepped down so the fair value was 400 000 and we compare the 400 000 to 475 so there was an existing loss okay an existing loss of 75 000 so we say we say 400 000 the fair value when asset was contributed minus the adjusted basis of 475 the existing loss that we contributed was 75 000 now obviously we have additional losses because now our losses is 125 well well if we have additional losses of 50 000 those are the losses that we are going to we are going to recognize why because 125 is the total of which 75 existed prior therefore the additional 50 happened after now we can take the additional 50 and the reason we can take the additional 50 recognize the additional 50 because we distributed the property to a 30 percent shareholder that's very important okay now if we distribute the property to somebody with 50 plus 50 plus then none of it none of it will be none of it will be recognized so simply put the total loss is 125 75 is not recognized and 50 is recognized 50 is recognized if you have any questions any comments about this topic please email me if you happen to visit my website 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