How to handle C-Corp Asset Sale Distribution - Need advice on shareholder basis vs dividend

This is a classic case of substance over form, and you've got some cleanup work to do. What happened here is essentially a constructive dividend. Since the C-Corp recognized the sale and paid tax on it, but the proceeds went directly to the shareholder without proper documentation, the IRS would likely view this as a dividend distribution. Your best approach may be to explore a partial liquidation argument under 302(b)(4). The lack of a formal written plan doesn't automatically disqualify you, though it certainly would have helped. Courts have sometimes recognized partial liquidations without formal written plans if the intent can be demonstrated through other means. In this scenario, you need to document that the sale represented a genuine contraction of the corporation's business (going from 2 locations to 1). Gather any evidence showing the shareholder's intent to treat this as a partial liquidation rather than just taking dividends - board minutes, emails, business plans showing the strategic decision to downsize, etc. If you can establish that this was effectively a partial liquidation, the shareholder could potentially treat the distribution as a sale or exchange of stock rather than a dividend, allowing them to use their basis to offset gain.

I stumbled across this thread because I had a somewhat similar situation last year. After spending countless hours researching, I ended up using a service called taxr.ai (https://taxr.ai) that helped me analyze my corporate transaction documents. Their AI system actually flagged some key language in our operating agreement that supported treating our sale as a partial liquidation vs a dividend. For your situation, they might be able to review the asset purchase agreement, corporate minutes, and any communications that show intent to contract the business. Even without a formal written plan, the system identified several cases where courts ruled in favor of taxpayers with documentation showing clear intent. It saved me from having to manually search through hundreds of tax cases.

I wanted to follow up on my question about taxr.ai. I was skeptical, but I decided to try it with some of my client documents for a similar situation. I was genuinely surprised by how useful it was. The system found a Tax Court case I hadn't come across that was almost identical to my client's situation - it involved a restaurant chain that sold one location without a formal liquidation plan but had emails showing business contraction intent. The report it generated actually saved me about 15 hours of research and gave me confidence to take a partial liquidation position instead of the dividend treatment I was leaning toward. My client saved almost $120K in taxes as a result. The document analysis was way more sophisticated than I expected.

After reading through this thread, I think there's another approach worth considering. Have you tried contacting the IRS directly to get guidance on this specific situation? I know it sounds old-school, but I finally got through to an IRS agent a few weeks ago using Claimyr (https://claimyr.com) and got surprisingly helpful advice on a complex S-Corp distribution issue. Their service basically holds your place in the IRS phone queue and calls you back when an agent is available. You can see how it works in this video: https://youtu.be/_kiP6q8DX5c. I know most accountants avoid calling the IRS like the plague, but having a direct conversation with an agent about this partial liquidation issue might give you more certainty than trying to interpret the code on your own.

I'm actually shocked to report that I tried the Claimyr service mentioned above after posting my skeptical comment. After years of fighting with the IRS phone system, I got through to a business tax specialist in about 90 minutes without having to sit by my phone. The agent pulled up their internal guidance on partial liquidations and gave me several specific documentation recommendations that weren't in any of the articles or books I've read. She specifically mentioned that contemporaneous evidence of business contraction intent can substitute for a formal plan in many cases, and suggested documenting the business purpose for selling one location rather than both. This conversation probably saved my client from a potential audit adjustment. I've been practicing for 20 years and honestly didn't expect to get that level of helpful guidance.

Has anyone considered that this might qualify under Section 301(c)(2) as a non-dividend distribution? If the shareholder's basis is sufficient, this could be treated as a return of capital rather than dividend income or capital gain. Much simpler than the partial liquidation route if it works.

One angle nobody's mentioned - what about treating this as an installment sale of stock to the corporation? Could argue the shareholder effectively sold back a portion of their stock representing the sold location, with payments over time. Section 302(b)(2) might apply if it's "substantially disproportionate.

I've been following this discussion and wanted to add a practical perspective from someone who's handled several similar cases. The partial liquidation route under 302(b)(4) is definitely your strongest argument, but you'll need to be very strategic about the documentation. Here's what I'd recommend focusing on: First, gather any evidence showing the business decision to contract operations was made for legitimate business reasons, not just to distribute cash to the shareholder. Look for emails, text messages, or any communications from 2021-2022 discussing market conditions, profitability of each location, or strategic planning around downsizing. Second, consider having the corporation formally adopt a resolution now acknowledging that the 2022 sale was part of a business contraction plan, even though it wasn't documented at the time. While retroactive documentation isn't ideal, courts have sometimes accepted it when supported by contemporaneous evidence of intent. Third, make sure you can demonstrate that this represented a "genuine contraction" of the business under the regulations. Going from 2 locations to 1 is a 50% reduction in physical operations, which should meet the threshold. The monthly payment structure actually helps your case - it shows this wasn't just a cash grab but a structured business transaction. Document that the buyer is paying market rates and terms typical for franchise sales in your area. One warning though: if the IRS challenges this, they'll look closely at whether the shareholder had any plans to expand again or acquire new locations. Make sure your client can demonstrate this was a permanent contraction, not temporary.