How to qualify C-Corp Asset Sale Distribution to offset shareholder basis against gain?

This looks like an inadvertent constructive dividend situation. Since the C-Corp recognized and paid tax on the full gain from the asset sale, but the proceeds went directly to the shareholder without proper documentation, the IRS would likely consider this a constructive dividend by default. Your best approach might be pursuing the partial liquidation angle under 302(b)(4). You don't necessarily need a formal written plan for a partial liquidation if you can demonstrate that there was a genuine contraction of the business operations. The fact that one of two locations was sold completely could support this position. You'll need to document that this wasn't just a distribution of earnings while continuing the same business operations. The key elements to establish would be: 1) a genuine contraction of business operations, 2) the distribution was not essentially equivalent to a dividend, and 3) the redemption was substantially disproportionate with respect to the shareholder. Document everything you can about the business reasons for selling one location and consider having the shareholder and corporation execute a resolution retroactively acknowledging the intent for this to be treated as a partial liquidation (though acknowledge this was done after the fact).

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Has anyone considered whether a section 338(h)(10) election might apply here? If properly structured, it would treat the asset sale as if the assets were sold by the corporation followed by a complete liquidation. This might allow the shareholder to offset their stock basis against the gain. The issue would be timing since this was a 2022 transaction. You'd need to file an amended return and the election is typically made at the time of sale. But I've seen the IRS grant relief for late elections under certain circumstances.

Have you looked into treating this as a return of capital under Section 301(c)(2) rather than a dividend? If the C-Corp has sufficient E&P to cover the distribution, that's problematic, but if not, you might be able to treat at least part of it as a return of capital up to the shareholder's basis. Also, consider whether the franchise sale could qualify as a sale of a separate business segment under Section 302(e)(2), which would support partial liquidation treatment even without explicit documentation.

This is a complex situation that requires careful analysis of multiple code sections. Given that the C-Corp already paid tax on the gain but the shareholder received the proceeds directly, you're essentially dealing with a constructive dividend unless you can successfully argue for different treatment. Your best path forward is likely the partial liquidation argument under Section 302(b)(4) combined with 302(e)(2). The key factors working in your favor are: 1) genuine contraction of business operations (50% reduction from two locations to one), 2) complete termination of one business segment, and 3) the distribution was directly attributable to the business contraction. The lack of formal documentation is problematic but not necessarily fatal. Rev. Rul. 75-223 and several Tax Court cases have recognized partial liquidations based on substance over form when there's clear evidence of business contraction. Document everything you can about the business reasons for the sale and consider preparing a detailed memorandum establishing the facts and legal basis for partial liquidation treatment. One additional consideration: make sure to calculate whether the shareholder has sufficient basis to absorb the distribution. If the basis exceeds the distribution amount, the entire amount could be treated as a return of capital under a successful partial liquidation argument. You might also want to consider filing a protective election or amended return with alternative treatments to preserve your options if the IRS challenges the characterization.