What are the tax consequences of dissolving an S corporation?

Ines Zemelman, EA
Ines Zemelman, EA
• 21.05.24 • 5 mins read
What are the tax consequences of dissolving an S corporation?

Dissolving an S corporation is an important decision with significant tax implications. Whether due to economic reasons, strategic changes, or shareholder agreements, understanding the tax consequences is essential to ensuring compliance and minimizing the financial impact.

This article examines the tax consequences of dissolving an S corporation, including the steps involved, the treatment of gains and losses, and the final tax filings required.

Company dissolution preparation

Each state has its own procedures for dissolving a corporation. Typically, you must file Articles of Dissolution with the state's Secretary of State. This officially notifies the state that the corporation has ceased to do business. The process generally involves:

  1. Preparing the articles of dissolution. Complete the required forms, which typically include the name of the corporation, the date of dissolution, and a statement that the dissolution was approved by the shareholders.
  2. Paying the filing fee. Most states require a fee for filing articles of dissolution. The amount varies from state to state.
  3. File the forms. Submit the completed forms to the state secretary of state. Some states allow online filing, while others require filing by mail or in person.
  4. Receive confirmation. Once the state processes the filing, you will receive confirmation. Keep this confirmation as part of your permanent records.
NOTE

As discussed above, shareholder approval must be obtained before an S corporation can be dissolved. This generally requires a majority vote as set forth in the corporation's articles of incorporation or bylaws.

Filing the Articles of Dissolution is an important step in the dissolution process. It ensures that the corporation is formally recognized by the state as dissolved and helps prevent future tax and legal obligations.

Tax consequences for the S corporation

Upon dissolution, an S corporation must recognize gains and losses on the distribution of its assets. This process involves several important considerations:

  1. The corporation must determine the fair market value of each asset to be distributed. This includes both tangible assets (e.g., real estate, equipment) and intangible assets (e.g., patents, trademarks).
  2. Gains and losses are calculated by comparing the fair market value of each asset to its adjusted basis. The adjusted basis is generally the original purchase price of the asset plus any improvements, less any depreciation.
  3. These gains and losses are reported on the corporation's final Form 1120-S, U.S. Income Tax Return for an S Corporation.

Proper reporting is essential to ensure compliance with IRS regulations and to avoid potential penalties.
For example, if the corporation distributes equipment with a fair market value of $10,000 and an adjusted basis of $6,000, it will recognize a gain of $4,000.

Tax consequences for shareholders

The dissolution of an S corporation also has significant tax implications for the shareholders. These include the distribution of assets and the calculation of gain or loss based on the shareholder's basis in the corporation's stock.

Distribution of the assets

When an S corporation dissolves, its remaining assets are distributed to its shareholders. The tax consequences to the shareholders depend on the type and value of the assets received. Key issues include:

  • Fair market value. Shareholders must include the fair market value of the assets received as part of their gross income.
  • Character of income. The nature of the asset determines the character of the income. For example, a distribution of inventory may be treated as ordinary income, while a distribution of capital assets may result in capital gain or loss.
  • Timing of recognition. The gain or loss is recognized in the tax year in which the assets are distributed. This requires careful tracking of the distribution date and related values.
    For example, if a shareholder receives real estate valued at $100,000, this amount will be included in his or her gross income, and the nature of the asset (capital gain) will affect his or her tax liability.

Basis and capital gains

The shareholder's basis in the S corporation stock plays a critical role in determining the tax impact of the liquidating distribution. There are several important considerations:

  • A shareholder's basis is adjusted annually for his or her share of the corporation's income, losses, and distributions. The final calculation of the basis is critical in determining the gain or loss of the distribution.
  • The gain or loss is calculated by subtracting the shareholder's adjusted basis from the fair market value of the assets received. If the fair market value exceeds the basis, the shareholder recognizes a capital gain. If it is less, the shareholder recognizes a capital loss.
  • Shareholders must report these gains or losses on their tax returns, typically using Schedule D (Capital Gains and Losses).
    For example, if a shareholder's adjusted basis in their stock is $50,000 and they receive assets valued at $70,000, they will recognize a capital gain of $20,000. Conversely, if they receive assets valued at $40,000, they will recognize a capital loss of $10,000.

Final tax filings

Proper final reporting is essential for an orderly liquidation and IRS and state compliance.

This includes filing the final federal tax return and satisfying any state and local tax obligations.

File final tax returns

The S corporation must file its final Form 1120-S, U.S. Income Tax Return for an S Corporation. Key steps include:

  1. Indicate that this is the final return by checking the appropriate box on the Form 1120-S.
  2. Ensure that all income, gains, losses, deductions, and credits through the date of dissolution are accurately reported.
  3. Provide each shareholder with a final Schedule K-1 detailing his or her share of the corporation's income, deductions, and credits for the last year of operation. Shareholders will need this information to complete their tax returns.

State and local tax considerations

Each state has its requirements for dissolving a corporation and filing final tax returns. Important considerations include:

  • In addition to filing articles of dissolution, some states require separate final tax returns or additional forms to officially close the corporation.
  • Ensure that all state taxes are paid, including all corporate income, sales, and payroll taxes. Unpaid state taxes can result in penalties and interest.
  • Address any local tax obligations, such as property taxes or business licenses, to ensure all financial responsibilities are met.

Consult with a tax professional or legal counsel to ensure that all state and local tax requirements are met, and keep detailed records of all filings and payments.

Let a tax pro do your business tax return.

Book free discovery call

Bottom line

Dissolving an S corporation requires numerous steps and careful consideration of the tax consequences. From obtaining shareholder approval and filing articles of dissolution to handling liabilities, recognizing gains and losses, and making final tax returns, each step is critical to ensuring a smooth and compliant dissolution process.

 

Disclaimer: This article is for informational purposes only and does not constitute legal or tax advice. Always consult with a tax professional regarding your specific case.