Deciding to close down your S corporation is no small decision, and understanding the federal income tax implications is essential to ensure that you’re making the right moves. Whether you’re selling the stock or liquidating the assets, there are different tax rules to navigate. Let’s break down the two most common scenarios: stock sale and asset sale with liquidation.
Scenario 1: Stock Sale
If you’re considering selling the stock of your S corporation as part of the shutdown process, it’s important to understand how the gain is taxed.
When you sell your S corporation stock, the gain generated from the sale is typically classified as capital gain. If you’ve held the stock for more than one year, the gain is treated as long-term capital gain which generally receives more favorable tax treatment. The maximum federal tax rate on long-term capital gains is 20 percent. However, this rate only applies if your income is high enough to reach the top tax brackets.
Consideration of Net Investment Income Tax (NIIT)
In addition to federal capital gains taxes, you may also face the 3.8 percent Net Investment Income Tax (NIIT). However, this tax applies only to passive investors. If you’re an active participant in the business, you’ll be exempt from the NIIT.
State Income Tax
It’s important to remember that state income taxes may also apply to the gain from selling your S corporation stock, depending on where you live. The rate and applicability vary from state to state, so check with a tax professional familiar with your state’s laws.
Scenario 2: Asset Sale and Liquidation
A more common way to close an S corporation is to sell all of its assets, pay off any liabilities, and distribute the remaining cash to shareholders. This process is called liquidation, and it has its own set of tax implications.
Taxable Gains and Losses
When the S corporation sells its assets, it recognizes taxable gains or losses on the sale of those assets. These gains or losses are then passed through to shareholders and reported on their personal tax returns.
You’ll receive a Schedule K-1, which shows your share of the gains and losses from the sale. The gains and losses reported on the K-1 are then included in your Form 1040 tax return.
Long-Term Capital Gains vs. Ordinary Income
The gains that result from assets held for more than a year are usually taxed as Section 1231 gains, which qualify for long-term capital gains rates. This means you can pay lower taxes on these gains.
However, some assets, especially those that have been depreciated can trigger higher tax rates. For example, if you sell an asset that has been depreciated (like machinery or equipment), those gains may be taxed as ordinary income, up to 37 percent. Real estate depreciation gains, for instance, can be taxed at a maximum of 25 percent if the asset was depreciated using straight-line depreciation.
NIIT Considerations
As with stock sales, if you’re a passive investor, you may owe the 3.8 percent NIIT on the passed-through gains from the asset sale. On the other hand, if you’re an active participant in the business, you’re exempt from the NIIT.
Liquidating Distributions
After the S corporation sells its assets and settles its liabilities, it distributes the remaining cash to its shareholders. If the cash you receive is more than your basis in the S corporation shares, the excess amount is treated as capital gain.
- If you’ve held your shares for more than one year, this gain is taxed as long-term capital gain.
- If the cash distributed is less than your basis, it’s treated as a capital loss.
Tax-Saving Strategy for Asset Sales
One of the most important strategies for minimizing taxes in an asset sale is to allocate more of the sale price to assets that generate lower-taxed gains, such as land or buildings. On the flip side, allocate less to assets that generate higher-taxed ordinary income, such as receivables or heavily depreciated assets.
Properly allocating the sale price can make a big difference in your tax outcome, so work with a tax professional to make sure the allocation is handled appropriately.
Compliance and Reporting
After you’ve completed the sale of assets and liquidation, there are several compliance and reporting requirements to keep in mind:
- IRS Form 8594 (Asset Acquisition Statement Under Section 1060): This form is used to report the allocation of the sale price across the different assets sold.
- Final Federal Income Tax Return: The S corporation must file a final tax return using Form 1120-S, marking the end of the corporation’s tax status. This return should include final shareholder Schedule K-1s, showing each shareholder’s share of the gains, losses, and distributions.
Next Steps: Plan for Tax Efficiency
Shutting down your S corporation involves more than just closing the doors; it also requires careful consideration of the tax implications. Whether you’re selling stock or liquidating assets, you’ll want to plan ahead to minimize your tax liability. Working with a tax professional who understands these complexities is critical to ensuring that your exit is as smooth and financially advantageous as possible.
If you’re in the process of shutting down your S corporation and need guidance on how to navigate the tax implications, I’m here to help. Give me a call at 480 355-1398, and let’s talk through the best approach for your situation.