Key Takeaways

  • Dissolving an S corporation triggers specific tax consequences under IRS rules, including gain/loss recognition for both the corporation and its shareholders.
  • Shareholders must report distributions and gains under Sections 331 and 1001, often resulting in capital gains or losses.
  • Both federal and state filings, including Form 966 and final Form 1120S, are essential.
  • The corporation may owe taxes on appreciated assets before distributing them to shareholders.
  • Failure to properly handle tax and creditor obligations may lead to personal liability or IRS penalties.

Closing an S corporation requires official dissolution with the Secretary of State where your business operates. A corporation is an independent legal entity that is responsible for taxes and other filings until it is officially dissolved, even if it is no longer doing business in the state. While laws for dissolution vary by state, the procedure is usually similar.

Corporate Authorization

Directors and shareholders must vote to pass a resolution that authorizes the dissolution of an S corporation. This requires documentation of a formal meeting even for corporations made up of only one shareholder.

The minimum number of directors and shareholders that must pass the dissolution resolution is dictated by state law. This could be a simple majority, though some states require a larger majority, such as two-thirds of eligible directors or voting shares. When corporate bylaws state a specific minimum, this number must be used.

Closing an S corporation simply requires adherence to the dissolution guidelines outlined in your Articles of Incorporation. In most states, an S corporation requires shareholder authorization to dissolve. Regardless of the steps taken to dissolve the company, they must be documented and filed in writing with the Secretary of State in all states where you are registered to do business.

Dealing with Creditors

After the resolution to dissolve your S corporation has been approved, you must cease all business operations. The exception is creditor notification of the upcoming distribution. You must also pay your creditors, then distribute assets that remain to shareholders if applicable. This is known as the winding-up process. Other steps of this process include:

  • Filing corporate income tax returns with both the IRS and state taxation authorities. These should be noted as the final tax return and all unpaid taxes should be resolved.
  • Create and distribute a Schedule K-1 to each shareholder.
  • Provide subcontractors with final payment information.
  • Provide employees with final withholding and wage information where applicable.

If you cannot pay all your business's outstanding debts, you may need to consider bankruptcy proceedings. For this reason, it's important to notify your creditors so liquidated company assets can be appropriately distributed.

Distributing Assets to Shareholders

When distributing remaining assets after repaying creditors, consult the corporate bylaws to determine the percentage each shareholder should receive. If this is not detailed in the bylaws, follow the state laws for distribution. These typically require distributions to be in accordance with each shareholder's percentage of the company. Shareholders who are also creditors should be repaid before any assets are distributed.

Tax Consequences of Dissolving an S Corporation

Dissolving an S corporation carries significant federal tax consequences for both the corporation and its shareholders. When the corporation distributes its remaining assets, the IRS treats this as a taxable event that may trigger gain or loss recognition.

For the Corporation:An S corporation must recognize gain or loss on the distribution of appreciated or depreciated assets to shareholders. This means the business must treat each distributed asset as if it had been sold at fair market value, potentially resulting in taxable gain reported on the corporation’s final return. Common triggers include:

  • Appreciated real estate or equipment
  • Inventory with increased value
  • Unrealized receivables

These gains flow through to the shareholders on their Schedule K-1 and are reported on individual tax returns.

For Shareholders:Under IRC Sections 331 and 1001, shareholders treat the liquidation as a sale or exchange of their stock. This generally results in capital gain or loss, calculated as the difference between the fair market value of the distributed assets and their basis in the stock. The character of the gain (short- or long-term) depends on the length of time the shareholder held the stock.

Shareholders must also report:

  • Gain from excess distributions over stock basis
  • Ordinary income from certain types of corporate assets (e.g., depreciation recapture under IRC §1245/1250)
  • Final year tax reporting on Form 8949 and Schedule D

Proper planning can help minimize taxes. For instance, shareholders might strategically time the distribution of assets or use capital losses to offset gains.

State and Federal Filings

In most states, you'll need to file Articles of Dissolution to officially dissolve your S corporation, though some states call this paperwork by a different name. Certain states require that you first settle any outstanding tax obligations and provide the state with a tax clearance certificate along with your filing.

S corporations that are dissolving must also file IRS Form 966 and cancel any outstanding state and municipal licenses and permits. You must file a certificate of termination with the finance department in the state where your S corp is registered.

Form 966 must be submitted within 30 days of the corporation resolution for S corp dissolution and liquidation. This form will require information such as your company's name, address, and date of incorporation.

The S corp's final income tax return must be submitted within three months of the dissolution date using Form 1120S. You'll also need to submit Form 4797 if you gave away or donated any business assets as part of the wrapping-up process.

Final Tax Reporting and Common Mistakes

In addition to filing IRS Form 966 and Form 1120S, S corporations must ensure that shareholders receive a final Schedule K-1 and that any required depreciation recapture is accurately calculated.

Common errors during final tax reporting include:

  • Not timely filing Form 966 within 30 days of adopting the dissolution plan
  • Failing to recognize taxable gain on distributed assets
  • Overlooking depreciation recapture rules
  • Distributing assets before paying all liabilities or finalizing the tax return

Also, failure to update shareholder stock basis prior to liquidation may lead to incorrect capital gain or loss reporting.

Some states require a separate clearance certificate before accepting Articles of Dissolution. Without this, the business may still owe taxes or penalties even after filing federally.

Employee Obligations

Your state law will dictate how much time you have to issue final paychecks to your employees. You must pay all final payroll taxes or risk being held personally liable by the IRS. Employers with more than 100 employees must also give at least 60 days written notice of the business's closing. Giving notice to employees is good policy for all companies to follow, even those with only a few workers.

In addition to final paychecks, you must issue final W-2 forms to employees and final 1099-MISC forms to independent contractors. These should also be sent to the Social Security Administration.

Frequently Asked Questions

  1. What are the tax consequences of dissolving an S corporation?
    The corporation may need to recognize gain or loss on distributed assets. Shareholders report capital gains or losses based on the fair market value of the assets received.
  2. Do shareholders owe taxes on asset distributions during liquidation?
    Yes. Shareholders typically recognize capital gain or loss on the liquidation based on the difference between asset value received and their stock basis.
  3. What IRS forms must be filed to dissolve an S corporation?
    Form 966 (Corporate Dissolution), Form 1120S (Final Return), Schedule K-1 (for shareholders), and possibly Form 4797 or 8949, depending on the nature of asset disposition.
  4. When is Form 966 due?
    It must be filed within 30 days of adopting the plan to dissolve the corporation.
  5. Are tax clearance certificates required for dissolution?
    Some states require a tax clearance certificate before approving dissolution, which confirms the S corporation has no outstanding tax liabilities.
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