Key Takeaways

  • Liquidating an S corporation involves state-mandated steps and IRS filings including Forms 966 and 1120S.
  • A s corp liquidating distribution is treated as a sale of stock, generally resulting in capital gains or losses for shareholders.
  • Assets distributed may create corporate-level gain if their fair market value exceeds basis.
  • Shareholders may need to adjust stock basis to determine gain/loss.
  • Improper planning can trigger significant unintended tax liabilities, especially when appreciated property or installment obligations are involved.
  • State laws and creditor claims can influence how distributions and liabilities are settled.

How to Dissolve and Liquidate an S Corporation

Liquidating an S corporation requires some specific steps to be done legally. An S corporation falls under the state laws that dictate other types of corporations, but what sets it apart is pass-through taxation, which is approved by the IRS. Since an S corporation is dictated by state laws, any steps taken to liquidate and dissolve the business must follow the laws of the company's state of operation. The codes around state business registration and operation outline the required procedures that corporation owners must take in order to legally terminate an S corporation and liquidate its assets.

There are six major steps required to dissolve an S corporation:

  1. Take a vote and make a majority decision among the shareholders to dissolve the S corporation. From there, the managing partners may be able to begin following the state dissolution process, but they must have authorization from the S corporation's shareholders.
  2. The next step is to cease all business operations that relate to the S corporation. The managers must focus solely on liquidating assets and dissolving the business within a reasonable amount of time. However, those involved in the dissolution process can engage in transactions and communications that are necessary to liquidate the assets of the business. One example is a law in the state of Texas, which allows an S corporation to continue engaging in or file for civil, criminal, or administrative legal proceedings, as long as the action relates to something that was outstanding prior to beginning the process of dissolution. Dissolving the S corporation will not allow the business to withdraw or be exempt from any legal proceedings that began before the process started.
  3. It's also important to notify all creditors of the plan to dissolve the S corporation. Laws in each state require that the managers of the business inform any creditors who have pending claims with the S corporation. By taking this step, it's easier to identify who has the right to claim a portion of the proceeds after the company assets have been liquidated.
  4. After notifying creditors, the next step is liquidating all assets of the business. Liquidation refers to selling and distributing any property and assets owned by the business. After selling and distributing the property, the proceeds will go toward paying any obligations and debts held by the S corporation. Members, owners, and creditors could be on the list of those who will qualify to receive any of the proceeds from the liquidation process. In certain states, the creditors will be first to claim any proceeds to settle outstanding debts. From there, the owners could receive any remaining proceeds, as long as the debts and obligations have been resolved.
  5. Upon completion of the dissolution process, the company owners will need to file the required certificate with the applicable state agency in which the S corporation operates and is registered. Since an S corporation is a tax-paying entity, it must also settle any outstanding tax obligations for the previous year, along with any unpaid taxes from prior years. Before an S corporation can be legally dissolved, it will typically need to clear anything outstanding with the state finance department.
  6. The sixth and final step of dissolving an S corporation is filing the last IRS tax documents. The corporation must file IRS Form 966 within 30 days of making the decision to liquidate and dissolve the business. This form requires certain information, such as:
  • Date of incorporation
  • Business name
  • Business address

Additionally, the corporation must file Form 1120S within 90 days of the date of dissolution. The final return must be filed with the IRS by the 15th day of the third month following the completion of the dissolution process.

Considerations Before Initiating Liquidation

Before beginning the liquidation of an S corporation, owners should consider the following:

  • Asset Valuation: Conduct a fair market valuation of the corporation’s assets. This is crucial for determining potential gain or loss upon liquidation.
  • Installment Sales: Assets sold under installment agreements before liquidation can create unexpected tax burdens if not reported correctly.
  • Built-in Gains Tax: If the S corporation was previously a C corporation and is within the 5-year built-in gains tax recognition period, certain asset sales may trigger corporate-level tax.
  • Professional Appraisal: For assets with significant appreciation (real estate, equipment, etc.), obtaining professional appraisals can help accurately calculate gains and ensure compliance with reporting rules.

Advance tax planning with a CPA or tax attorney can help avoid costly missteps.

Tax Consequences of Distributions From S Corporations

All credits, deductions, losses, and income of an S corporation are passed through the business to the shareholders. They must then report these amounts on their personal tax returns. Since the profits of an S corporation are taxed to the shareholders, a safeguard is necessary to protect shareholders from being double-taxed during the distribution of the money. State laws and tax rules help to track and adjust the amounts, based on the stock held by the shareholder.

Timing and Reporting Requirements

  • Form 966: Must be filed within 30 days of the resolution to dissolve the S corporation.
  • Final Return (Form 1120S): Must be marked as “final” and include a complete accounting of the liquidation, including gains recognized and distributions made.
  • Schedule K-1: Must reflect any capital gains passed through to shareholders, which will affect their personal tax filings.

Timely and accurate reporting helps avoid penalties and ensures compliance with IRS expectations.

Corporate-Level Gain on Asset Distributions

Even though S corporations are pass-through entities, they must recognize gain on the distribution of appreciated property during liquidation under IRC Section 336.

  • Recognized Gain: The corporation recognizes gain as if it had sold the asset at FMV.
  • Example: If an S corporation distributes a property with an FMV of $150,000 and a basis of $100,000, the corporation must recognize a $50,000 gain.
  • Pass-Through Effect: This gain is then passed through to shareholders, increasing their basis before determining individual gain or loss on the liquidating distribution.

This rule prevents shareholders from avoiding taxation on built-in gains through non-cash distributions.

Special Considerations for Installment Obligations and Debt

  • Installment Obligations: If an S corporation holds installment receivables at the time of liquidation, they are treated as distributions of property. Shareholders who receive these obligations must report the income under the installment method.
  • Corporate Debt: If the corporation is indebted to any shareholder, this can impact the character of distributions and may require special tax treatment or recognition of gain on cancellation of debt.
  • Creditor Priority: Before any distributions to shareholders, all outstanding debts to third-party creditors must be paid. Failure to do so can result in personal liability or IRS scrutiny.

How S Corp Liquidating Distributions Are Treated for Tax Purposes

In a complete liquidation, a s corp liquidating distribution is not treated as a dividend. Instead, it is considered a return of capital under IRC Section 331, meaning shareholders recognize gain or loss as if they had sold their stock.

  • Gain or Loss Calculation: The shareholder’s gain or loss is the difference between the fair market value (FMV) of the property received and their adjusted basis in the stock.
  • Capital Treatment: These gains or losses are generally capital in nature (long-term or short-term based on holding period).
  • Stock Basis Adjustment: Shareholders must adjust their basis to account for prior S corp income, losses, and distributions before computing gain/loss.

Frequently Asked Questions

1. What is a liquidating distribution in an S corporation? A liquidating distribution occurs when an S corporation dissolves and distributes its assets to shareholders. It is treated as a sale of stock for tax purposes.

2. Do S corp liquidating distributions result in double taxation? No, typically only shareholders are taxed. However, the S corp may recognize gain on appreciated assets, which flows through to shareholders and is taxed once.

3. How do shareholders report liquidating distributions? They report capital gain or loss on their personal returns based on the difference between the FMV of distributions and their stock basis.

4. Can you distribute appreciated property in liquidation? Yes, but the S corporation must recognize gain as if it sold the property at FMV.

5. What forms must be filed with the IRS when liquidating an S corp? IRS Form 966 (corporate dissolution) and a final Form 1120S must be filed, along with Schedule K-1s for shareholders.

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