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Tax Consequences of Liquidating an S Corporation (Part I)

Posted by McDonald & Osborne Posted on Oct 12 2015

So you want to liquidate your S Corporation… Before you surf over to your state’s division of corporations and print out the liquidation forms, there are a few things you should keep in mind regarding the tax consequences of the liquidation at both the corporate and shareholder level. This is part one of a two-part series that covers the income tax aspects of S Corporation liquidation.

Part I: Understanding the tax consequences of the liquidation on the S Corporation

First things first, under law, your S Corporation is a separate entity and as such, the sale or exchange of any assets it holds could result in the recognition of gain or loss. This is true regardless of whether the corporate assets are sold to an unrelated third party or you decide to distribute them to yourself as the shareholder. Under statute, in the complete liquidation of a corporation, a distribution of assets from the corporation results in gain or loss to the corporation as if the distributed assets were sold at fair market value.

The gain or loss on the sale or distribution of corporate assets is determined by deducting the cost basis that has been adjusted for depreciation (if applicable) from the amount received in a sale or the fair market value in the event of a distribution. The character of the gain or loss recognized by the S Corporation depends on the character of the asset distributed or sold, subject to the recapture rules. The taxable gain flows through to the shareholder under the pass-through rules and will be reported on the shareholder’s income tax return via the K-1.

To illustrate, let’s suppose that you want to keep some of the office furniture from your liquidating S Corporation. Let’s further assume that the cost basis adjusted for depreciation is $1,574 and that the fair market value of the furniture is $6,800. This would be treated as a distribution which means that it would be recorded as a sale at the fair market value.

Fair Market Value

$6,800

Cost Basis

$6,000

Accumulated Depreciation

$4,426

Adjusted Basis

$1,574

Gain on Distribution

$5,226


Since these are assets that were used in the business, their character is ordinary to the extent of depreciation recapture. In this example, the total gain of $5,226 is passed through to the shareholder on the K-1; $4,426 of the gain is reported as ordinary income and $800 is reported as capital gain.

So we see that a liquidating S Corporation will not recognize tax at the corporate level unless the built-in gains tax applies. The built-in gains tax is a rather complicated section of the tax code that was enacted by Congress to discourage C Corporations from electing S status to avoid double taxation upon liquidation and it is beyond the scope of this article. The disposal of assets by the liquidating S Corporation will be reported at the corporate level but the applicable income will be passed through to the shareholder’s individual income tax return. This will increase the shareholder’s basis in the S Corporation which prevents double taxation on the liquidation at the shareholder level. We will be exploring the tax effects of liquidation at the shareholder level in more detail in Part II.

Angela Krape, CPA
Accountant
alkrape@mo-cpa.com

Photo Credit: BigStockPhoto.com