This is part two of a two-part series that covers the income tax aspects of S Corporation liquidation. In Part I, we attempted to simplify the tax aspects of the S Corporation liquidation and explain the tax impact at the entity level. In Part II, we explore the consequences of the liquidation to the shareholder.
Part II: Understanding the tax consequences of the liquidation on an S Shareholder
The largest factor affecting the tax consequences of a complete liquidation to the shareholder is the basis in the S Corporation stock. The basis of an S Corporation shareholder’s stock is recomputed annually and is comprised of the initial purchase or capitalization of the stock acquisition plus the shareholder’s pro-rata share of income (loss), less distributions made to the shareholder. Ordinarily, distributions to an S Corporation shareholder are tax-free to the extent of the shareholder’s basis. Once the distribution exceeds the basis amount, capital gain results and is reportable by the shareholder on Schedule D of his individual income tax return. If the S Corporation was previously a C Corporation and has accumulated earnings and profits from the period in which it was a C Corporation, ordinary income could result if distributions in excess of basis are made. However, in a complete liquidation, these rules do not apply.
Distributions in complete liquidation are treated as payments in exchange for the shareholder’s surrendered stock. Since basis and accumulated earnings and profits are not relevant to the characterization of a liquidating distribution, an S Corporation with accumulated earnings and profits should identify liquidating distributions as such. Any distributions not identified as liquidating distributions will be subject to the regular rules therefore it is important to adopt a plan of complete liquidation and monitor shareholder basis and accumulated earnings and profits prior to any regular distributions being made in the year of liquidation.
Since liquidating distributions are treated as payments in exchange for stock, the capital gain or loss on the liquidation will be the shareholder’s adjusted basis in the stock subtracted from the cash and fair market value of the property received from the corporation. If the shareholder assumes known corporate liabilities, or receives corporate property subject to a liability, the amount realized is reduced by the amount of the liability. The resulting gain or loss will be reported on the shareholder’s Schedule D of his individual income tax return.
So we see that the liquidation of an S Corporation requires careful planning to result in the most beneficial outcome for the shareholder. In some cases, an alternative to complete liquidation may be more advantageous to the shareholder wishing to dispose of his corporate business. If you are contemplating disposal of your business, please contact our office and let us help devise a plan that’s right for you.
Angela Krape, CPA