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Change is a constant part of life, and perhaps you’re at the point where you’re moving on from your S corporation. It’s a big change, but just because you’re ending your ties with that particular business doesn’t mean it has disappeared entirely from your finances yet. You want to make sure that you get the most from your tax deductions when you disband your corporation.
Liquidation
That’s where liquidation can come into play. If the building and some of the assets owned by your corporation have decreased in value, liquidation (selling the assets at fair market value) allows you to:
- Keep the building and some of the assets personally, and
- Use losses from the drop in value on those assets to claim tax deductions on your personal tax return.
Of course, turning a business loss into a personal benefit is like a soufflé; if you don’t follow the instructions exactly, it could fall flat. So, here’s a little guidance:
- Protect Your Assets—When your assets belonged to the corporation, you probably planned ahead and included some kind of liability protection for them. Well, they don’t stop being worth protecting after liquidation, so you can choose from a couple of options to keep them safe. Once choice is purchasing liability insurance. Another option is to transfer the personal assets to a limited liability company (LLC) or other limited-liability entity structure.
- No New Corporations—Don’t create a new corporation, at least not as far as your now-personal assets are concerned. Tax law disallows the reincorporation of liquidations.[1] In some cases, if you wait long enough, you may be able to re-use the assets for another corporation you create. However, tax law doesn’t specify a specific amount of time that makes this action allowable. The longer you wait, the safer your liquidation will be. You also decrease the chance of the IRS denying your liquidation if your new business is distinct from the previous one.
Considering Losses
Although the particulars are different, S corporation liquidation is subject to the same rules as C corporation liquidation.[2] Since you are the shareholder of your S corporation, any gains or losses realized through the sale of assets pass through you. You see, when you receive the assets from your corporation, it’s as if they were sold at fair market value.[3]
Example: Your S corporation owns a piece of land. The basis is $1 million, but the fair market value is only $600,000. At the time of liquidation, you get the land in trade for your stock. The corporation then has a loss of $400,000 ($1 million minus $600,000). Now, if you can overcome the IRS loss barriers, then that loss passes to you for tax-deduction purposes.
Here are the loss barriers that may prevent you from realizing a deduction:
- Inadequate Basis in Stock for Your S Corporation—This one is simple to calculate. Basically, you cannot reduce your stock basis lower than zero.[4] If you’re stock basis at time of liquidation is $150,000 and your losses are $400,000, you can only realize $150,000 of losses because any more would take your basis below $0. So, if you don’t have enough basis in stock, you could lose a whopping $250,000 in deductions.[5]
- Tax-Free Property Contributions Made Recently—Was your corporation’s land previously your personal land? If so, and you gave it to the corporation within the most recent five years as a tax-free contribution, then the corporation cannot claim a loss on the land during liquidation[6] because the land was distributed to a majority shareholder (you, as the sole owner of an S corporation).[7] Put simply, you don’t get to deduct any losses. This does not apply, however, if the corporation bought the land, even from you.[8]
- Disproportionate Asset Transfers—The majority of this information applies to sole owners of an S corporation, but as you may know, you can split income with S corporation stock. When you do that, you no longer own 100 percent of the company. In that case, the assets from liquidation must be transferred proportionately among all shareholders. Using the land scenario above, let’s say you own 99 percent of the stock, and your friend owns 1 percent. For the land, you should get a 99 percent interest from the corporation, with the other 1 percent going to your friend. Such would be the distribution for each asset. However, if you do not follow this rule, and you distribute assets disproportionately, the corporation cannot recognize loss on any property allocated to a majority shareholder (one who owns more than 50 percent of the stock).[9] As an example, if your corporation ignores the minor ownership of your friend and gives you all the land, no one will get to deduct the $400,000 loss. You do not want that to happen.
If these barriers create a problem for your ability to realize full loss deductions, liquidation may not be your best option.
What about Stock Losses?
Up until now we’ve talked about pass-through losses (the losses that passed from the corporation to you in liquidation). But, you’ll be happy to know that you also get a special tax break on stock losses.[10] This benefit allows you to consider some of your capital loss to be ordinary, tax-favored loss in amounts up to $50,000 if you file an individual return or $100,000 if you file a joint return.[11]
Of course, there is a stipulation. To qualify for this tax break, you must not have invested $1 million or more into the original capital contribution to your S corporation. Here’s a practical application using the land example above, and considering you meet the contribution qualification. After calculating your pass-through income and loss from the liquidation, you have an $800,000 basis. You then receive the land, valued at $600,000. You have a $200,000 capital loss on the stock ($800,000 minus $600,000. If you’re married and filing jointly, you can consider up to half of that $200,000 an ordinary loss (tax-favored).
The Deal Breaker
In the event that property passed from your S corporation to you is depreciable property (such as a building), any gain recognized on that property must be treated as ordinary income, not capital gain. This pretty much destroys your tax benefits from liquidation.[12] Why is the IRS oh-so-cruel? Actually, their reasoning makes sense. Upon receiving the building in liquidation, you will get ordinary deductions by depreciating the asset yourself. Getting the additional long-term capital gain benefits would be like double-dipping.
An additional warning: For those who operated a company as a C corporation, and then converted to an S corporation, you may be subject to the built-in gains tax when you liquidate.
It may seem like a lot to think about, but be sure to go over these guidelines when you’re ready to liquidate your S corporation. You could be looking at big money in liquidation assets. So, make sure you get the deductions you’re entitled to.
- Reg. Section 1.331-1(c). ↑
- See IRC Section 1371(a). ↑
- IRC Section 336(a). ↑
- IRC Section 1367(a)(2). ↑
- CCA 201237017, p. 4. ↑
- IRC Section 336(d)(1). ↑
- IRC Section 336(d)(1)(A). ↑
- See Genl. Expl. of Tax Reform Act of ’86 (PL 99-514), p. 341-344. ↑
- IRC Section 336(d)(1)(A)(i). ↑
- IRC Section 267(a)(1), second sentence. ↑
- IRC Section 1244. ↑
- IRC Section 1239. ↑