S Corporation Closure: Tax Strategies for Stock and Asset Sales

As a business owner, shutting down your S corporation requires careful consideration of the federal income tax implications. Whether you decide to sell your stock or liquidate assets, understanding the tax basics for both the corporation and its shareholders is essential. Here, we outline the tax implications under two common scenarios: stock sale and asset sale with liquidation.

Scenario 1: Stock Sale

One way to shut down an S corporation is by selling all your company stock. This approach generates a capital gain from the sale. If you have held the shares for more than a year, long-term capital gain tax rates apply. The maximum federal rate for long-term capital gains is 20 percent, primarily affecting high-income individuals.

For passive investors, an additional 3.8 percent Net Investment Income Tax (NIIT) may apply. However, active participants in the business are exempt from the NIIT. State income tax might also be applicable on the gain from selling your shares.

Key Points:

• Capital Gain: Sale generates a capital gain.

• Tax Rates: Long-term capital gain tax rates apply (max 20% federal rate).

• NIIT: 3.8% NIIT for passive investors; active participants are exempt.

• State Tax: Potential application of state income tax.

Scenario 2: Asset Sale and Liquidation

A more common method for shutting down an S corporation is selling all its assets, settling liabilities, and distributing the remaining cash to shareholders. The tax implications for this process are as follows:

1. Taxable Gains and Losses: The S corporation recognizes taxable gains and losses from selling its assets. These are passed through to shareholders and reported on their personal tax returns. Shareholders will receive a Schedule K-1 detailing their share of the gains and losses to report on Form 1040.

2. Long-term Gains and Ordinary Income: Gains from assets held for more than a year are generally taxed as Section 1231 gains at long-term capital gains rates. However, gains attributable to certain depreciation deductions are taxed at higher ordinary income rates, up to 37 percent. Real estate depreciation gains from straight-line depreciation can be taxed up to 25 percent.

3. NIIT Considerations: Passive investors may owe the 3.8 percent NIIT on passed-through gains, while active participants are exempt.

4. Liquidating Distributions: Cash distributed in liquidation that exceeds the tax basis of your shares results in a capital gain, taxed as a long-term capital gain if held for more than a year. If the cash is less than the basis, it results in a capital loss.

Key Points:

• Taxable Gains and Losses: Passed through to shareholders and reported on personal tax returns.

• Tax Rates: Long-term capital gains and ordinary income rates apply.

• NIIT: 3.8% NIIT for passive investors; active participants are exempt.

• Liquidating Distributions: Taxed as capital gain if cash exceeds tax basis.

Tax-Saving Strategy for Asset Sales

To minimize tax liability, allocate more of the sale price to assets generating lower-taxed gains (e.g., land, buildings) and less to those generating higher-taxed ordinary income (e.g., receivables, heavily depreciated assets).

Compliance and Reporting

Ensure compliance by:

• Reporting asset sales and allocations on IRS Form 8594 (Asset Acquisition Statement Under Section 1060).

• Filing the final federal income tax return using Form 1120-S, including final shareholder Schedule K-1.

Shutting down your S corporation involves significant tax implications that require strategic planning. By understanding these scenarios and following the outlined strategies, you can navigate the process more efficiently and potentially save on taxes.