Liquidating a Corporation? Avoid Double Taxation with Smart Planning

Perhaps you're considering selling off your C corporation's assets and liquidating the firm. Typically, such a transaction is accomplished in three stages:

Tax Effects of Liquidating a Corporation
  1. The corporation makes a direct sale of its assets to the buyer (or buyers).
  2. The company pays off all its debts (including any tax bills).
  3. The corporation distributes the remaining sales proceeds to the shareholders in complete liquidation of the entity.

This article explains the basic federal income tax considerations for both the corporation and its shareholders.

Corporate-Level Tax Results

The sale of assets results in taxable gains and losses for the corporation that must be calculated on an asset-by-asset basis. Most gains and losses are then reported on an IRS Form, which is filed with the corporation's Form 1120, U.S. Corporation Income Tax Return, for the year of sale.

If the corporation has loss or tax credit carryovers, they can be used to offset gains and taxes resulting from the asset sale. However, if the corporation's assets are highly appreciated, there may be substantial corporate-level income taxes to pay. The later distribution of the remaining cash sales proceeds to the shareholders will usually have no corporate-level tax consequences.

Shareholder-Level Tax Results

For federal income tax purposes, each shareholder's receipt of the liquidating corporate distribution amount is treated as a sale of all the shareholder's stock in exchange for the distribution.

This means each shareholder must recognize a taxable gain (or loss) equal to the difference between the distribution amount and the shareholder's basis in the stock relinquished in the liquidating transaction. Assuming the shares have been held for investment for over a year, any shareholder profit will generally qualify for long-term capital gain treatment. Currently, long-term capital gains recognized by individuals are taxed at a maximum federal rate of no more than 20%. The 20% rate only affects singles with taxable income above $441,450, married joint-filing couples with income above $496,600, heads of households with income above $469,600, and married individuals who file separate returns with income above $248,300. (In 2019 the figures were: $434,550,  $488,850, $461,700, and $244,425 respectively).

Capital gains on investments held less than a year are short-term capital gains and taxed at ordinary income tax rates of 10, 12, 22, 24, 32, 35 or 37% in 2020 (and 2019).

There may be state income taxes to consider too. Special tax rules apply if the corporation sells assets on the installment method and distributes the resulting notes receivable to the shareholders as part of the liquidation process.

Key Point: As you can see, a corporate liquidation can potentially trigger income tax bills at both the corporate and shareholder levels. In other words, double taxation may apply. If so, the combined corporate-level and shareholder-level tax tax bills may be surprisingly expensive.

However, advance planning can often result in better tax results. Also, it may be possible to structure an asset sale in a way that doesn't involve a corporate liquidation if that would mean lower taxes. Consult with your tax advisor to develop the best strategy for your corporation and its shareholders.

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