C Corporations: Tax Issues to Consider When Closing a Business

20 January 2025

Are you thinking about closing your business? Rising prices, labor shortages, fluctuating demand and supply chain disruptions have caused a number of businesses to shutter in recent years. In addition, many businesses have closed because the owners wanted to retire.

Before you wind down a business that operates as a C corporation, you should understand the basic federal income tax implications.

Complete Liquidation Basics

For federal income tax purposes, a "complete liquidation" occurs when your corporation:

• Ceases to be a going concern,
• Winds up its affairs and pays its debts, and
• Distributes its remaining assets to the shareholder(s).

For federal income tax purposes, distributions to shareholders in a complete liquidation mean one or more distributions in a redemption of all the corporation's stock pursuant to a plan. A formal written plan isn't required for distributions in complete liquidation. However, having one is recommended because it:

• Fixes the date that the liquidation process begins,
• Creates a dividing line between regular dividend distributions, if any, and liquidating distributions, and
• Shows when a series of liquidating distributions begins and ends for a liquidation that takes more than one tax year to complete.

A complete liquidation of a C corporation can be accomplished in the following three ways:

1. All the corporation's assets can be distributed to the shareholder(s).

2. The corporation can sell all its assets and then distribute the sales proceeds to the shareholder(s).

3. The corporation can sell some assets and then distribute the resulting sales proceeds and any remaining unsold assets to the shareholder(s). 

These three alternatives usually result in roughly the same bottom-line federal income tax results for C corporations and their shareholders. 

Asset Sales Followed by Liquidation

If you sell some or all of the C corporation's assets and then distribute the proceeds to the shareholder(s), you can make one or several liquidating distributions. Depreciable property held for more than one year and business real property held for more than one year are called Section 1231 properties. If your corporation's sales of Sec. 1231 properties result in an overall tax loss, the corporation can generally treat it as a fully deductible ordinary loss. If sales of Sec. 1231 properties result in an overall tax gain, the corporation generally treats the gain as a long-term capital gain. However, gain attributable to depreciation or amortization of Sec. 1231 property counts as ordinary income rather than capital gain.

The federal tax distinction between capital gains and ordinary income usually isn't meaningful because, for a C corporation, a flat 21% federal income tax rate currently applies to both. However, in the unusual situation where a C corporation has capital assets, such as stock or mutual fund shares held for investment, the distinction can be important because a C corporation can't deduct a net capital loss. A C corporation can only use its capital losses to offset its capital gains.

Important: The current flat 21% corporate federal income tax rate is permanent under current law and unlikely to be increased during President Trump's tenure. During the campaign, Trump promised to lower the corporate tax rate from 21% to 15% for businesses that make their products in America. If that happens, corporate tax obligations from complete liquidations would be lower. However, it's currently unclear whether congressional support for this proposal exists.

Assets Distributed to Shareholders in Liquidation

What happens if a corporation distributes property (other than cash) to shareholders in a complete liquidation? In this situation, the corporation must recognize taxable gain or loss as if the corporation had sold the distributed property to the shareholder(s) for fair market value (FMV).

Again, depreciable properties held for more than one year and business real properties held for more than one year are Sec. 1231 properties. For these assets, the previously described treatment applies to the gains and losses upon liquidation. Corporate-level deemed sales of distributed assets are reported the same as actual sales. As explained, the distinction between capital gains and ordinary income usually isn't meaningful under the current rules because a flat 21% corporate tax rate applies to both.

Shareholder-Level Tax Results

At the shareholder level, a liquidating corporate distribution is treated for federal income tax purposes as a payment in exchange for corporate stock. The shareholder must generally recognize taxable gain or loss equal to the difference between 1) the FMV of the assets received (cash, property or both) and 2) the adjusted basis of the surrendered stock. 

The shareholder's tax basis in any noncash distributed property received in the complete liquidation is the property's FMV at the time of distribution. When the stock is a shareholder's capital asset (which it likely will be), a liquidating distribution will trigger a capital gain or loss at the shareholder level. (See "Tax Outlook for Individual Long-Term Capital Gains" at right.)

The federal income tax impact of the complete corporate liquidation can be summarized as follows:

1. If the corporation sells all its assets and distributes the proceeds to shareholders. In this case, the tax process for a recipient shareholder is complete when the shareholder recognizes taxable capital gain or loss upon receiving the cash from the last distribution. If shareholders receive multiple liquidating cash distributions, they're allowed to recover all their stock's tax basis before recognizing any taxable gain. After they've recovered all their basis, any subsequent distributions are treated as taxable gains.

2. If a shareholder receives noncash assets in the liquidation. In this case, the initial tax basis of the assets generally equals their FMV on the distribution date. Shareholders must recognize capital gain or loss based on the difference between the FMV of the assets received (including any cash) and the tax basis in the surrendered stock.

The complete liquidations of C corporations with appreciated assets will often result in double taxation — once at the corporate level and again at the shareholder level.

Hypothetical Example

Here's an example of how a complete corporate liquidation would pan out for a fictitious C corporation with appreciated assets.

Two equal shareholders own Sea Corporation. The owners decide to liquidate the business by distributing its assets to the shareholders. The company owns two assets:

A corporate bank account with a balance of $1.255 million, and
A tract of undeveloped land with FMV of $3 million and tax basis of $1.5 million.
Each shareholder has a tax basis of $750,000 in their stock, which they've owned for several years.

The land is deemed to be sold for FMV in the liquidation. So, Sea Corporation recognizes a $1.5 million corporate-level taxable gain on the liquidating distribution of the land ($3 million FMV minus $1.5 million tax basis). Ignoring any state income tax consequences, the corporate-level federal income tax obligation would be $315,000 (21% times $1.5 million).

Sea Corporation pays that tax bill and distributes the remaining $940,000 of cash ($1,255,000 minus $315,000). Therefore, each shareholder receives $470,000 in cash and an undivided 50% interest in the land (worth $1.5 million for each 50% interest). So, each shareholder receives a liquidating distribution of $1,970,000 for federal income tax purposes ($470,000 plus $1.5 million) in exchange for their corporate stock.

The exchanges are treated as stock sales. Therefore, each shareholder recognizes a long-term capital gain of $1,220,000 (liquidation proceeds of $1,970,000 minus stock basis of $750,000). Assuming the gains are taxed at the 20% maximum federal rate and the 3.8% net investment income tax applies, the tax hit for each shareholder is $290,360 (23.8% times $1,220,000).

As a result, the combined total of the federal income tax bills is $895,720 ($315,000 at the corporate level and $290,360 times two at the shareholder level).

To help lower the tax hit, the shareholders might consider paying themselves reasonable salaries or bonuses before distributing the cash in the corporate bank account. These payments would reduce the amount subject to double taxation. However, the payments would be subject to applicable payroll taxes and taxed at ordinary income rates (which are higher than the rates for long-term capital gains for individuals).

Now and in the Future

The current federal income tax rates that apply to complete corporate liquidations will likely continue to apply until at least after the 2028 general election. However, the GOP-controlled Congress could pass additional business-friendly tax laws. Contact your tax advisor for help navigating the financial aspects of unwinding your business whenever it might happen.

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