If you are terminating a business that you have operated as an S corporation and you are dissolving or liquidating the corporation, there would generally be federal income tax effects for the S corporation and for the shareholders.
When the corporation is dissolved or liquidated, the assets, whether cash, property or both, that are distributed to the shareholders are transferred at fair market value. This would be treated for tax purposes as a deemed sale of the assets by the corporation to the shareholders. The corporation would recognize a gain or loss for the difference between the fair market value and the basis of the assets for the corporation.
The shareholders would recognize gain or loss for the difference between the fair market value of the assets received in the distribution and their adjusted basis in their shares of the S corporation. Then if the shareholders later sell these assets, in the case that property is distributed, they would recognize a gain or loss for the difference between the selling price and their adjusted basis in the property, which would be the fair market value at the time the property was distributed by the corporation plus or minus any subsequent adjustments.
As explained by the IRS, the shareholders’ basis in their shares in the S corporation must be calculated. The basis of each shareholder’s stock in the corporation starts with the initial capital contribution or the amount the shareholder paid to purchase the shares. This amount is then adjusted for the amounts that flow through from the S corporation to the shareholders. These amounts should be reported on the Schedule K-1 that the S corporation issues to the shareholders each year.
Items from Schedule K-1 that would increase the shareholder’s basis in the stock include ordinary income, separately stated income items, tax exempt income, and excess depletion. Items that would decrease the basis include ordinary loss, separately stated loss items, nondeductible expenses, non-dividend distributions, and oil and gas depletion.
If the stock in the S corporation is a capital asset for the shareholder, the distribution of the corporation’s assets when it is dissolved would result in a capital gain or loss for the shareholder rather than ordinary income.
If the shareholder incurs a loss on the distribution, normally the capital loss could be used to offset other capital gains on his or her individual tax return. If there is any remaining capital loss, up to $3,000 could be applied against other income, and any unused portion of the loss could be carried forward. But if the stock in the corporation qualifies for Section 1244 treatment as small business stock, the shareholder could claim the loss as an ordinary loss up to the maximum allowable amounts.
When an S corporation is dissolved, a final federal income tax return must be filed on Form 1120S and Form 966, Corporate Dissolution or Liquidation, must also be filed.
Form 966, Corporate Dissolution or Liquidation
Form 1120S, U.S. Income Tax Return for an S Corporation
S Corporation Stock and Debt Basis, IRS