Succession planning has long been an important issue for contractors. Sadly, one of the many tragic effects of the novel coronavirus (COVID-19) pandemic is it’s forced many companies — particularly small businesses — to close sooner than anticipated.
In these circumstances, and others, the most expedient and beneficial way to end the existence of a company is sometimes through a planned liquidation. This process involves distributing assets to claimants and selling off the remainder to pay creditors and provide cash to the owner(s). The tax consequences vary depending on business structure.
Sole Proprietors, Partners and LLCs
Sole proprietorships and sole member limited liability companies (LLCs) can simply report the asset sales on their tax returns and check a box where it says, “This company is no longer in operation.” Owners of other entity types will face more complex tax filing challenges.
If a company is operating as a partnership or multi-member LLC, each partner’s interest or capital account must normally be calculated annually. This is so the proper Schedule K-1 tax form can be issued identifying the tax implications for each partner or member. A partner then keeps track of his or her own basis in the partnership as the value of any money plus whatever property he or she contributes over time.
Any assumption of partnership liabilities increases the partner’s basis, as do any reported profits. Conversely, the partner’s basis is decreased by distributions of cash or property or by losses reported. The adjusted basis of each partner’s interest is different from any book value of capital contributed by the partner that’s held on the books. The book value of capital contributed on the books is irrelevant to the tax reporting of the liquidation.
Partners’ adjusted basis is likewise determined on the date of liquidation. If a partner receives money or property from the liquidation, he or she marks the new basis in any property received on his or her own books to reflect the partnership’s adjusted basis less any cash received from the liquidation.
Partners don’t recognize any gain or loss on property received, until and unless they dispose of that property later in a sale or an exchange. This would be a capital gain.
If an item is held less than a year, it’s considered a short-term gain. The IRS considers gains as long term if the partner possesses the item for over a year, including the time the partnership possessed it. If a partner was the one who contributed the item to the partnership in the first place, the amount of time he or she held the item before contributing it is also added to determine the gain status.
An S corporation must also issue a K-1 to its shareholder or shareholders. Each shareholder’s basis in stock is calculated at year end. Basis in stock is first increased by any reported profits, then reduced by any distributions of cash or property (but not below zero), and then further reduced by any expenses and deductions.
A shareholder must carefully look at his or her Schedule K-1 and compare any losses reported to his or her basis in stock of the corporation reflected in the shareholder’s records. If he or she has sufficient basis in stock, the losses reported on the K-1 may be deductible on his or her personal tax return. When cash is distributed, it generally isn’t taxable to the shareholder as long as, in aggregate, the cash is less than the shareholder’s basis in stock. Distributions that exceed the shareholder’s basis in stock are taxed as capital gains to the shareholder.
C corporations are self-contained taxpaying entities. So, when they close, the company is responsible for reporting its final year to the IRS and paying any tax itself. Assuming assets are sold off, the corporation recognizes the sales as gains or losses. After selling its assets and paying its liabilities, the business will either have cash on hand or owe money. If the latter, debts may be settled, negotiated or abandoned; whereas distributions of excess cash to owners are taxed but typically at a lower rate than ordinary income.
Construction company owners usually want to pass along their businesses to carefully chosen successors. But when cash is needed quickly because of a sudden economic downturn or other circumstances, a planned liquidation might be the right move. Your CPA can help you choose the best succession planning strategy.
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Who Else Wants to Know?
When undertaking a planned liquidation, you’ll obviously need to notify the IRS via the required tax filings. For example, federal quarterly payroll reports require a company to mark “final return” on the last one to indicate it’s going out of business. In addition, you’ll need to file an annual payroll report at year end, regardless of whether you paid any wages in the year of closing.
Various other entities need to be informed about the liquidation as well. States sometimes require annual corporate reports and/or separately reported business income tax returns. Be sure to file them and, again, mark the last one “final report” or “final return.”
Some states and counties tax tangible property, such as equipment, and will follow a company year after year charging tax unless they’re notified that the business is no longer operating. They may want to know how the business property was disposed of and for what price.
In some cases, a business must file a form with the U.S. Department of State notifying them that the company is no longer operating. And, finally, you must notify the construction licensing bureaus in your municipality and state that the license in question is no longer associated with the business.