Economic fallout from the COVID-19 pandemic has caused some small businesses to permanently close. No owner plans to close when entering into business, so the tax implications may not be front of mind when it comes time to shut operations down. The following provides important federal tax considerations for individual taxpayers who own pass-through entities and C corporations as they walk through the closure process.
Pass-Though Entity Issues
If you close a business operated as a pass-through entity — including a partnership, an LLC treated as a partnership for tax purposes, or an S corporation — you will probably arrange for the entity to sell assets, possibly abandon some assets, and liquidate. If so, that will trigger tax losses (and possibly tax gains) at the entity level that will pass through to the owner(s) and be taken into account on their individual tax return(s).
Each owner must be issued a Schedule K-1 to report his or her passed-through shares of income, deductions, and credits from the entity. Those passed-through tax items are then reflected on each owner’s personal tax return (Form 1040). Gains and losses from selling business assets must be reported with the pass-through entity’s return (Form 1065 or Form 1120S).
For real estate held for over one year, gain attributable to prior depreciation deductions is taxed at a maximum individual federal rate of 25% under current law. For other depreciable or amortizable assets (such as furniture, equipment, purchased software, and purchased intangibles) gains attributable to prior depreciation or amortization deductions are taxed at higher ordinary income rates (up to 37% under current law).
Any remaining gains from real estate and depreciable or amortizable assets held for more than a year are generally taxed at lower long capital gains rates. Gains from selling receivables, inventory, and other assets held for a year or less are taxed at higher ordinary income rates.
A tax loss exists if the sale price of an asset is less than the tax basis of the asset. Under current law, you can generally fully deduct an overall net loss from selling business assets — including passed-through losses from a partnership, LLC, or S corporation — against your other income.
You must also report any net self-employment (SE) income from the closed or closing business and calculate any SE tax due. You may be eligible to defer some 2020 SE tax thanks to a favorable COVID-19 relief provision.
In addition, your pass-through business entity must file a final federal income tax return and issue the related K-1 schedules to you and the other owners for the year it closes. A business that operated an S corporation must file additional IRS forms if the corporation adopted a resolution or plan to dissolve or liquidate any of its stock.
C Corporation Concerns
If you close a business that operated as a C corporation, you will probably arrange for the corporation to sell assets, possibly abandon some assets, and liquidate. If so, that will trigger tax losses and possibly some gains at the corporate level, along with a tax gain or loss at your personal level for the deemed sale of your stock in exchange for the liquidating distribution that you receive from the corporation.
So, there will be tax consequences that must be reflected on the corporation’s final federal income tax return (Form 1120) and on your personal Form 1040.
Net Operating Losses
Closing your business may result in a net operating loss (NOL) for the year for you personally or for your C corporation, if applicable. Thanks to a favorable provision included in the CARES Act, an NOL that arises in 2020 can be carried back for up to five tax years to recover some or all of the federal income taxes paid for those years. As things currently stand, a NOL that arises in 2021 can only be carried forward to future tax years to offset income in those years.
Payments to Employees and Contractors
If your business has employees, you must pay any final wages and compensation owed to them. You will also need to file any necessary final federal payroll tax returns and make any required final federal payroll tax deposits. Don’t forget to file W-2 forms with the IRS for the calendar year in which final wages are paid and send copies to your employees. Likewise, if you paid an independent contractor at least $600 for services during the calendar year in which you close your business, you must report the total payments to the IRS and provide copies of 1099 forms to the contractors.
Also ask your tax pro about eligibility for various COVID-19 federal tax relief provisions that may be available for employee wages paid in 2020 and 2021.
If your business has a retirement plan for employees, arrange to terminate the plan and distribute final amounts to participants, as required. Terminating a plan calls for detailed notice, funding, timing, and filing requirements. In addition, complicated requirements may apply if you offer a flexible spending account (FSA), health savings account (HSA), or other similar programs to employees.
Other Tax-Related Issues
When you set up your business entity, you obtained an Employer Identification Number (EIN) that was used to identify the business for federal tax purposes. If so, you’ll need to cancel the EIN and close your IRS business account. The IRS won’t close your account until all necessary returns have been filed and all taxes have been paid.
Your tax pro can also help resolve various other issues related to closing your business, such as:
• Tax treatment of Paycheck Protection Program (PPP) loans,
• Tax treatment of debt cancellation transactions,
• Deductions for suspended passive activity losses from prior years,
• Recapture of depreciation deductions, and
• Bankruptcy, if applicable.
It’s also important to retain tax-related records after you close your business, in case of an audit. In general, you should keep records relating to property until the later of:
• The period of time expires during which you can amend your federal tax return to claim a credit or refund, or
• The date beyond which the IRS can no longer assess additional tax for the year in which you disposed of the property.
Keep records of employment taxes for at least four years. Your tax pro can answer questions about how long to retain other records, including tax returns.
Payment relief provisions may be available if you or your business owes federal income tax after you wind down operations. Consult your tax advisor for possible relief measures, along with advice on how to facilitate tax matters related to closing your business.
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