Closing a business has important federal income tax implications that owners should understand. The following provides tax information owners of sole proprietorships and single-member (one-owner) limited liability companies (SMLLCs) need to know.
Reporting Gains, Losses, and Other Items
You will need to report federal income tax gains and losses from selling or abandoning business assets on your personal tax return. The existence of a sole proprietorship or SMLLC treated as a sole proprietorship for tax purposes is ignored under the federal income tax rules. Therefore, you (as an individual taxpayer) are considered to directly own all the business assets.
Gains – You have a tax gain if the sale price for an asset exceeds its tax basis. Generally, an asset’s tax basis equals the asset’s original cost minus any depreciation or amortization deductions.
For real estate held for over one year, gain attributable to prior depreciation deductions is taxed at a maximum federal rate of 25% under current law. For other depreciable or amortizable assets (such as furniture, equipment, purchased software, and purchased intangibles) gain attributable to prior depreciation or amortization deductions is taxed at higher ordinary income rates (up to 37% under current law).
Any remaining gain from real estate and depreciable or amortizable assets held for more than a year is 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.
Losses – You have a tax loss if the sale price of an asset is less than its tax basis. In general, you can fully deduct an overall net loss from selling business assets against your other income under current tax law.
You must also report 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.
Net Operating Losses
Closing the business may result in a net operating loss (NOL) for the year. Thanks to a provision in the CARES Act, you can carry back an NOL that arises in 2020 for up to five tax years and recover some or all the federal income taxes paid for those years. As things currently stand, an NOL that arises in 2021 can only be carried forward to future tax years to offset income in those years.
Wrapping Up Payments to Employees and Contractors
If your business has employees, you must pay any final wages and compensation owed to them. You’ll 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 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.
Paying Federal Income Tax Due
If you owe federal income tax after closing your business but are cash-strapped, payment relief provisions may be available, including:
- An installment payment agreement,
- An offer in compromise, or
- A delay in collection activities.
The IRS recognizes that many taxpayers are struggling due to the COVID-19 economic fallout. The agency has introduced the new Taxpayer Relief Initiative, which is intended to help struggling taxpayers who were adversely affected by the pandemic.
For example, eligible individuals who owe less than $250,000 may be able to set up installment agreements without providing financial statements or other substantiation if their monthly payment proposal is deemed to be sufficient.
Tying Up Other Tax-Related Loose Ends
When you set up your business, you may have 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 will not close your account until all necessary returns have been filed and all taxes have been paid. Contact your tax advisor to help cover all the bases.
Your tax professional can help resolve various other tax issues related to closing your business, such as how to handle:
- Paycheck Protection Program (PPP) loans,
- Debt cancellation transactions,
- Deductions for suspended passive activity losses from prior years
- Recapture of depreciation deductions, and
- Bankruptcy issues, if applicable.
Retain tax-related records after you close your business, in case you get audited. 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 after 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.
Closing a business involves more than just turning off the lights and locking the doors. Tax advisors can provide much-needed support for small business owners during this emotional time. Contact us to help you manage the administrative chores and simplify the process of closing shop.
© Copyright 2021 Thomson Reuters.
Disclaimer of Liability
Our firm provides the information in this article for general guidance only, and does not constitute the provision of legal advice, tax advice, accounting services, investment advice or professional consulting of any kind. The information provided herein should not be used as a substitute for consultation with professional tax, accounting, legal or other competent advisors. Before making any decision or taking any action, you should consult a professional advisor who has been provided with all pertinent facts relevant to your particular situation. Tax articles are not intended to be used, and cannot be used by any taxpayer, for the purpose of avoiding accuracy-related penalties that may be imposed on the taxpayer. The information is provided “as is,” with no assurance or guarantee of completeness, accuracy or timeliness of the information, and without warranty of any kind, express or implied, including but not limited to warranties of performance, merchantability and fitness for a particular purpose.