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Tax Rules for Closing Down a Business

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You’ve seen the signs — “Going Out of Business”… “Liquidation Sale.” When you’re not involved, you can only guess what led up to it.

Businesses close for a variety of reasons. An owner may simply want out… an owner may have died and the family wants to liquidate the business… the operation may be unsuccessful and not worth sustaining. Whatever the reason, the process is essentially the same. By law, certain steps must be taken to terminate a business, and there are tax consequences for this type of exit strategy. What you need to know if you’re involved in closing down a business…

STATE LAW TERMINATION REQUIREMENTS

Entities created by state law, such as a corporation or limited liability company, must follow state rules to terminate or dissolve. Typically, this includes satisfying any state taxes, filing a form of dissolution, and usually paying a fee. Check with your state’s finance/revenue/tax department as well as the department of state for procedures to follow.

FINAL RETURNS

Any closing business must file an annual tax return for its final year. The fact that it is the business’s final return is noted on the return (check the box for this purpose near the top of the form). Also, check the “final return” box on the Schedule K-1, Partner’s Share of Income, Deductions, Credits, etc., a statement to owners of terminating partnerships and limited liability companies. (There’s a similar Schedule K-1 for S corporations.) Other considerations…

Short tax year. The business may close on a day prior to the end of the business year, which makes the final year a “short tax year.”

Advantage: No tax items need to be prorated for the period of time that the business was functional. For example, if you paid an annual membership fee and close your business after eight months of the subscription year, you still get to write off the full year’s subscription.

Unused deductions. On the final return, a business can deduct any unamortized start-up costs.

Example: You started your business in January 2004 and paid $10,000 in start-up costs. You close in December 2007. On your 2007 return, you can deduct $4,000 — the remaining unamortized start-up costs. (You had already deducted $2,000 each year for 2004, 2005, and 2006.)

Reporting for workers. If the business has employees, the business must, of course, make any final federal tax deposits covering payroll taxes and file a final Form 941, Employer’s Quarterly Federal Tax Return. It must also file W-2 forms for employees by the due date of the final Form 941. Copies of the Form W-2, along with Form W-3, Transmittal of Wage and Tax Statements, must be filed with the Social Security Administration by the last day of the month following the due date of the final Form 941.

The business must file a final Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return — check the box on page one indicating that no forms will be filed in the future (i.e., that this is a final form).

Also, check with your state for any final employee-related returns that need to be filed.

If you have independent contractors that were paid at least $600 during the business’s final year, file Form 1099 for each.

Retirement plans. If the business has a qualified retirement plan, it must file a final return for the plan on Form 5500, Annual Return/Report of Employee Benefit Plan. In order to terminate the plan, it must be in compliance with current law — this means adding any amendments necessitated by law changes.

Note: You may want to file a Form 5310, Application for Determination for Terminating Plan, to ask the IRS for a determination of the plan’s qualification status at the time of the termination. This form is not required, but you may want to file it anyway to avoid future IRS questions.

Ask your financial institution where you have your plan (such as your bank or mutual fund company) whether any further action is necessary to terminate your plan.

REPORTING ASSET SALES

If the company sells some of its assets, either individually or as a group of assets, it will need to report the transactions…

Sales of individual assets. Sales of business assets are reported on Form 4797, Sales of Business Property, which is attached to the final return.

Group asset sales. If the business disposes of a group of assets that make up an entire trade or business, (rather than selling only some of the assets), both the seller and the buyer must report the transaction on Form 8594, Asset Acquisition Statement, and attach it to their returns for the year of sale.

The form reports the total consideration (amount paid to you, the seller) for the assets. The form is also used to allocate this consideration among the classes of assets sold. The allocation, which is partly a function of negotiation between the buyer and seller, is used to determine the seller’s gain (or loss) for each class of assets. The IRS has created various asset classes for this purpose, and an allocation must follow this fixed order…

Class I. Cash and savings accounts.

Class II. Actively traded securities, such as publicly traded stock and US government securities.

Class III. Securities that the seller marks to market (an accounting method used by securities traders).

Class IV. Stock-in-trade (inventory, for example) and property held primarily for sale to customers in the ordinary course of business.

Class V. Assets that don’t fall within another class (for example, furniture, fixtures, buildings, land, vehicles, and equipment).

Class VI. Section 197 intangibles (such as trademarks, covenants not to compete, licenses, and customer lists).

Class VII. “Goodwill and going concern” value, an intangible value above the value of all other assets.

Strategy: The different classes get different tax treatments. For the seller, it is advantageous to negotiate for allocations that favor assets that will produce tax-favored capital gains (goodwill, for example), rather than ordinary income (such as stock-in-trade). However, the consideration must be allocated in descending order of class — reducing the assets in class I assets transferred, then class II assets, etc. Only when there is any remaining consideration can it be allocated to class VII assets.

Example: Your tangible assets are worth $1 million, but a customer is willing to pay $1.2 million because of your brand. The buyer will be arguing for an allocation that favors depreciable assets (such as equipment) rather than assets that will just be sitting on the books (such as goodwill).

CORPORATE LIQUIDATIONS

A sole proprietor can decide on his/her own to close up shop, but entities formed under state law require more formality. State law dictates the type of vote required to terminate a corporation. If the shareholders of a corporation (C or S) want to dissolve or liquidate it, the matter must be voted on by the required parties as specified under state law (usually the shareholders).

When a corporation (C or S) liquidates by selling off its assets or transferring them to shareholders rather than selling the business as a whole, it must file a plan of liquidation with the IRS — use Form 966, Corporate Dissolution or Liquidation.

The form must be filed within 30 days after the resolution of dissolution or liquidation is adopted — it is not filed with the corporation’s final return. Attach a notarized copy of the corporate resolution or plan of liquidation to the form.

Corporate tax: A corporation recognizes gain or loss on the distribution of its assets to shareholders in complete liquidation. For purposes of determining gain or loss, the assets are valued at their fair market value on the date of distribution.

A C corporation, for example, must retain sufficient cash or assets that can be sold to raise cash in order to pay the tax bill on the liquidation — only the net assets are then distributed. With an S corporation, the tax on the sale of corporation assets is passed through to its shareholders.

Shareholders’ tax: Shareholders are taxed on the distribution to them of corporate assets. Their gain (or loss) is the difference between their basis in the stock of the corporation and what they receive. (This is why corporations are viewed as producing a double tax — first on the corporation and then on its shareholders.)

LAST WORD

Once the business has been wound up, cancel any licenses and permits that you haven’t sold, and close the business bank account.

Resources: For a checklist of tax forms to file when closing a business, go to www.irs.gov/businesses/small/
article/0,,id=98703,00.html
. Also, contact your state for any special forms needed for closing a business in your jurisdiction.

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Source:
Tax Hotline interviewed Barbara Weltman, Esq., an attorney based in Millwood, New York, www.barbaraweltman.com. She is author of J.K. Lasser’s Small Business Taxes (Wiley) and publisher of the free monthly on-line newsletter Big Ideas for Small Business.
Date: February 1, 2008 Publication: Bottom Line Personal
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