By Jigar Desai
As the coronavirus pandemic has plagued the world, many businesses have found it difficult to continue operating, and owners have resorted to selling their business or dissolving it. Pre-pandemic, business owners usually decided to sell or dissolve their business for various other reasons, such as experiencing burnout, lack of profits, low demand for their products and so on. Selling a business allows an owner to detach themselves from the business and possibly make a final profit. However, there are still tax implications that apply to the business after its sale that an owner should know.
Taxes on a Dissolution of a Partnership
A partnership is an agreement between two or more people to manage and operate a business. Partnerships typically invest money or labor into a business to launch it. Within the partnership, the partners will share the profits, losses and liabilities. This means that a partnership is not a separate entity from those who run the business, and therefore the partners will not be shielded from any risk and liabilities. For example, if a partnership owes money to a creditor and the business goes bankrupt, the creditor can go after the partner’s personal finances. Under the same concept, partners have to pay taxes on the gains or losses generated from the sale of the partnership.
Each partner has a specific tax partnership based on the after-tax value they have contributed to the partnership. Typically, each partner reports their percentage interest in the partnership in their tax forms yearly. This is typically the tax that the partner pays on their income stream from the business. Similarly, when a partnership dissolves and liquidates their assets, through the wind-up process, a partner can recover their initial partnership investment back tax-free. You can read more about the wind-up process in a partnership here. The governing authority over the taxation of a partnership liquidation resides in the IRS code 736(b). Bloomberg Tax provides a detailed description of the code. Upon the liquidation of the partner’s assets, a business can realize a profit after paying off their creditors. After the liquidation process and paying off their debts, a business distributes their profits amongst the partners. If a partner receives a larger profit than their initial investment to the partnership, then they will be taxed accordingly. The profits they made from the liquidation will be taxed as capital gains on their income tax. Investopedia provides a further explanation on capital gains. For example, if a partner provided a $100,000 investment into the partnership, then upon dissolution received $150,000, the partner will be taxed on the $50,000 profit. In contrast, a partner can also report a loss that they experienced from dissolution for tax purposes. Similar tax implications will occur to the transferrer of a partnership interest, under IRS code 741, regardless of whether the buyer is a partner or not. The profits earned from the sale of an interest will be taxed as capital gains. For example, if a partnership wants to sell an interest in their business to a new-third partner, the profits of the sale will be taxed under capital gains accordingly to each partner.
When a partner receives cash from the dissolution of the business that is less than the initial investment they gave, they have experienced a loss. This loss can be beneficial for partners who have multiple streams of income, as they can report this as a loss for their overall income taxes. A dissolving partnership does not have to pay-out their partners in cash; they can pay their departing partners in non-cash assets based on their fair market value. This can be beneficial to the receiving partner, as a non-cash asset can appreciate tax free. A partner would not have to pay taxes on the asset pay-out until they sell the asset for a profit. This can be a beneficial tool to avoid paying immediate taxes on the gain, as taxes on cash profits are almost inevitable. However, if the partner passes the asset through a will, the asset will avoid future taxes.
An important idea to keep in mind is that to determine whether the partner has received a gain or a loss, is based on their investment or partnership “basis.” A basis can be the amount of money they put into the business, but a partner’s basis can also change. A partner’s basis can increase if they make further contributions to the business, increase in the share of liabilities, or pay for any additional interest after their initial payment. This is important as an increased partner basis allows for the partner to receive a higher payment from the liquidation that will be tax free. For example, if a partner invests $100,000 into the partnership, their basis is $100,000. If over the years, they contribute an additional $50,000, then their basis has increased to $150,000. This would allow them to receive a payment up to $150,000 during liquidation that would be tax-free. Vice versa, a partnership basis can be reduced from its initial investment. Reductions in basis can occur if a partner sells some of their interest or takes a reduction in liabilities. This means an adjusted partnership basis can bring a liquidated partner a loss which would have been a gain based off their initial investment. Keep in mind that a partnership basis cannot be below zero.
Oftentimes, a single partner may leave the businesses for the reasons above and the other partner or partners will continue on with the business as is. This dissolution used to require the complete dissolution of the partnership, but under modern law, a leaving partner can be bought out without a complete liquidation of the business. Unlike the aforementioned scenario above, the business will continue on. When a leaving partner is bought out, the partnership may claim the payment as a deduction. The Internal Revenue Code section 736(a) allows the business to claim the buyout as a guaranteed payment, thus allowing for tax savings for that tax year. Similar to the above scenario, the bought-out partner will have to pay income tax on the buy-out payment. The bought-out partner will also be barred from providing additional services in the year that they are leaving to increase their buy-out payment. The buy-out payment must be paid in full to the leaving partner within the year they leave. This creates competing interests between the partnership and any partner that is leaving, due to the different ramifications of 736(a) and 736(b). The IRS and tax codes has provided little guidance on how to operate and report the different tax codes for a partnership. A partnership will try to claim their payments to be a section 736(a) to claim the tax deduction for the business. A leaving partner will try to claim this to be a 736(b) payment so they can pay capital gain taxes on the payment rather than income tax.
The tax implications that occur during the liquidation of a partnership are the same tax implications that occur during the liquidation of a Limited Liability Company. For tax purposes, LLCs are treated as partnerships.
Tax Implications of a Closely Held Corporation
Some small businesses are closely held corporations, which means they are owned by a few shareholders. The benefits of running a corporation is that a corporation is separate entity, which means that shareholders do not share the liabilities of the corporation. The specific steps to dissolve a corporation will be written in each corporation’s articles of incorporation and are governed by the law of the state where the corporation has incorporated. Generally, dissolving a corporation requires a vote by the majority of the shareholders. In a closely held corporation, this could be around the same number of owners as a partnership. When dissolving a corporation, the company must liquidate themselves into cash, meaning the owners must collect all the debts they are owed and pay the debts they owe. The company must generate the cash by selling everything they own. You can read more about it here. The remaining cash is distributed to the shareholders based off their equity in the corporation. For example, if the corporation has $100,000 and the primary shareholder owns 60% of the company, they will receive 60,000. Chron describes this more.
The IRS treats a corporate dissolution as a stock sale because shareholders are essentially selling their shares in the company for cash. Similar to the partnership process, when a shareholder receives a profit from the sale that is higher than the initial price they paid for the shares, they will have to pay capital gains on the profit. Similarly, a loss is when a shareholder receives less than what they initially paid for the stock. Corporations also have their own tax obligations, so they must report their gains and losses as well. This payout is different from dividends that a shareholder may receive during the company’s operations. A shareholder cannot claim that their liquidation distribution is a dividend. This is important because a dividend can receive many tax protections and unlike dividends, a liquidation distribution will not receive any tax protections.
A corporation receives a gain when they distribute less than the original shareholder basis and receive a loss when they distribute more than the shareholder basis. This means a corporation’s gains or losses are the opposite of what the shareholders experience. This also means that the money paid by the corporation to the shareholders is essentially taxed twice, once for the corporation and another by the shareholder. This double-taxation is unique to closely held corporations. Shareholders must also account for the fair market value of any property they receive that is not sold. Similar to partnerships, they will not be taxed until they sell it. If the shareholder waits long enough, they can file the profits from the property under long term gains rather than capital gains.
Even if a corporate dissolution operates as quickly as they can so the company can clear their books and avoid any future liability, the process may take a long time to complete. This means that the tax implication can run over a number of years, so shareholders will be receiving various amounts over a few tax years.
Finally, when a corporation closes its operations and liquidates, there are a number of filings the company must make before they are permanently closed. These filings include final employment tax returns and final federal tax deposits. The IRS has provided a checklist for corporations looking to liquidate.
The dissolution of a business is a difficult and long process, but you must also keep in mind the tax implications that come with dissolving your business. This article is an overview of what to expect after dissolution, but in order to apply specific tax credits and to use of state tax laws, we recommend you consult a tax attorney or an accountant.
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