Liquidating an S Corp

[gwithers13]

My co-owner and I are liquidating an S-Corp. My percentage of losses in the business far exceed my basis (my losses are 100K and my basis is/was 25K). With the liquidation, I will receive assets which have a value of about 40K. Do I have to declare this final distribution as income or can I take it against my unused losses. None of this is passive, it is all active.

[Uncle Sam]

Liquidating S Corp

We need to know the composition of the $ 100,000 loss.
Was it all operating losses, or some losses on disposition of assets.
What I'm getting to, is some are capital losses, some are ordinary losses, and depending upon WHAT they are, will determine WHERE on the tax return they're reported.

[Bees Knees]

When a corporation liquidates, it must pay tax on the difference between its basis in its assets, and the FMV of its assets.

So lets say the $40K worth of stuff you get only has a basis of $10K in the hands of the corporation. The corporation must pay tax on the $30K difference.

However, since it is an S corporation, the $30K taxable income flows through to you on your K-1, thus increasing your basis, which in turn frees up unused loss carryovers, so it evens itself out. In turn, however, you now own $40K worth of assets with a tax basis in your hands of $40K. You could turn around today and sell the $40K for cash and not pay any more tax on it since the gain would be zero.

[gwithers13]

Clarification

My portion of the Assets are $40K in cash. My question is that
I put in 25K to create the business and raised other funds from other investors
The the other investors were bought out so I own the business with a co owner.
We are liquidating. Our losses are all operating losses and my portion of them is $100K which are non passive losses incurred in trying to make the business go forward. Over the years, I have taken some losses up to the level of my initial basis (25K cash up front). So for the last 2 years I have not been able to take any losses since I have used my basis in the years prior to that.

Now we want to shut down and distribute the cash (40K each). There will be a further operating loss this year (my percentage being perhaps 10K) increasing my carryover loss plus current loss to $110K.

So I will have a total unused loss at $110K and a distribution of 40K cash. My assumption was that since I had not put in but 25K and have already used it in prior years, I have no way to use the 110K to offset the 40K distribution. Hope I am wrong!

[veritas]

Did you personally purchase shares from previous shareholders?

[Bees Knees]

So I will have a total unused loss at $110K and a distribution of 40K cash. My assumption was that since I had not put in but 25K and have already used it in prior years, I have no way to use the 110K to offset the 40K distribution. Hope I am wrong!

Your assumption is correct. If you used up all prior year basis, so that you started this year at zero, and you liquidate the corporation where the corporation has another loss, and you get $40K in cash, then you now have a capital gain of $40K to report on Schedule D, and zero basis in prior year and current year losses.

You can't count losses against income if you really didn't lose any thing.

I question why you could liquidate a corporation with those kind of losses and take $40K cash out? Those losses had to be generated by something. Aren't there any corporate loans or other liabilities that need to be paid off? What funded the losses if the money didn't come from you?

[gwithers13]

where the losses came from

Unfortunately it was our money (from which we already used our basis in prior years) and that of our investors.

[gwithers13]

Capital gain or regular income

Can you pls confirm that since we are liquidating, the cash taken out will be a schedule d entry rather than income on schedule e? Am I to assume that liquidation means taking the assets and distributing them to shareholders and then the "distribution" is taken as long term gain (corporation existed for 5 years)? This is obviously better than taking it as a gain on Schedule E.

[rosieea]

Can you pls confirm that since we are liquidating, the cash taken out will be a schedule d entry rather than income on schedule e? Am I to assume that liquidation means taking the assets and distributing them to shareholders and then the "distribution" is taken as long term gain (corporation existed for 5 years)? This is obviously better than taking it as a gain on Schedule E.

Liquidating distributions constitute a deemed sale of stock. That is, the corporation is distributing its assets in exchange for all shares of outstanding stock. Accordingly, the recipient of the distribution reports the transaction on schedule D. It is long- or short-term as determined by how long the individual has held the stock.

[Bees Knees]

Unfortunately it was our money (from which we already used our basis in prior years) and that of our investors.

That still doesn’t answer my question.

Lets say you put $1,000 into the S corp in exchange for stock, another person put $1,000 in exchange for stock, and a third person loaned the corporation $10,000 as an outside investor, with no ownership interest.

You are a 50% shareholder along with one other person. Your basis is $1,000 in the corporation.

Now the corporation operates with total available funds of $12,000. Lets say it spends $6,000 on an unprofitable venture. It passes $6,000 of losses through to you and your partner, your share being $3,000, but you can only deduct $1,000 due to your basis. So you have $2,000 of unallowed carry forward losses.

Now when you think about it, who generated that $2,000 of losses that you cannot deduct? The money didn’t come from you, it came from the guy who loaned the corporation $10,000. You already used up all the money you stuck into the business. The minute your business spent more than the capital contribution of you and the other stockholder, and any occasional profits it may have earned in between, it started to spend the money loaned from this outside investor.

Now you decide to liquidate the corporations because it can’t make any money. There is $6,000 cash left in the checkbook. Who gets the money?

Well, chances are that outside investor that loaned you $10,000 is entitled to get his share back plus interest, before you get any. That is generally how loans work. He gets the $6,000 checkbook balance, and you get zero upon liquidation.

The point is, if you used up your prior basis on prior year losses, where did the rest of the money come from? Why do you get a cash distribution upon liquidation without having to pay off the investor that generated those un-allowed losses?

[OldJack]

Well, chances are that outside investor that loaned you $10,000 is entitled to get his share back plus interest, before you get any. That is generally how loans work. He gets the $6,000 checkbook balance, and you get zero upon liquidation.

We should also point out that in the Bees example of the loan from the outsider, if $10,000 is considered forgiven (not paid back) by the investor it may or may not become taxable income to the corp and the shareholders before the liquidation transaction.

This case is a serious tax situation that can only be calculated and properly dealt with by a local tax professional where all the facts can be taken into consideration.

[Jesse]

We should also point out that in the Bees example of the loan from the outsider, if $10,000 is considered forgiven (not paid back) by the investor it may or may not become taxable income to the corp and the shareholders before the liquidation transaction.

This case is a serious tax situation that can only be calculated and properly dealt with by a local tax professional where all the facts can be taken into consideration.

I know someone in a similar situation, however they just closed up shop and now there is creditors that are not going to get their money. It's not my client, but for learning purposes I'm curious as where would you even begin?

What if the $10,000 was not paid back? Would this be taxable if the business is now insolvent? What if the business filed bankruptcy? What other facts would you have to consider?

[gwithers13]

appreciate everyone's time--again clarify

In this case there was no loan. So using Bee's Knees example
a. 6 investors put in 2000 dollars (one being Inventor) but no loans
b. Inventor owns 50% and 5 investors own 10% each of outstanding stock
c. Inventor runs it for 3 year on no salary.
d. operations uses up 5000$ leaving 7000$.
e. Inventor uses up his $2000 basis by having absorbed 50% of losses (5000/2=2500) and having 500 left over but not usable since basis is exhausted.
f. operations can continue or be shut down.
g. decision to shut down; remaining 7000$ is paid to all investors on basis of stock ownership.
h. Inventor gets 3500$ (50% of remaining cash and all others get 10% each or $700.
i. How does inventor account for this gain? Is it by Sch D? $3500-$2000=$1500 LT gain? Or is it ordinary income?
j. Can the other $500 of the unused losses be used at all?
k. Is it worth the investor keeping the company "open" inactively on his own and adding basis (thus stopping losses in order to use more losses in current year? Or does this just delay the inevitable longer term when final shut down occurs.

I think this example reflects the situation.
Thanks to all for their time and it is appreciated.

[Bees Knees]

In an S corporation, in order for the inventor to get a 50% share of profits, he had to have put in 50% of the capital. If part of his 50% was contributed through labor (his inventing skills), then he would have had to have had a W-2 issued to him for the value of the stock he was acquiring in exchange for his inventing skills. After paying tax on his labor, he would get basis in that labor, which would have allowed him to deduct 50% of the losses against that labor. In your example, there should have been no unallowed losses, as the inventor would have been allowed a full deduction on his 50% share of the losses.

If the inventor did not pay tax on his full 50% interest in the S corp, then you disqualified the S corporation by having two classes of stock. Since you disqualified the S corporation, none of those prior year losses were deductible since a C corporation cannot pass losses through the corporation to the shareholders.

You have a problem here. You could do something like this in a partnership or a C corporation, but you cannot give someone an ownership percentage of an S corporation based on future profits.

[gwithers13]

thanks for the time on this

I guess this could go on forever as I am not giving obviously the correct and full detail you need (I am not omitting details intentionally however, I am just an inventor not an accountant or lawyer). I will raise these questions with the attny and accountant who were there at the origination. I guess the only thing I could offer in addition that might bear on this is that the investors purchased their stock after the corp had been in existence for about a year. They paid more on a per share basis since the corp had a higher "perceived" value at the time. Can't think of anything to add in addition. But at the time there was no concern about having 2 classes of stock. We were guided through this by the professionals (or so we thought).
Thanks