Unfortunately, many businesses have already been forced to close their doors due to the economic fallout from COVID-19, and more will surely follow. Closing a business has important federal income tax implications that owners should understand. Here’s what owners of sole proprietorships and single-member (one-owner) limited liability companies (SMLLCs) need to know.
Reporting Gains, Losses and Other Items
Federal income tax gains and losses from selling or abandoning business assets will be reported on your personal tax return. That’s because the existence of a sole proprietorship or SMLLC that’s 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.
Important: Your tax advisor can help you file the appropriate forms to report gains and losses, as well as other business income and deduction items for the final year of business. You also must 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. Consult your tax professional about the applicable deadlines.
Important: 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
- A delay in collection activities.
The IRS recognizes that many taxpayers are struggling due to 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 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 won’t 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 pro 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.
It’s also important to 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. You tax pro can answer questions about how long to retain other records, including tax returns.
Tax Treatment Depends on Business Structure
When a business closes, its tax classification has important tax implications. There are three main ways to structure a business, which, in turn, affect how the closing will be handled for tax purposes:
1. If you’ve operated the business as a sole proprietorship or as a single-member (one-owner) limited liability company (SMLLC), all the federal income tax implications of closing your business will be reflected on your personal tax return.
2. If the business has been operated as a pass-through entity — including a partnership, an LLC treated as a partnership for tax purposes or an S corporation — you’ll probably arrange for the entity to sell assets, possibly abandon some assets and liquidate. If so, that will trigger tax losses (and possibly gains) at the entity level that will pass through to the owner(s) and be accounted for on their individual tax return(s). Put another way, there will be tax consequences that must be reflected on the pass-through entity’s return (Form 1065 or Form 1120S) and on your personal return (Form 1040).
3. If the business has been operated as a C corporation, you’ll 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 and 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 federal income tax return (Form 1120) and on your personal Form 1040.
These summaries seem simple enough, but the tax consequences of closing a business may get complicated. Contact your tax advisor for details.
We Can Help
Closing a business involves more than just turning off the lights and locking the doors. Tax advisors can provide much-need 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.