The Hidden Dangers of Corporate Liquidations
Time and time again, clients are shocked to discover the true tax consequences of liquidating a corporation. Though the reasons for the misinformation may differ-perhaps they were wrongly advised, heard some misleading information from a friend, or failed to get any advice whatsoever-client reactions to hearing the tax consequences of corporate liquidations are usually those of shock and even despair.
At first glance, the 21% flat corporate tax rate implemented by the Tax Cuts and Jobs Act (TCJA) made the corporate form of doing business appear far more tax favorable than partnership or flow through tax treatment. On the highest end, partnership income is taxed at rates up to 37% as flow through income to the company’s owners. Though the TCJA allows for an offsetting deduction for certain types of businesses taxed as partnerships as an attempt to balance the significant difference in tax rates, this offsetting deduction does not result in an equivalent tax rate on the entity’s income. Where a company’s main goal is long term growth and investors wish to keep the money inside the entity for years to come, the corporate tax rate is undeniably favorable.
However, when you take into consideration the double taxation of the corporate entity, first, at the 21% flat rate at the corporate entity level and second, at the 23.8 qualified dividend rate (if held long term), the picture begins to look quite different. Depending on how many distributions the company wants to make and how often, as well as the income levels of the individual partners to whom the flow through income is attributed, the combined effective tax rate at the entity level and on distributions may be more favorable where a company is treated for tax purposes as a partnership. A far more intricate analysis must be completed to tell one way or the other.
However, many business owners seem to lack the full appreciation for the tax consequences of closing shop or dissolving an entity when choosing the form of entity and tax treatment of a business. When a corporation is liquidated, the transaction is treated in two steps. First, the corporation is treated as if it sold all of its assets at fair market value and is taxed on all appreciation or gain inherent in those assets at corporate tax rates, currently 21%. Second, amounts distributed to the shareholders in liquidation of the corporation are treated as a sale of stock by the shareholder. Where the fair market value of the assets received by the shareholder is greater than the shareholder’s stock basis, the shareholder will be taxed on gain equal to the difference between the value of the assets received and his or her basis in the stock. Depending on how long the shareholder held the stock, this will result in either an additional 20% (or 23.8% for passive income earning assets) or up to 37% if the stock was held for less than a year.
In contrast, partnership liquidations only result in one level of tax. Because there is no tax at the partnership level on any deemed sale of assets, partnership liquidations are often far less tax burdensome to its owners than those of a corporation. Liquidation tax treatment is just one of a myriad of factors that are important to keep in mind when deciding how to set up and operate a business in the U.S. Allow Barbosa Legal to assist you in analyzing these factors to obtain the best possible results for your individual needs.