Federal Tax Obligations When a Business Shuts Down
23 August 2023Is it time to close your small business? Unfortunately, closing isn't as simple as handing over the keys to a landlord or even selling a building you own. You still have various responsibilities to meet as you wind down, including some tax and legal obligations.
Income Tax Requirements
What you have to do from a federal income tax perspective depends on your form of business ownership.
Sole proprietorships and single-member LLCs. If your business operates as a sole proprietorship or as a single-member limited liability company (LLC), shutting it down is relatively simple. All the federal income tax implications of closing your business will be reflected on your personal tax return. When we prepare your tax return, we'll check a "final return" box.
Federal income tax gains and losses from selling or abandoning business assets are reported on your personal tax return. That's because the existence of a sole proprietorship is ignored under the federal income tax rules. Therefore, you (as an individual taxpayer) are considered to directly own all the business assets.
Pass-through entities. If your business has been operating as a pass-through entity — including a partnership, an S corporation or a multi-member LLC that's treated as a partnership for tax purposes — 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, tax consequences must be reflected on both the pass-through entity's return and the owners' personal returns.
Each owner must be issued a Schedule K-1 to report his or her passed-through shares of income, deductions and credits from the entity. Those passed-through tax items are then reflected on each owner's personal tax return (Form 1040). Gains and losses from selling business assets must be reported with the pass-through entity's return (Form 1065 or Form 1120S). You also must report any net self-employment (SE) income from the closed or closing business and calculate any SE tax due.
In addition, a pass-through business entity must file a final federal income tax return and issue the related K-1 schedules to you and the other owners, for the year it closes. A business that operated an S corporation must file additional IRS forms if the corporation adopted a resolution or plan to dissolve or liquidate any of its stock.
C corporations. If the business has 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. It will also result in 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, tax consequences must be reflected on the corporation's final federal income tax return (Form 1120) and on your personal Form 1040.
Important: Regardless of the type of business entity, you must notify the IRS about the dissolution of the business. Send the IRS a letter that provides the following information:
- The business name,
- The business address, and
- Your Employer Identification Number (EIN).
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 (OIC) or a delay in collection activities. The IRS will then cancel your EIN.
Other Tax Considerations
When you close a business, income taxes aren't the only concern. 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.
This includes Federal Insurance Contributions Act (FICA) tax, which has two components:
1. Social Security tax. The Old Age, Survivors, and Disability Insurance (OASDI) portion is taxed at a 6.2% rate on the amount up to an annual wage base. The inflation-adjusted base for 2023 is $160,200.
2. Medicare tax. The Hospital Insurance (HI) portion of the tax is 1.45% on all wages. There's no wage base for this component.
Both employers and employees must pay their share of FICA tax. Employers also must withhold the employees' share from their paychecks. Furthermore, the employer must deposit unemployment taxes and file the appropriate tax forms.
Similarly, employers must provide employees with their final W-2 wage income statements and send copies to the IRS. The deadline is the due date of the final quarterly payroll or annual payroll tax deposit.
Likewise, if your business pays more than $600 in its final tax year to an independent contractor, you must provide the worker and the IRS with the requisite tax form (1099-NEC).
There may be other tax issues related to closing your business, such as how to handle:
- Debt cancellation transactions,
- Deductions for suspended passive activity losses from prior years,
- Recapture of depreciation deductions, and
- Bankruptcy issues, if applicable.
Additionally, 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 requires you to meet detailed notice, funding, timing and filing rules. Complicated requirements also may apply if you offer a Flexible Spending Account (FSA), Health Savings Account (HSA) or other similar program to employees.
There's no definitive time frame for how long you should hold on to the tax records for a closed business. But the bare minimum is the statute of limitations for the final period. Usually, the IRS has three years from the due date of the final return to inspect it and impose any additional tax or conduct an audit. That's the same amount of time for you to amend your return.
To be on the safe side, you might want to retain your records longer. A conservative approach would be to maintain them for a period of seven to ten years. When you finally discard them, make sure any sensitive information is shredded.
For More Information
The tax consequences of closing a business can be complicated. This article provides just a quick overview. Other special rules may apply to your situation, as well as obligations relating to state and local taxes. Contact your tax advisor for details.
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