In this episode of Toni Talks, enrolled agent (EA) Toni Covey is joined by special guests Carl Zoellner, Esq. and Gary McHenry, CPA, to talk about how to dissolve a corporation with a loss and utilize the Section 1244 stock-loss option.
Updated October 6, 2020
Sometimes, a client reaches out asking about dissolving their corporation with a loss and taking that loss on their personal tax return. So, let’s break down the complexities of dissolving a corporation with a loss. There are multiple factors to consider both at the formation of the corporation as well as its dissolution.
How to Dissolve a Corporation
First, let’s step back. How do you even dissolve a corporation? What do you need to do?
Really, there are three steps or layers to dissolving a corporation. These are:
- Third parties
- The state
- The federal government
Dissolving a Corporation Step 1: Third Parties
Your corporation probably has contracts or dealings of some sort with third parties. Examples could include bank accounts, loans, or any other contracts your corporation may have entered into. Your first step in dissolving your corporation is actually a pre-dissolution step: cleaning up the balance sheet and closing accounts or contracts with third parties, where possible.
State law is supposed to provide for a “wind-down” period for corporate dissolutions. This wind-down period is meant to cover post-dissolution, allowing corporations to close bank accounts and wrap up other dealings with third parties after dissolution. However, I’ve actually seen banks refuse to close bank accounts & release remaining funds to corporations that are no longer active. This has happened to clients.
So, why risk it? Personally, I prefer the path of least resistance. If you know that something could cause you a pain point down the road and you know there’s a way to prevent it, let’s do that. To this end, I recommend closing bank accounts and relationships with other third parties before dissolving the corporation, to the extent possible.
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Dissolving a Corporation Step 2: State
With step 2, you’ll actually submit articles of dissolution to the Secretary of State in the state of incorporation. Depending on the state, you may also need to file documentation of corporate dissolution with the Franchise Tax Board (in California, for instance).
Also depending on your state, you may need to swap steps 2 and 3. Some states will not let you file articles of dissolution without a tax release, which documents the filing of your corporation’s final tax return.
Dissolving a Corporation Step 3: Federal
Finally, the last step to dissolving your corporation is to file its final tax return with the federal government. Again, depending on your state, you may actually need to swap steps 2 and 3. Also depending on your state of incorporation, you may additionally need to file a final tax return with the state government.
Dissolving with a Loss
After you’ve made the decision to dissolve, what do you do with a loss if you have one? There’s a lot of confusion about this out there, and folks don’t seem to be aware about the reprieve offered by the Section 1244 stock-loss option, or are confused about it.
The Section 1244 stock-loss option allows you to take a corporate loss on your personal tax return against your ordinary income, including W-2 income. However, this is not about net operating loss (NOL) of your corporation. It’s about the value of your shares in the corporation and the fact that it dissolved.
For example, let’s say I have 1,000 shares on the books and those 1,000 shares are worth $100,000. If the corporation dissolves, I’m left with $100,000 of worthless stock. This is where Section 1244 comes into play.
Section 1244 Qualifications
The Section 1244 stock-loss option allows an individual stakeholder to deduct up to $50,000 ($100,000 for married joint-filers) after the dissolution of a corporation, which can be taken as an ordinary loss to offset ordinary (including W-2) income. This is why you want to make sure that you qualify for Section 1244 from the start, not when you’re ready to dissolve the corporation. When you set up your corporation, you want to ensure that there’s a written statement in the articles of incorporation that establishes the shares as Section 1244 stock. Moreover, to further memorialize this, you should keep including it in your minutes to prove your profit motive.
Many people hold the misconception that the Section 1244 stock-loss option applies automatically. This is not the case. You actually have to qualify. Here are some of the qualifications that must be met to use this option.
The corporation must be a domestic corporation, not an LLC that’s elected to be taxed as a corporation.
Small Business Entity
The corporation must be a small business entity. To qualify as a small business entity, the corporation could not have had more than $1 million in assets at the time of its creation. It also must have fewer than 25 shareholders.
More than 50% of the corporation’s income over the 5 years preceding dissolution must come from the company’s active business. If the corporation receives passive income (including rents, dividends, royalties, interest income, etc.), that income cannot account for more than 49% of the corporation’s total income. If there’s no income in the corporation, it qualifies.
Original Issue Stock
The stock you hold in the corporation must have been originally issued to you. This doesn’t mean that the stock you hold must have been issued upon incorporation — it just means that it must have been originally issued to you, not transferred to you from someone else.
For example, if I have 1,000 shares upon incorporation and I put $1,000 into the corporate bank account, the value of those 1,000 shares is $1,000. If I then want to infuse another $50,000 into the corporation to get the business going, I can’t put that money in as additional paid-in capital. That would not be considered original issued stock. The $1,000 would qualify for the Section 1244 stock-loss option, but that $50,000 would just be considered capital. If I do it this way, I would have the capital loss limitation on my personal tax return, limiting the deduction to $3,000 of this $50,000 every year. However, if I infused the business with the additional $50,000 and then issued myself a second certificate and a second 1,000 shares in consideration of the $50,000, that would qualify as original issued stock for Section 1244. It’s important to note that there can only be one class of stock. I wouldn’t create a second class of stock with that second issuance.
Funding the Corporation & Section 1244
One final note about dissolving a corporation with a loss and claiming the Section 1244 stock-loss option: this does not apply to loans granted to the corporation. Section 1244 captures equity, not debt. So, if you funded the corporation with debt, that money is not recognized as a capital investment; it’s recognized as a liability. If you funded the corporation almost completely with debt, it has no capital value. In fact, it has a negative value because it owes you money.
When I consult with clients about starting a C-corporation, I almost always tell them to fund the corporation with debt because it makes it much easier to actually get the money back out of the corporation. However, to hedge your bets and ensure those funds are still covered under Section 1244, you can take that debt and exchange it for capital down the road. It’s critical to note that you don’t want to do this exchange with the intent to dissolve. Documenting your intent is crucial here. Otherwise, you’re sending up red flags with the IRS.
Overall, it’s critical that business owners work with a professional from the outset of their endeavors. There are a lot of intricate details and complexities that come with making choices about business entities and how they’re set up. If you use the do-it-yourself method, you run a high risk of overlooking something critical that could negatively affect you down the line.
When you’re ready to seek the guidance of professionals in this area, schedule your complimentary Strategy Session with a Senior Advisor. It’s a value of $750, and you’ll walk away with a Wealth Planning Blueprint that outlines the best entity structure for your individual business and investing situation and goals. You can schedule online or by calling 888.871.8535.
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