When a corporation ceases its business operations, all assets owned by the company must be distributed. This process is known as liquidation and is necessary, even in cases when the corporation is being sold or converted into a different business structure. As part of every liquidation, state and federal income, payroll and capital gains taxes must be paid at both the corporate and individual levels.
A C corporation is a business entity governed by Subchapter C of the Internal Revenue Code. Corporations are the most widely known business forms, providing limited liability to shareholders and allowing ownership to be freely transferred through the buying and selling of stock. C corporations are also subject to what is known as "double taxation." This type of tax treatment means that income and gains on property are taxed first at the corporate level and then again at the individual shareholder level for any dividends received.
The double taxation feature inherent in C corporations plays a special role in liquidation. The liquidation of a company means that the business operations have ceased and the assets and property owned by the corporation are redistributed. Liquidation is generally accomplished by either selling these assets or transferring all of the shares in the corporation. Possible reasons requiring liquidation are the closing or sale of the business or changing the business structure to provide more favorable tax treatment. Each of these actions produces potentially taxable events at the corporate and individual shareholder levels.
The owners of a C corporation may be interested in converting the company into a limited liability company, or LLC. While there are several reasons for doing this, one reason is to eliminate the double taxation feature of corporations. As part of the conversion, the assets owned by the corporation must first be transferred to the shareholders in exchange for stock. The shareholders will then transfer the assets to the newly created LLC. This liquidation results in an initial tax on the corporation for any gains on the property. Gain is calculated by subtracting the value of the property transferred from its worth at the time it was acquired. The shareholders are also taxed on the transfer, provided the assets exceed the value of the stocks traded. These taxes can be significant if the corporation and shareholders own primarily intellectual property, such as a secret recipe, that had no value at the time the company was established but is now worth millions as a trade secret.
The sale of a C corporation is also a taxable event for both the company and shareholders. A sale can be accomplished by either transferring all of the corporate assets or transferring all of the stock. Liquidation of the assets will result in a tax on the gains, similar to that observed in changing business structure. If the stocks are transferred instead, this will result in a capital gains tax on any appreciated value in the stocks at both the corporate and shareholder level. Many owners choose this option because the capital gains tax rate is lower than the rate applied to the sale of appreciated assets.
- Digital Media Law Project: Corporation
- Digital Media Law Project: Double Taxation
- Cornell University Law School, Legal Information Institute: 26 U.S.C § 336
- Cornell University Law School, Legal Information Institute: 26 U.S.C § 331
- Internal Revenue Service: Topic 409 - Capital Gains and Losses
- Internal Revenue Service: Part 4. Examining Process