9009 / What tax considerations make the liquidation of an S corporation different than the liquidation of a C corporation?

IRC Section 1371 provides that an S corporation is subject to the same rules that apply in the context of a C corporation unless there is a specific rule that has been developed for S corporations. Despite this, one of the primary differences between an S corporation and a C corporation is their basic tax treatment, which has an important impact upon the issues that the entity will face during liquidation. Because S corporations are taxed at a single level, taxation of a sale or other liquidation of the business will usually occur only at the individual level, unlike in the context of the C corporation, where the corporation itself will be required to pay taxes on any gain before passing the profits through to shareholders, who will also be taxed on the amounts they receive.

Many S corporation shareholders will have a higher stock basis than that of a C corporation shareholder. This is because the basis of an S corporation shareholder’s stock is increased by any earnings of the S corporation that are passed through for tax purposes.¹ Depending upon how long the corporation had existed as an S corporation, and the level of earnings that were passed through to shareholders, S corporation shareholders may have substantially higher tax bases upon sale. Because tax basis decreases the amount of gain that the shareholders are required to recognize upon sale, the S corporation shareholder’s total tax liability will often be lower than the C corporation shareholder’s upon liquidation of the company.

If the S corporation was ever a C corporation, however, the S corporation will be required to account for any built-in gains, which are taxed at the highest rate applicable to C corporations (see Q 8955).² The tax on built-in gains is designed to preserve a part of the double tax structure for certain S corporations that were formerly C corporations. The built-in gains tax applies if the S corporation sells an asset within a five year period (formerly 10 years) following its S corporation election.³ The tax on built-in gains is imposed at the S corporation level, in addition to any taxes that are paid by the S corporation’s shareholders. This tax will only apply in situations where the S corporation was formerly a C corporation and liquidates within 10 years of making its S election.