When a corporation decides to shut down, it might liquidate its remaining assets, and even some of its debts, to shareholders.The tax treatment of liquidating distributions of debt to shareholders impacts the amount of gain or loss shareholders report on their tax returns.Distributions to the shareholder are not included in the shareholder’s gross income to the extent that the distribution does not exceed the shareholder’s basis in the stock.
Because the income of S corporations is taxed to the owners when the income is earned, a mechanism is needed to ensure that the shareholder is not taxed again when the earnings are distributed.
This is done through a system of rules that track and adjust the shareholder’s stock basis.
This means that you may have a gain or loss to report on your return.
Gains and losses are calculated as the difference between your tax basis in the stock exchanged and the overall fair market value of the distribution you receive, which is treated as the gross proceeds of the deemed stock sale.
These rules (a) allocate the partnership’s income, losses, deductions, and credit among the partners and (b) adjust basis to reflect each partner’s allocation of those items.
As stated in Taxation of Limited Liability Companies and Partnerships, limited liability companies are taxed as partnerships by default.
Unlike the rules that apply to C corporations, which tax income both at the entity and at the owner level, the partnership rules are designed to only tax income once, at the owner level.
A partnership’s income, losses, deductions, and credit are passed through to the partners for Federal tax purposes and taxed directly to them, regardless of when income is distributed. Since the partners have already paid tax on the income when it is earned, a complex system of rules applies to prevent double taxation when the income is later distributed to the partners.
Liquidating distributions also has tax implications for the corporation that may need to be reported to the Internal Revenue Service on the company's final return.