Tax Implications of Closing a Startup: What Entrepreneurs Should Know
Thinking of closing your startup? You're not alone. Dissolving a startup is a financial and emotional challenge, with intricate tax considerations involving the IRS, state tax boards, and municipal levies. A hasty exit could leave you with unexpected bills.
This blog sheds light on how taxation works according to different business structures and how tech startups shutting down in 2023 can minimize their tax liability.
The tax implications of closing a tech startup are mainly determined by its business structure.
The IRS documentation requirements also vary according to how a startup is structured.
Proper asset disposal, employee layoffs, and fulfilling tax obligations are key to reducing your tax liability.
What are the Tax Implications of Closing a Tech Startup?
The tax implications of closing a tech startup are mainly decided by the company’s business structure. That said, general considerations include potential state, local, and capital gains tax, selling or disposing assets, handing out employee severance, canceling debt, and dissolving your business entity. Finally – and most importantly – seek professional advice.
Before we discuss how startups can close operations in a tax-efficient way, let’s look at how the final taxation works for different tech companies.
Closing a sole proprietorship has straightforward tax implications, largely due to 'pass-through taxation.' What does this mean? Essentially, the business itself isn't taxed separately. Instead, the income and losses of your startup are passed through to your personal tax return.
This direct link means that you, as the business owner, are personally responsible for paying taxes on your business income. These taxes include self-employment tax (which covers Social Security and Medicare) and any regular income tax.
Also, when shutting down, you could incur capital gains or losses once you sell company assets, which will be reported on your personal tax returns. To calculate capital gains or losses, you’ll need to find out the ‘tax basis’ of each asset, i.e., the original purchase price, adjusted for any depreciation or capital improvements.
If the capital gains are more than the losses, you’ll have to pay the applicable capital gains tax.
Note: The tax on long-term gains (assets under possession for more than a year) is usually less than the ordinary income tax rate.
The Tax implications of closing an LLC depend on the tax classification you select. So, you can choose to be taxed as a sole proprietor, partnership, S corporation, and a C corporation. A pass-through taxation applies if you opted for sole proprietorship, partnership, or S corp.
Generally speaking, with multi-owner LLCs (i.e., partnerships), each owner will receive assets according to their share in the company and must file a final partnership tax return. These partners will then be taxed on their share of the business’s income and losses, regardless of whether the company has actually distributed any cash to them.
For example, let’s assume a tech startup has two partners, Mike and Vance. Mike owns a 60% stake in the partnership, and Vance owns 40%.
The partnership liquidates and sells all of its assets at a gain of $20,000. Mike will be taxed on $12,000 of the gain, whereas Vance will be taxed on $8,000, even if both Mike and Vance have yet to receive the proceeds from the sale of company assets.
Note: The above explanation and scenario serve as a general example. The exact procedures can vary based on the guidelines mentioned in the company’s operating agreement (founder’s documents). Please consult a tax professional.
Although the tax consequences of dissolving an S corporation are similar to sole proprietorships and partnerships, there are a few key differences you should know about.
Firstly, sole proprietors and partnerships are subject to self-employment tax on their net earnings from the business. However, S corporation shareholders can potentially reduce self-employment tax.
They can pay themselves a reasonable salary for their services to the corporation, which is subject to payroll taxes, and take the remaining profits as dividends, which are not subject to self-employment tax.
Secondly, S Corporations that convert to C corporations or shut down operations must pay built-in gains tax (or Big Tax). It’s a countermeasure to prevent C corporations from converting into S corps to escape corporate-level taxes.
In any case, these unrealized capital gains must be settled when an S Corporation closes operations.
C Corporation is a common business structure for startups because of the limited liability aspect and also that they are taxed as separate entities.
The tax consequences of closing a C Corporation include ‘double taxation,’ meaning that the same income is taxed twice. The company must pay tax on its profits, and then the shareholders pay taxes on the dividends that they receive from the corporation.
For example, if a C corporation has $30,000 in profits, it will pay taxes on those profits at the corporate tax rate. After the corporation has paid its taxes, it distributes the remaining profits to its shareholders as dividends. The shareholders will then pay taxes on the dividends they receive at their individual income tax rate.
So, are these points a major tax concern for startups? Not really. Double taxation doesn’t apply to most early-stage startups because they aren’t profitable to begin with, and typically, any or most profits are reinvested back into the business.
Secondly, the founders are paid a small salary (if any), so the personal tax numbers are relatively low.
How to Close a Tech Startup in a Tax-Efficient Way
Not all of the points mentioned in the following section apply to all startups who want to close operations in a tax-efficient way. The specific tax implications of closing a tech company vary depending on circumstances like its business structure, tax status, and financial situation.
Liquidation involves selling a startup's assets and using the proceeds to pay creditors and shareholders. This process can be tax-intensive, and it's vital to understand the implications.
For example, consider your startup owns a valuable patent licensed to other companies. In liquidation, you might sell this patent to settle debts with creditors. However, if there are outstanding bills, such as for software subscriptions, these need to be paid from the patent sale proceeds. Failing to do so can lead to tax consequences.
Here's where it gets complex: If your startup owes $40,000 to creditors but sells the patent for only $20,000, the creditors receive half of what's owed. The IRS may view the unpaid $20,000 as 'cancellation of debt' income. This means your startup might owe taxes on this amount, as it's considered income by tax laws.
The specifics can vary, especially if bankruptcy or insolvency is involved, highlighting the need for professional tax advice in these situations.
Asset Sale and Abandonment
When closing a tech startup, you must deal with the assets your business owns. This process involves deciding how to get rid of these assets, whether by selling them for cash or leaving them behind if they're not valuable. Careful planning is crucial to minimize your tax liabilities.
Your options include:
Sell the assets.
Distribute the assets among the owners.
Abandon the assets if they're not worth selling.
Your choice will impact your startup's overall tax situation and affect aspects like capital gains or losses. Ensure proper documentation and compliance with tax regulations to maximize the money you keep when closing your startup.
When a tech startup shuts down or downsizes, it often provides employee severance, which includes compensation and various benefits. This not only supports employees during their transition but also can be structured to be tax-efficient for both the company and the employees.
From a business perspective, severance payments are generally deductible as business expenses, potentially lowering the company's taxable income. A strategic approach to enhance tax efficiency is to spread these severance payments over multiple years, balancing immediate financial obligations with long-term tax planning. For employees, the tax treatment of their severance pay depends on factors like the total amount and their individual tax circumstances.
It's crucial to note that legal requirements for severance can vary. In some regions, laws dictate minimum severance standards, especially in cases of large-scale layoffs.
Companies should carefully plan these packages, considering both compassionate support for employees and the financial and tax implications for all parties involved.
Note: For more details, check out our guide on managing employee layoff and severance during a tech startup shutdown.
Debt cancellation is when a business has outstanding debts that it cannot repay, and the lender forgives the debt. It’s a form of forgiveness income (it's money earned), so you may have to pay taxes for it.
There are exceptions to the rule. For example, debt cancellation in a bankruptcy proceeding may be eligible for tax-free treatment.
Closing a startup involves settling all outstanding tax obligations with the IRS to ensure compliance with tax regulations. It also includes notifying the IRS by filing the necessary tax returns, such as the final tax return for the business, and accurately reporting all income, deductions, and transactions.
Address any outstanding payroll taxes, income taxes, or other tax matters to avoid potential penalties, legal issues, or hefty disputes with tax authorities. The following table offers a quick overview of the type of IRS documentation required based on the startup’s business structure.
IRS Documentation Requirements
File a Schedule C with your personal tax return (Form 1040)
File a final partnership tax return (Form 1065) and provide partners with a Schedule K-1
The required documentation will depend on the chosen tax classification
File a final tax return using Form 1120-S and provide shareholders with a Schedule K-1
File a final corporate income tax return using Form 1120 (If shareholders receive dividends, they should report it on their individual tax returns).
As always, consult a professional before making any final decisions.
Unemployment and Payroll Tax Account Closure
A critical yet often overlooked aspect of closing a tech startup is the proper management of Unemployment and Payroll tax accounts. This involves submitting a final payroll report to account for all employee wages and withholdings and ensuring all payroll taxes are fully settled. Neglecting this step can lead to severe penalties, with business owners potentially held personally liable for unpaid taxes.
After reporting the final payroll, it’s essential to formally close your Unemployment Tax Accounts with state agencies, indicating your business will no longer be paying wages. This process varies by state, so specific state guidelines should be consulted. For federal obligations, ensure compliance by filing final tax returns, including all payroll-related taxes. Given the complexity of these tasks, seeking assistance from a professional is highly advisable to ensure thorough and compliant closure of these accounts.
Is Goodwill Taxed as Capital Gains?
Yes, goodwill is usually taxed as capital gains. It’s an intangible asset representing the value of a company’s reputation, customer relationships, brand, and other factors that add value to the business beyond its physical – or tangible – assets.
What Are the Tax Implications of Buying Out an LLC Partner?
The tax implications of buying out an LLC partner depend on factors such as the type of LLC, the tax basis of each partner, and the partnership agreement. However, one of the most important considerations is capital gains tax which may apply when an LLC partner sells their interest in the company.
Having read this far, you now know that the tax implications of closing a business can be complex. You’ve got to figure out what you owe the IRS while also working out how to close your startup without making costly mistakes.
But you don’t have to do it alone. SimpleClosure simplifies the shutdown process by automating the tedious bureaucratic and manual work using a combination of Fintech, legal tech, and AI.
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