How to Close an S Corp: 6 Tax Steps That Land on the Shareholders

Getting out of business as an S corporation means knowing where the tax liability lands. In an S corp, gains from distributing the assets pass through to the shareholders on the final K-1, and the owners may be taxed on that if there are profits. Each shareholder also has a gain or loss based on the sale or deemed liquidation of their stock, compared to its basis. And just because the business has stopped doesn’t mean there is no more IRS correspondence. There are six tax steps.

Pay Outstanding Creditors

First, an S corporation that adopts a resolution or plan to dissolve has an obligation to file Form 966. This form is used to notify the IRS of the “corporate” dissolution or liquidation. This return must be filed within 30 days after the date of the resolution or plan. You still have to file a final tax return, too.

Second, pay outstanding creditors before you begin to pay yourself any of your share of the net assets. When an S corp closes its doors, it is typical for some of the remaining cash to go toward unpaid payroll taxes and any other creditor claims against the business. Also, even if the business is closing, if it paid wages in the final quarter or year, the final Form 941 or Form 944 must still be filed, on time. And the “closed business” box must be checked. Also, the company must issue the W-2s to the employees by that due date. If a responsible person willfully doesn’t pay over withheld trust fund taxes (income and payroll tax withholding), the IRS can make that individual person personally liable for 100% of it.

When a lender forgives part of an S corp’s debt, the corporate level insolvency exclusion or bankruptcy exclusion must be applied at the corporate level. The corporation can’t pass the excluded amount on to the shareholders. And that exclusion is capped by the liabilities in excess of the fair market value of all its assets just before the debt discharge occurs.

Distribute the Property Itself

Third, you don’t have to convert assets to cash first, but rather can distribute the property itself to you and the other shareholders. If an S corp distributes the marketable securities, real estate, tangible personal property and so forth in lieu of money, the sale amount will be based on the fair market value (FMV) of the assets. If the assets have increased in value, there is an increase in the corporate income taxable to the shareholders.

An S corp that hands out appreciated equipment generally creates a taxable gain for the corporation. That gain will pass to you and the other shareholders in proportion to your stock percentage. You could end up having to write a check to the IRS when the tax return is filed. In other words, you can be taxed when there is no cash. Equipment distributed to the owners also can have hidden tax due to depreciation recapture. Cash distributions don’t create corporate gain.

Fourth, shareholders are taxed on a final deemed sale of their stock. Each one is taxed on their share of the final year’s profit, their share of the corporate gain on the assets distributed and whatever gain they have on the sale of their stock. In figuring your individual capital gain (or loss) on your final tax return from the sale or deemed liquidation of the stock, you should have an accountant compare the stock’s adjusted basis to the final cash or asset values received upon liquidation.

The order in which you take losses and profits matters. The final K-1 gain raises stock basis before figuring the gain or loss from the final sale or deemed liquidation of the stock. Net losses are deductible only up to the stockholder’s basis plus any direct loans to the corporation. Any remaining suspended loss may be lost. Each shareholder’s tax is calculated separately.

Fifth, if the S corp was once a C corporation, there may be a built-in gain (BIG) tax if it disposes of assets that increased in value from when it was a C corporation, generally within the five years following the S election. The BIG income is taxed at the corporate level before any distribution of assets to you. Dissolving the S corp doesn’t eliminate the BIG. Handing the property out in liquidation can count as a “taxable disposition” of the asset. However, the “five-year rule” isn’t a waiting period for every S corporation. Check the date of the election.

Closing the Business

Sixth, even though you’re closing the business, your S corporation must file a 1120-S return for the final year with all the K-1s attached. The final tax return has a check box to indicate the business closed during the year, so the IRS knows it is the final return. Once everything is finished, make sure each K-1 is marked “final K-1” for the year. This way it’s clear it’s the shareholder’s last K-1 from that business. The final Form 1120-S generally must be filed by the 15th day of the third month after the dissolution. The penalty for filing late in 2026 is $255 per shareholder per month, and can go for 12 months.

The S corp files a Form 1099-DIV to each shareholder who is paid $600 or more in liquidation. It includes distributions of cash, and property at fair market value. And even if you have closed, the IRS account for the EIN won’t be closed until the IRS is sure all returns have been filed and all taxes have been paid. To close the IRS account, send a letter to the IRS. Include the business name, EIN, address, and reason you want to close your account.

Consider dissolving the company or leaving it inactive. You don’t have to dissolve. However, that means the state might want annual reports, franchise fees, registered agent, business license renewal, and you may also have to file the state and federal tax returns, even if inactive. It can make sense to dissolve when you no longer want to be involved and operations ended for good, and any debt can be resolved. Look at state rules for dissolving or closing the business entity. Just because the business is closed doesn’t mean it isn’t still active in the eyes of the state agency.

When there is gain in the assets as of the date of dissolution, there isn’t some loophole to avoid it. It is true that asset timing can be used to minimize the effect, but the gain can’t be retroactively erased. Keep good track of your stock basis and keep all the tax returns. In case there are ever questions after the entity is gone, you have a way to prove what it was.