Business Tax Preparation · Advising the business taxpayer

Life cycle of the business (e.g., formation, dissolution)

A business passes through four moments where tax law is decisive: formation, election, a change of ownership, and exit. Only the first is cheap. The others are governed by deadlines that have already run or by consequences fixed years earlier, which is why the useful advice at each stage is mostly about the stage after it.

The rule

Formation costs split into two categories. Start-up expenditures — amounts paid or incurred in investigating the creation or acquisition of an active trade or business, in creating one, or in a profit-seeking activity before the business begins in anticipation of it becoming active — and only where the amount would have been deductible if incurred by an existing business in the same field^TY2026 (IRC § 195(c)(1)) — get $5,000, reduced but not below zero by the amount by which start-up expenditures exceed $50,000, deductible in the year the active trade or business begins^TY2026 (IRC § 195(b)(1)(A)) with the remainder is deducted ratably over the 180-month period beginning with the month in which the active trade or business begins^TY2026 (IRC § 195(b)(1)(B)). Organisational expenditures under IRC § 248 follow the same structure with their own limit. Note an amount for which a deduction is allowable under IRC § 163(a), § 164, § 174 or § 174A is not a start-up expenditure^TY2026 (IRC § 195(c)(1)).

Getting property in. no gain or loss is recognised where property is transferred to a corporation by one or more persons solely in exchange for stock and, immediately after the exchange, those persons are in control of the corporation within IRC § 368(c)^TY2026 (IRC § 351(a)) or no gain or loss is recognised to a partnership or to any partner on a contribution of property to the partnership in exchange for a partnership interest — with no control requirement and no time limit^TY2026 (IRC § 721(a)), depending on the form chosen.

The election window is short and unforgiving. an S election may be made at any time during the preceding taxable year, or during the taxable year on or before the 15th day of its third month — and an election made in that window is treated as made for the *following* year if the corporation failed the eligibility requirements on any earlier day of the year or a required shareholder did not consent^TY2026 (IRC § 1362(b)(1) and (2)). And the entity classification election has its own window — the effective date specified on Form 8832 may not be more than 75 days before the filing date nor more than 12 months after it; an earlier date defaults to 75 days before filing and a later one to 12 months after^TY2026 (Reg. § 301.7701-3(c)(1)(iii)).

Leaving subchapter S. an election is revoked only with the consent of shareholders holding more than one half of the shares on the day of revocation; a revocation made on or before the 15th day of the third month takes effect from the first day of that year, and one made later from the first day of the following year, unless a prospective date is specified^TY2026 (IRC § 1362(d)(1)), then a corporation whose S election has terminated may not elect again before its fifth taxable year beginning after the first taxable year for which the termination was effective, unless the Secretary consents^TY2026 (IRC § 1362(g)). Converting from C to S brings where an S corporation has a net recognised built-in gain for a taxable year beginning in the recognition period, a tax is imposed on its income for that year, computed by applying the highest rate specified in IRC § 11(b) to the net recognised built-in gain (IRC § 1374(a), (b)(1))^TY2026 (IRC § 1374).

Dissolving a corporation costs twice. a liquidating corporation recognises gain or loss on distributing property in complete liquidation as if the property were sold to the distributee at fair market value^TY2026 (IRC § 336(a)), and amounts a shareholder receives in a distribution in complete liquidation are treated as in full payment in exchange for the stock, so the shareholder has capital gain or loss rather than a dividend^TY2026 (IRC § 331(a)).

A partnership is harder to terminate than to end. a partnership terminates only where no part of any business, financial operation or venture of it continues to be carried on by any of its partners in a partnership — so continuing the business through the remaining partners is not a termination^TY2026 (IRC § 708(b)(1)), with on a merger or consolidation the resulting partnership is treated as the continuation of any merging partnership whose members own more than 50 percent of the capital and profits of the resulting partnership^TY2026 (IRC § 708(b)(2)(A)). On the way out, a partner recognises gain on a distribution only to the extent money distributed exceeds the adjusted basis of the partnership interest immediately before it, and recognises loss only on a liquidating distribution of money, unrealised receivables and inventory alone^TY2026 (IRC § 731(a)).

Current figures

How it works in practice

Fix the start date before anything else. IRC § 195 allows nothing until the active trade or business begins, and the amortisation period runs from the month it does — so a business that spends two years investigating carries every dollar until the doors open. That date is a question of fact, and the file should record what happened on it.

Do not let the S election window pass without checking eligibility for the whole year. The trap is in IRC § 1362(b)(2): an election made in the first two and a half months of a year is treated as made for the following year if on any earlier day of that year the corporation failed the § 1361(b) requirements or a person who was a shareholder on such a day did not consent. So a mid-January share issue to an ineligible holder, cured in February, pushes an otherwise timely election out by a whole year.

Advise on the exit at every stage, not only at the end. The tax cost of dissolving a corporation is set by IRC § 336 and IRC § 331 and cannot be planned around once the assets have appreciated inside it. The useful conversations are early: whether appreciating property should sit inside the entity at all, and whether the entity should have been a corporation.

Treat a change of ownership as a separate event with its own rules. A partnership does not terminate merely because partners change — IRC § 708(b)(1) requires that no part of any business, financial operation or venture continue to be carried on by any of its partners in a partnership. A corporation is even more continuous. What the ownership change does affect is basis, the IRC § 754 election, and in an S corporation the per-share per-day allocation and the possibility of a terminating election.

Remember that leaving is expensive in both directions. Revoking an S election starts the five-year bar in IRC § 1362(g), and re-electing before it expires needs the Secretary’s consent. Converting a C corporation to S status brings the IRC § 1374 built-in gains tax for the recognition period and the IRC § 1375 passive income tax where accumulated earnings and profits survive. Neither direction is a free adjustment.

Wind up in the right order. Final returns, final employment tax filings and information returns, the deposit obligations that run to the last payroll, and the retention of records long enough to cover the assessment period all continue after the business has stopped trading. A business that has ceased operating has not ceased filing.

Scenarios

Traps

How this has changed

The formation rules were simplified in 2004, when the start-up and organisational provisions were given their present shape — an immediate deduction phasing out against total expenditures, with the balance amortised over a fixed period. Before that the whole amount was amortised, so a small business had nothing currently deductible. The dollar figures have not been indexed since, so the phase-out threshold now bites at a level it did not twenty years ago.

The most consequential change at the other end of the life cycle was the repeal of the General Utilities doctrine in 1986, which produced IRC § 336 in its present form. Before it a corporation could generally liquidate without recognising gain on the appreciation in its assets, and the second layer of tax on a wind-up did not exist. Every planning instinct about holding property inside a corporation dates from a regime that ended forty years ago.

The partnership termination rule was narrowed in 2017. Pub. L. 115-97 § 13504 repealed the technical termination rule in former IRC § 708(b)(1)(B), under which a sale or exchange of 50 percent or more of the interests in capital and profits within twelve months terminated the partnership — closing the taxable years, restarting depreciation periods and ending elections. For taxable years beginning after 31 December 2017 only the general rule in what is now § 708(b)(1) applies, so partnerships now survive ownership changes that formerly ended them.

Exam focus

Know the IRC § 195 structure — a deduction in the year the active trade or business begins, phasing out against total expenditures, with the balance amortised over the statutory period from that month — and that IRC § 248 mirrors it for organisational expenditures.

The S election window is heavily tested. Know both limbs of IRC § 1362(b)(1), and know the IRC § 1362(b)(2) rule that pushes an election into the following year where eligibility failed earlier in the year.

Know the revocation timing in IRC § 1362(d)(1) — the more-than-half consent, and the 15th day of the third month as the pivot — and the IRC § 1362(g) five-year bar with its consent exception.

For dissolution, be able to state both layers of a corporate liquidation with the right section for each, and contrast IRC § 731(a) where a partnership distributes.

Finally, know that the technical termination rule for partnerships is gone for years beginning after 2017, so a sale of a majority of the interests no longer terminates the partnership.

Check yourself

1. A business incurs $47,000 of start-up expenditures and begins trading in September. What may it deduct that year?

Answer: The immediate deduction is the lesser of the expenditures or the statutory amount, reduced by the excess of the expenditures over the phase-out threshold. At $47,000 the expenditures are below the threshold, so the full statutory deduction is available, and the balance is amortised ratably over the statutory period beginning with the month the active trade or business begins — September. So the first year gets the deduction plus four months of amortisation. Nothing is available for any earlier year, however long the investigation took.

2. A calendar-year corporation meets every IRC § 1361(b) requirement from 1 March onward but had a non-resident alien shareholder in January. It files Form 2553 on 10 March. When is the election effective?

Answer: For the following taxable year. IRC § 1362(b)(2) applies because the election was made during the year on or before the 15th day of the third month and, on one or more days in that year before the election was made, the corporation did not meet the IRC § 1361(b) requirements. The January failure controls even though it was cured before the filing. The corporation is a C corporation for the current year unless it obtains relief for an inadvertent invalid election, which is discretionary.

3. An S corporation revokes its election on 20 April of a calendar year, with no prospective date specified. When does the revocation take effect, and when may the corporation elect again?

Answer: From the first day of the following taxable year, because IRC § 1362(d)(1)(C)(ii) makes a revocation after the 15th day of the third month effective on the first day of the next year. It also needs the consent of shareholders holding more than one half of the shares on the day the revocation is made. Re-election is then barred by IRC § 1362(g) until the corporation’s fifth taxable year beginning after the first taxable year for which the termination was effective, unless the Secretary consents.

4. Sixty percent of the interests in a partnership are sold in a single transaction and the business continues unchanged. Does the partnership terminate?

Answer: No. The technical termination rule in former IRC § 708(b)(1)(B), which terminated a partnership on a sale or exchange of 50 percent or more of the interests in capital and profits within twelve months, was repealed by Pub. L. 115-97 § 13504 for taxable years beginning after 31 December 2017. Only the general rule now applies, and it terminates a partnership only where no part of any business, financial operation or venture continues to be carried on by any of its partners in a partnership. The taxable year, the methods and the elections all continue.

5. Why is advice about dissolution most useful at formation?

Answer: Because the cost of dissolving is determined by decisions taken years earlier and cannot be undone once value has accrued. A corporation holding appreciated property faces gain under IRC § 336(a) on liquidation as though it had sold at fair market value, plus shareholder gain under IRC § 331(a) — and converting to S status does not escape it, because IRC § 1374 taxes the built-in gain through the recognition period. The only cheap moment to decide whether appreciating property belongs inside a corporation is before it is put there.