Tax Implications of Closing a Sole Proprietorship

A sole proprietorship is an unincorporated business owned by one individual, with no legal distinction between the business and its owner. All profits, losses, and liabilities are the owner’s direct responsibility. While closing this type of business is simpler than dissolving a corporation, it requires specific tax-related actions to ensure compliance. The process involves filing a final tax return, accounting for the disposition of business assets, completing final employment tax duties if applicable, and closing accounts with the Internal Revenue Service (IRS).

Filing the Final Annual Tax Return

When a sole proprietorship closes, its final year’s financial activities must be reported on the owner’s personal Form 1040. This is done using Schedule C, Profit or Loss from Business, to calculate the net profit or loss by tallying all income and subtracting deductible expenses. You must check the box on Schedule C indicating it is the “final return,” and the resulting profit or loss is transferred to Schedule 1 of your Form 1040.

The net profit from Schedule C is also used to calculate self-employment taxes on Schedule SE, Self-Employment Tax. This form, which covers Social Security and Medicare contributions, is required if the business’s net earnings are $400 or more for the year. The final self-employment tax is then reported on Schedule 2 of Form 1040.

If the business incurs a loss in its final year, this can offset other income on your Form 1040. A loss that exceeds your total income from all other sources may create a Net Operating Loss (NOL). These NOLs can be carried forward to future years, though the deduction is limited to 80% of that year’s taxable income. You must also make any final estimated tax payments to cover the tax liability from the business’s income in its last year.

Reporting the Disposition of Business Assets

When a sole proprietorship ceases operations, the owner must account for all business property, which may be sold, converted to personal use, or abandoned. The tax treatment of these assets is reported on Form 4797, Sales of Business Property. The results from Form 4797 are then transferred to the owner’s personal tax return.

For assets that are sold, the gain or loss is calculated by subtracting the asset’s adjusted basis from the sales price. The adjusted basis is the original cost of the asset, minus any depreciation deductions taken over the years, plus the cost of any improvements.

A consideration when selling depreciable property is depreciation recapture. For property like equipment, vehicles, and furniture, a portion of the gain on the sale may be taxed as ordinary income rather than at capital gains rates. The recaptured amount is the lesser of the total depreciation deductions previously claimed or the total gain on the sale. Any gain that exceeds the recaptured amount is treated as a Section 1231 gain, which may be taxed as a long-term capital gain.

It is common for a business owner to keep some business assets for personal use after closing the business, which is not a taxable event at the time of conversion. However, if you previously claimed a Section 179 expense deduction for the property, you may have to recapture some of that deduction. This happens if the business use of the property drops to 50% or less, and the recapture is reported as ordinary income on Form 4797.

Final Employment and Information Return Filings

Sole proprietors who had employees have additional filing responsibilities related to final payroll taxes. After all final wages are paid, the business must file a final Form 941, Employer’s Quarterly Federal Tax Return, for the last quarter in which wages were paid. On this form, you must check a box indicating the business has closed and enter the date that final wages were paid.

In addition to the quarterly filing, a final Form 940, Employer’s Annual Federal Unemployment (FUTA) Tax Return, must be submitted for the calendar year in which the business closed. A specific box must be checked on Form 940 to designate it as the final return. Failure to properly withhold and deposit payroll taxes can lead to significant penalties, including the Trust Fund Recovery Penalty, which can be assessed against responsible individuals personally.

The business must also furnish a Form W-2, Wage and Tax Statement, to each employee for the final calendar year. These forms must be provided to employees by the due date of the final Form 941. Subsequently, the business must transmit all the employee W-2s to the Social Security Administration using Form W-3, Transmittal of Wage and Tax Statements.

If the sole proprietorship paid independent contractors $600 or more for services during its final year, it must also file Form 1099-NEC, Nonemployee Compensation, for each contractor. A copy of this form must be sent to the contractor and another must be filed with the IRS.

Final Administrative Tax Requirements

After all tax returns have been filed and all outstanding taxes have been paid, there are final administrative tasks to complete with the IRS. One is formally closing the business’s IRS account and its Employer Identification Number (EIN). While the IRS does not technically cancel an EIN, you can request that they close the associated business account to prevent potential identity theft or fraudulent use.

To close the account, the business owner must send a letter to the IRS. This letter should include the business’s complete legal name, the EIN, the business address, and a clear statement of the reason for closing the account. The IRS will only close the account after all required tax returns have been filed and all taxes have been paid.

Finally, the former business owner must adhere to record-keeping requirements. Records related to property must be kept until the period of limitations expires for the year in which the property is disposed of. Employment tax records must be kept for at least four years after the date the taxes were due or were paid, whichever is later. You should keep copies of all filed tax returns and supporting documents for at least seven years.