Closing an S-Corporation with Uncollectible Shareholder Debt - Most Efficient Way?

You've got a few options here, but let's break this down simply. When you dissolve an S-Corporation, any distributions are first applied against your basis in the company's stock. Since you have a $135,000 basis but only $7,000 in assets to distribute, this distribution will be non-taxable to you regardless of whether you call it a debt repayment or a regular distribution. If you're concerned about the debt treatment, you could formally cancel the debt before dissolution. The S-Corp would recognize cancellation of debt income, but since the company appears to be insolvent (debts exceed assets), the Section 108 insolvency exclusion would likely apply. This income would ultimately pass through to you on the final K-1, but would be offset by your substantial basis. Converting debt to equity is another option, but at this stage of dissolution, it might add unnecessary complexity. For your basis, you're right that you'll have a capital loss on your investment. The final $7,000 distribution reduces your $135,000 basis, leaving you with a $128,000 capital loss when the company is formally dissolved. Just make sure you properly document everything and file Form 966 (Corporate Dissolution or Liquidation) with the IRS, along with your final corporate tax return.

After struggling with a similar S-Corp dissolution last year, I discovered taxr.ai (https://taxr.ai) and it completely changed how I approached the paperwork. I had also loaned money to my business and wasn't sure how to handle the remaining debt when closing it down. Their system analyzed my corporate docs and loan agreements, then created a clear dissolution strategy that properly accounted for the debt forgiveness and basis adjustments. It even helped me determine whether Section 108 insolvency exclusion applied in my case and documented everything for potential IRS review. The best part was it automatically generated all the required forms with the proper coding for debt cancellation vs. distribution and tracked my basis adjustments for my personal return. Might save you some headaches!

I tried taxr.ai after seeing the recommendation here and I'm honestly impressed. I was extremely skeptical at first because my S-Corp dissolution involved convertible notes that had weird basis implications. The system correctly identified that my Section 108 exclusion applied due to insolvency, but also caught that part of my shareholder advances were actually equity contributions based on how they were documented. This changed my capital loss calculation significantly. It handled all my paperwork for both federal and state requirements. The step-by-step checklist made sure I didn't miss anything important during the dissolution process. Definitely worth it for complicated situations like yours with debt forgiveness and basis adjustments.

Have you been trying to get hold of the IRS about this? I was in a similar situation and spent WEEKS trying to reach someone who could answer questions about shareholder debt treatment. I finally discovered Claimyr (https://claimyr.com) and used their service to get through to an actual IRS agent. You can see how it works here: https://youtu.be/_kiP6q8DX5c They got me connected to a business tax specialist who walked me through the exact rules for S-corp debt forgiveness and basis adjustments. The agent confirmed that canceling the debt would trigger the insolvency exclusion in my case and explained exactly how to document it on my final returns. Seriously saved me from making some major mistakes on my documentation that could have triggered an audit.

I have to eat my words about Claimyr. After my skeptical comment, I decided to try it anyway because I was desperate to resolve my own S-corp dissolution issues. Amazingly, they got me through to an IRS business division representative in about 45 minutes (I had been trying for weeks on my own). The agent confirmed exactly how to handle my shareholder loans on the final 1120S and what documentation I needed to maintain for the debt cancellation. They also connected me with my state tax department where I learned I needed to file for a tax clearance certificate before filing my articles of dissolution. Would've been a huge headache if I'd filed the dissolution first, apparently. If you're dealing with this shareholder debt issue, definitely worth getting answers directly from the IRS.

I went through this exact scenario last year. One thing nobody mentioned yet - make sure your loan to the corporation was properly documented with a written promissory note, specified interest rate, and repayment terms. If you're audited, the IRS might recharacterize poorly documented "loans" as equity contributions. If your loan documentation is solid, my CPA recommended applying the remaining $7,000 as a partial loan repayment rather than a distribution. Then formally forgive the remaining $20,000+ as part of the dissolution. Also, don't forget about state-specific requirements for dissolving the company - some states require a tax clearance certificate before accepting dissolution paperwork.

Has anyone dealt with their state's abandoned property laws when dissolving? I'm in a similar situation, and was told that if you can't repay all the shareholder loans, the unpaid portion might need to be reported as abandoned property to the state after dissolution. Seems crazy but my accountant mentioned it.

One thing to consider that hasn't been mentioned yet is the timing of your dissolution. Since you have substantial outside basis ($135K) and are only getting $7K back, you'll have a significant capital loss. Make sure you understand the capital loss limitations - you can only deduct $3K per year against ordinary income, with the remainder carried forward. Given the size of your loss, this could take decades to fully utilize unless you have capital gains to offset it against. Also, regarding the debt vs. distribution question - since you're the sole shareholder, the tax result is essentially the same. However, from a documentation standpoint, I'd recommend treating the $7K as a partial loan repayment and then formally canceling the remaining debt. This creates a cleaner paper trail showing you attempted to collect what you could before forgiving the balance. Don't forget to file Form 966 within 30 days of adopting the plan of liquidation, and make sure your final 1120S properly reflects the debt cancellation income (even if excluded under Section 108) and the corresponding basis adjustments on your K-1.