Liquidating Distributions: Returning Cash to Startup Investors

How do we return money to investors when shutting down a startup?

Pay or set aside money for creditors and taxes first; only what is left goes to SAFE, preferred and common holders, in the order the charter and the SAFEs set. Under Delaware law, section 281, a dissolved corporation pays or provides for known, pending and likely claims before distributing "remaining assets" to stockholders.

The tax follows two tracks:

• The company pays corporate tax on any gain from selling or handing out its assets, at 21% federally, after any loss carryforwards.
• Each stockholder treats the cash as payment for their shares (26 U.S.C. 331): no tax until they recover their basis (usually what they paid), then capital gain; a capital loss once the final payment arrives.

A wind-down is not simple when the company sold assets at a gain, SAFEs never converted, any holder lives abroad, cash goes out over more than one year, or property such as code or a domain goes to a holder instead of cash. Each of these changes a filing or a tax result.

Gather: the cap table, every SAFE and note, the charter's liquidation terms, a final balance sheet, the loss carryforward schedule, each holder's Form W-9 or W-8, and the board and stockholder resolutions.

Who is paid first: creditors, SAFE holders, preferred or common?

Creditors and taxes come first, by law; after that, the company's own documents decide. The charter's liquidation preference usually pays preferred holders before common. A SAFE may have a dissolution clause that pays the holder its purchase amount ahead of common stock; read each SAFE's own wording, because its rank against preferred varies. Applying these terms is a legal question for the company's lawyer.

For the approvals and the Delaware filing order, see dissolving a Delaware corporation.

Is the company taxed on selling its code, customers or other assets before closing?

Yes. A C corporation that sells its assets owes tax on the gain, the price minus its tax basis in what it sold, at 21%. Self-built code and customer lists often have little basis, so most of the price can be gain.

Past losses can shelter the gain, but losses from tax years beginning after 2017 offset only 80% of taxable income in a year (26 U.S.C. 172(a)). Funding rounds may also have triggered a section 382 limit on old losses; see net operating losses for startups. States tax the gain under their own rules. When the sale is of a business, the company and the buyer each attach Form 8594 to their returns to allocate the price among the assets (26 U.S.C. 1060). Leave cash for this tax before paying holders.

Is cash paid to stockholders a dividend or payment for their shares?

In a complete liquidation, it is payment for the shares, not a dividend. Section 331 treats the amounts as full payment in exchange for the stock and switches off the dividend rules. Each holder compares what they receive with their basis in the shares (26 CFR 1.331-1).

One trap: if the business, or part of it, moves into another corporation, such as one the same people own, 26 CFR 1.331-1(c) warns the liquidation may be treated as a dividend or a reorganization instead.

How is a SAFE holder's payout taxed when the SAFE never converted?

This is unsettled. No statute, regulation or published IRS guidance addresses SAFEs, so the result depends on how the SAFE is classified:

Under each reading, the holder measures gain or loss against what they paid; the timing, the form the company issues and whether stock-only rules apply can differ. The company should choose one position, apply it to every SAFE, and tell holders before it files information returns. For how SAFEs were treated while outstanding, see SAFEs and convertible notes.

How do preferred holders and founders report what they receive?

Each holder reports gain or loss on Form 8949 and Schedule D, long-term if they held the shares more than one year. Publication 550 sets the timing:

• Payments reduce the holder's basis first and are not taxed until basis reaches zero; after that, each payment is capital gain.
• A loss is reported only after the final liquidating distribution, in that year.
• Shares bought at different times are separate blocks; the payment is split among blocks by share count.

An individual can deduct up to $3,000 of net capital loss against other income each year. Part of an individual's loss on qualifying stock can be ordinary instead under section 1244, and a founder whose common receives nothing may have a worthless-stock loss; deducting shares in a failed startup covers both.

A holder owning at least 1% of a private company's stock must attach a statement under 26 CFR 1.331-1(d), unless the payment follows a resolution reciting complete liquidation and the company is fully liquidated and dissolved within one year.

What does the company file: Form 966, Forms 1099-DIV and the final Form 1120?

Three federal filings carry the liquidation, plus any withholding returns for holders abroad.

Liquidating distributions go in boxes 9 and 10 only, not in the dividend boxes. Final payroll, contractor and state filings are in closing a company.

What if we hand out property, such as code or a domain, instead of cash?

The company is taxed as if it sold the property to the holder at fair market value (26 U.S.C. 336), so handing out a valuable domain or codebase can create corporate tax with no cash to pay it. The holder counts the property's fair market value as part of what they received and takes that value as their basis (26 U.S.C. 334(a)).

Get a supportable value before the transfer; it goes in box 10 of Form 1099-DIV. A loss on property going to a related holder can be disallowed if the distribution is not pro rata or the property was contributed to the company within five years (section 336(d)).

What changes for investors abroad?

The company decides on withholding before it pays. A US corporation must withhold on the whole distribution to a foreign holder unless it elects to treat the part paid in exchange for stock as exempt (26 CFR 1.1441-3(c)); a liquidating distribution generally fits that exception, but 30%, or a lower treaty rate, applies to any part that is not. If the company is, or within the last five years (or the holder's shorter holding period) was, a US real property holding corporation, section 1445(e)(3) requires withholding of 15% of the amount the foreign holder realizes.

Collect a Form W-8 from every foreign holder first; the company is liable for any tax it should have withheld (26 U.S.C. 1461). Even when nothing is withheld, the whole distribution is generally reported to each foreign holder on Form 1042-S, with a Form 1042 (26 CFR 1.1461-1(c)). A SAFE payout to a foreign holder carries the classification question above into withholding too. If a payment already went out without the right withholding, see missed withholding on payments abroad. Holders living in Canada should read closing a US startup as a Canadian founder.

How much cash should we hold back for late claims and taxes, and when is the last payment?

There is no fixed amount: hold back enough for every known, pending and reasonably likely claim, including the company's final taxes. A Delaware corporation that skips the court-notice process in section 280 must adopt a plan that provides for claims likely to arise within 10 years of dissolution (section 281(b)). The corporation continues for 3 years after dissolution to wind up (section 278).

Holding back protects directors and holders too. Directors who follow section 281 are not personally liable to the company's claimants (section 281(c)). A stockholder can be liable for a claim up to what they received (Delaware section 282), and the IRS can collect the company's unpaid income tax from those who received its assets, generally until one year after the company's own assessment period ends (26 U.S.C. 6901(c)). The IRS generally has 3 years after a return is filed to assess; a dissolving corporation can ask for prompt assessment on Form 4810, which requires assessment within 18 months of the request if the dissolution is begun in good faith and completed (26 U.S.C. 6501(d)).

Make the last payment once the reserve is no longer needed, and tell holders it is final: their loss, and the end of their reporting, depend on it.

Example

All figures are illustrative and in US dollars.

SAFEs take it all

A startup closes with $900,000 left after paying its debts and reserving for taxes. It has $1,500,000 of unconverted SAFEs whose terms pay them ahead of common. The SAFE holders split the $900,000 in proportion to their purchase amounts, 60 cents per dollar invested, and common receives nothing. Each SAFE holder has a $600 shortfall per $1,500 invested, but its tax timing and character depend on how the company and holder classify the SAFE.

Asset sale first

The company sells its code and customer contracts for $2,000,000; its tax basis in them is $200,000, so the gain is $1,800,000. It has $5,000,000 of losses from years after 2017 and no other income or loss in its final year. The 80% limit lets it deduct $1,440,000, leaving $360,000 taxable and about $75,600 of federal tax at 21%, before any section 382 limit or state tax. The company reserves that tax before paying holders.

A preferred holder's loss over two years

A seed fund paid $1,000,000 for preferred stock.

• Year 1: it receives $200,000. Nothing is taxed; its basis falls to $800,000.
• Year 2: it receives a final $100,000. Basis falls to $700,000 with nothing left to receive, so it reports a $700,000 capital loss in year 2.

Different for you?

• You still need Delaware approvals or a filing order: see dissolving a Delaware corporation.
• The asset sale gain meets old losses after several rounds: check the 80% limit and section 382 in net operating losses for startups, and get corporate tax help with the final return.
• SAFEs never converted, or holders are abroad: the classification and withholding choices are hard to undo once forms go out; get corporate tax help before paying.
• Common receives nothing: see deducting shares in a failed startup.
• A holder has a gain on stock that may be qualified small business stock: see QSBS for founders and early employees.
• A buyer is acquiring the whole company, not just its assets: see taxes when your startup is acquired.
• Founders or investors live in Canada: see closing a US startup as a Canadian founder and cross-border tax help.