A sale of a business can be accomplished in many ways. Generally, the seller will look to sell either the stock or the underlying assets of the business, which can be done in many ways for many reasons. Regardless of how a particular transaction is consummated, each can have unique tax complications or nuances, which can make for difficult structuring or planning when selling a business. There are two elements common to most transactions: A seller that prefers as much cash as possible paid at closing and a buyer that prefers to pay some percentage of the purchase price in cash with agreed-upon future payments or contingent payments (earn-outs) based on some agreed-upon criteria (or a combination of both).
In practice, most transactions will take the form of cash paid at closing with some element of future consideration paid on an installment basis. This item focuses on the specific tax implications to the seller of the sale of an S corporation's assets followed by a liquidation, or a case in which the seller sells the S corporation stock and agrees to elect to treat the transaction consistent with Sec. 338(h)(10), a deemed asset sale followed by a liquidation. In both instances, assume that cash and installment obligations (the note) make up the consideration. Further, the Sec. 1374 tax imposed on certain built-in gains is assumed not to apply. Conceptually, either transaction form is easily understood. However, a seller's tax position could be substantially affected based on how the transaction is structured.
The ProblemWhere an S corporation's assets are sold or the S corporation stock is sold and a Sec. 338(h)(10) election is made, the basis in the assets must be allocated to the cash portion distributed in liquidation for immediate income recognition and to the note portion in determining future income recognition as cash is collected on the note. Such allocations can be relatively simple where future consideration is fixed or may be problematic where future consideration is based on future events, milestones, etc. Care must be taken in this determination because the basis allocation must be made, using all facts available, on the date of the transaction. This correlates the basis allocation to the current and deferred portions of the transaction for income recognition purposes.
Generally, where the S corporation receives notes in an asset or deemed asset sale, Sec. 453B(h) will allow for a deferment of gain where the notes are distributed to the shareholder pursuant to a Sec. 331 liquidation. In addition, the character of gain is preserved as the holder of the obligation recognizes income. Based on this, Sec. 453B(h) appears innocuous, as the congressional intent was to allow the S corporation to sell its assets and distribute the closing consideration in liquidation without triggering gain on the distribution of the note. In application, this result can rarely be achieved without an acceleration of income tax liability.
Example: On June 1, SCO sells its assets for $1,000 in cash with a maximum of $4,000 in future consideration. There is adequate stated interest on the note, and no liabilities are assumed. The shareholders' tax basis in SCO stock is the same as the tax basis of SCO's assets—$2,000. Furthermore, SCO adopts a plan of liquidation prior to the sale of its assets. At the date of sale, SCO has the following assets:
|Tax Basis||Fair Value|
|Equipment||$ 500||$ 750|
|Intangible assets||- 0 -||1,000|
Under Sec. 453(h), the stock basis must be apportioned to the assets received in liquidation. In this example, 20% ($1,000 ÷ $5,000) of the stock basis is apportioned to the cash distribution and 80% ($4,000 ÷ $5,000) is apportioned to the note. By apportioning 20% of the new stock basis ($520 ($2,600 × 20%)) to the $1,000 cash distribution, a $480 gain is recognized on the cash received in liquidation. The remaining basis of $2,080 ($2,600 × 80%) is apportioned to the note. Accordingly, as cash is received by the old shareholder, gain recognition is determined as though there was a sale of stock as opposed to a sale of the assets by the corporation. In total, the shareholder would immediately recognize $1,080 ($600 + $480) in passthrough gain and gain on the liquidation. This is likely an unexpected result to an adviser not understanding the mechanics of the above liquidation.
The same result would occur where the shareholder sold the stock subject to a Sec. 338(h)(10) election—a deemed sale of assets followed by a liquidation. Quite often, where a buyer looks to acquire the stock of an S corporation, the buyer prefers a Sec. 338(h)(10) election to step up the basis of the assets. Accordingly, the issue of the accelerated gain on the deemed liquidation would be at issue as well.
Assume in the above example that there was no plan of liquidation and the corporation held the note until it was paid. At the time the assets were sold, the same $600 gain is recognized immediately with the same $2,400 deferred gain. In this instance, the same $1,000 could be distributed tax free to the shareholder under Sec. 1368. Furthermore, the deferred gain would be recognized into income as cash is received using the original 60% gross profit percentage. While this appears to be a possible solution to the liquidation example, there could be many tax or nontax reasons why this approach would not work (a sale of stock subject to a Sec. 338(h)(10) election, taxes imposed under Sec. 1375 on net passive income where the corporation has accumulated earnings and profits, incompatible shareholder intents, etc.).
It appears that the congressional intent in the liquidation example was to leave the taxpayer in the same tax position as if the assets were sold without liquidating. However, for this to occur, the basis allocation rules under Sec. 453(h) require a modification allowing the note's basis in the hands of the shareholder to be equal to the note's basis immediately prior to its distribution. Absent this change, there could be an acceleration of income as shown in the liquidation example—a trap for the unwary.
The SolutionWhere there is an asset or deemed asset sale followed by a liquidation that includes installment obligations, the adviser must be aware of the basis allocation rule discussed above. One solution is to structure the transaction so no cash is received at closing. Accordingly, the sale would be accomplished with 100% of the consideration being in the form of a note that is distributed in the complete liquidation of SCO. In structuring the transaction in this manner, there would be no gain on liquidation, and the Sec. 453(h) basis apportionment rules should have no effect as the basis is allocated to one asset—the note.
This may appear inadequate because most sellers would prefer some cash at closing. The solution would be to have the note require a cash payment on the day subsequent to the sale and to the distribution of the note in liquidation. If this approach had been used in the liquidation example above, the seller would get the same result as where no liquidation occurred. Accordingly, the $1,000 received the day after the sale would still result in the same $600 of recognized gain. However, the original problem of the $480 accelerated gain recognized on liquidation would be eliminated.
Most sellers would require a high level of comfort that the requisite cash would be paid following the liquidation. To protect the seller's interest, the adviser should consider having this payment obligation backed by a standby letter of credit or other guarantee from a third party. Due care must be taken that the form of guarantee is not in the form of a cash equivalent that could be deemed to be cash received at closing. For example, cash placed in escrow at closing that is transferred almost immediately to the seller could be a problem. The IRS has taken the position that such an arrangement would be deemed cash received at closing, thus not qualifying for installment sale treatment. However, the courts have not always agreed (see, for example, Sprague, 627 F.2d 1044 (10th Cir. 1980), and Reed, 723 F.2d 138 (1st Cir. 1983)). Accordingly, the adviser must use due care in not putting a taint to this type of arrangement.
ConclusionThe above examples are oversimplifications of what would occur in practice. However, the purpose is to illustrate the trap, albeit seemingly unintended, that lies within Sec. 453(h) as it relates to distributions of installment obligations of a liquidating S corporation. Accordingly, until these rules are revised to meet their intended purpose, the adviser must be aware of how the mechanics of this provision could affect the seller of S corporation assets followed by a liquidation or where a Sec. 338(h)(10) election is made with respect to a sale of S corporation stock.
Stephen E. Aponte is senior manager at Holtz Rubenstein Reminick LLP, DFK International/USA, in New York, NY.
Unless otherwise noted, contributors are members of or associated with DFK International/USA.
For additional information about these items, contact Mr. Aponte at (212) 792-4813 or firstname.lastname@example.org.