S Corporations
When consulting on S corporation asset sales or sales treated as asset sales from a tax perspective, such as a stock sale with a Sec. 338(h)(10) election, tax practitioners need to be aware that different tax consequences than expected can sometimes result under the installment sale rules of Sec. 453. The process is further complicated because, in many situations, a shareholder's outside basis in the S corporation stock is different from the inside basis of the S corporation's assets.
Different results can occur under the installment sale rules depending on whether the S corporation liquidates or stays in existence. Advance planning for when the plan of liquidation is adopted can make a big difference in the tax results for S corporation shareholders. In addition, the use of a "one-day" note could assure parity in treatment on when gains are recognized. Lastly, the risk of capital losses in future years, which are limited to $3,000 per year in excess of capital gains, can be mitigated by advance planning.
Example 1: An S corporation has one shareholder with zero stock basis. The S corporation has zero tax basis in its assets and no liabilities. The S corporation sells its assets and receives a $1,000 note due in one year. The entire $1,000 gain is eligible for installment sale reporting under Sec. 453.
The realized gain on the asset sale is $1,000, but none of the gain is recognized. After the asset sale, the S corporation adopts a plan of liquidation and distributes the note in liquidation. The general rule of Sec. 453B(a) provides that if an installment obligation (an obligation of the purchaser a seller received in an installment sale to which the installment method applies) is satisfied at other than face value or is distributed, transmitted, sold, or otherwise disposed of, the seller recognizes gain or loss equal to the difference between the obligation's basis and the amount realized on the sale or exchange.
Under these rules, the note's distribution is treated as a disposition of the installment obligation. The S corporation recognizes gain of $1,000. The shareholder recognizes no gain or loss on the distribution, as the basis in the S corporation is increased to $1,000 by virtue of the gain recognition, and takes a $1,000 basis in the note. When the shareholder collects the $1,000 in year two, the shareholder realizes no gain or loss.
Adopt a Plan of Liquidation Prior to Asset Sale
If the S corporation plans ahead and adopts a plan of liquidation before the asset sale, gain recognition can be deferred until the receipt of payment on the installment obligation in the subsequent tax year.
Example 2: Assume the same facts in Example 1, but the S corporation adopts a plan of liquidation before the asset sale and completes the liquidation within the 12-month period following adoption of the plan.
If the S corporation adopts a plan of liquidation before the asset sale, Sec. 453B(h) applies. No gain is recognized on the liquidating distribution, and the gain is deferred until the installment obligation is paid in the subsequent year.
Sec. 453B(h) is a special provision available only to S corporations. It provides that if an S corporation adopts a plan of liquidation before the sale of its assets and completes the liquidating distributions within 12 months of the date the plan is adopted, the note's distribution is not treated as the S corporation's disposition of the obligation. Instead, the shareholder's receipt of payments on the installment obligation (but not the receipt of the installment obligation in liquidation) is treated as the receipt of payment for the stock. Under these rules, the S corporation does not recognize gain on the liquidating distribution of the installment obligation, and thus the shareholder will take a zero basis in the installment obligation. When the installment obligation is paid in the subsequent year, the shareholder recognizes $1,000 of capital gain.
This planning technique becomes more valuable if the shareholder's outside basis in the S corporation stock is less than the S corporation's basis in the assets.
Example 3: A shareholder has a $250 basis in S corporation stock. At the date of the sale, the S corporation's tax basis balance sheet is as shown in Exhibit 1.
The S corporation sells its assets for $1,200: $400 cash and an $800 note due in one year. The S corporation uses the cash to pay off its liabilities and has the $800 note available to distribute to its shareholder. The S corporation realizes $200 of gain on the sale of its assets for $1,200. Of this gain, $67 is recognized in the year of sale, and the remaining $133 is deferred under Sec. 453. If the S corporation were to liquidate immediately without adopting a plan of liquidation before the sale, it would recognize the remaining $133 gain upon the liquidating distribution of the note, and the shareholder would report additional gain of $350 computed as shown in Exhibit 2. The result is that the shareholder recognizes his or her entire $550 gain in the year of sale.
If the S corporation has the foresight to adopt a plan of liquidation before the sale, Sec. 453B(h) would apply. In the year of sale, only the $67 of gain attributable to the cash the S corporation received would be taxable. Under the rules of Sec. 453B(h), no gain would be recognized on the distribution, and the shareholder would take a $317 basis in the installment note ($250 stock basis increased by the $67 S corporation gain on the sale). When the note is paid off in the subsequent year for $800, the shareholder will recognize the remaining $483 of gain. In this case, failure to adopt a plan of liquidation before the sale results not only in the acceleration of the installment gain, but also the excess of inside basis in assets over stock basis.
Allocation of Basis and the Sec. 453 Trap
Even when inside and outside bases are equal, the plan of liquidation is adopted before the sale, and liquidation occurs within 12 months, a potential trap still exists because of the required allocation of basis among the assets received in the liquidating distribution. This trap can cause tax to be paid on the cash distributed in liquidation from the S corporation even though the inside and outside bases are equal.
Example 4: An S corporation has one shareholder with zero stock basis, and the S corporation has zero tax basis in its assets and no liabilities. The S corporation sells its assets for $1,000—$100 in cash and a $900 note.
The S corporation recognizes gain of $100 attributable to the cash received. The shareholder then receives $100 cash and a $900 note in liquidation of the S corporation. The shareholder's tax basis is increased from zero to $100 as a result of the gain recognized. Since other assets were distributed in addition to the installment note in liquidation, the first step for the taxpayer is to allocate his or her stock basis among the assets received.
Upon a liquidating distribution of the cash and note, the shareholder's basis is apportioned between the cash and note based on the relative fair market values of the distributed assets. Of the total $100 basis, $10 of basis is allocated to the cash, and $90 is allocated to the note. In this case, when the shareholder receives the $100 cash in liquidation, $90 of gain is recognized. Upon collection of the note in two years, the shareholder will recognize the remaining gain of $810.
The rules allocating basis to the assets received in a liquidating distribution accelerate the gain of $90 in this case, as opposed to the result if the S corporation had remained in existence and collected the note payments (see Exhibit 3).
Example 5: Assume the same facts as in Example 4, except that instead of $100 cash and a note of $900, the S corporation sells its assets for a note of $1,000. The note contains two payments—$100 due in one day, and $900 due in two years.
Because no cash is received, the S corporation recognizes no gain, and the shareholder's basis remains zero. Since the installment obligation is the only asset distributed in liquidation, the shareholder takes a zero basis in the receivable, and all payments received are taxable. The results are the same as they would be if the S corporation had collected on the note and liquidated after all the cash was received. For this strategy to succeed, it is critical that the note be distributed to the shareholder before the payment on the one-day portion of the note. In practice, the short-term portion of the note might need to be more than one day in order to accomplish the first payment on the note.
When the owner of an S corporation has stock basis in excess of asset basis, Sec. 453 planning can provide significant benefits.
Example 6: An individual has a $600 stock basis in an S corporation. The S corporation's basis in the assets is zero, and it has no liabilities. The S corporation sells its assets for $800—$750 cash and a $50 note payable in the next year—and liquidates without adopting a plan of liquidation before the sale.
In this scenario, the S corporation would recognize the $750 gain attributable to the cash in the year of the sale and the remaining $50 gain upon the liquidating distribution. There is also a $600 capital loss on liquidation.
If the note does not pay out equal to face value in two years, the shareholder could incur a capital loss since shareholder basis in the note is equal to face. Furthermore, if the S corporation does not liquidate in the same tax year as the asset sale, the capital loss will not be offset against the capital gain from the asset sale. If the shareholder does not have other capital gains in the future year, he or she would be limited to deducting $3,000 of the capital loss per year.
Assume the taxpayer had the foresight to modify the transaction in the following manner:
- Instead of receiving $750 cash and a $50 note, the shareholder receives an $800 note with $750 payable one week after sale and the remaining $50 in the next year.
- The S corporation adopts a plan of liquidation before the sale and makes a liquidating distribution of the note immediately following the sale.
Under this plan, the S corporation recognizes no gain on the sale or on the liquidating distribution. The shareholder holds an installment note with a face value of $800 and a basis of $600. When the shareholder receives the first payment of $750 immediately following the liquidating distribution, only $188 of gain is recognized, and the remaining $12 is deferred until the final payment is received in the subsequent year.
Other Considerations
For simplicity, the previous examples assume all gain is capital and qualifies for the installment method. In addition, they assume no taxes are imposed by subchapter S, such as the built-in gains tax. Sec. 453B(h) specifically provides that taxes imposed by subchapter S must be recognized upon the liquidating distribution of an installment obligation.
Sec. 453B applies to the sale of an S corporation with a Sec. 338(h)(10) election (and presumably a Sec. 336(e) election) that includes an installment note under Regs. Sec. 1.338(h)(10)-1(d)(8). Thus, S corporations that are being sold in a Sec. 338(h)(10) or 336(e) transaction can avail themselves of the planning techniques described here.
EditorNotes
Howard Wagner is a director with Crowe Horwath LLP in Louisville, Ky.
For additional information about these items, contact Mr. Wagner at 502-420-4567 or howard.wagner@crowehorwath.com.
Unless otherwise noted, contributors are members of or associated with Crowe Horwath LLP.
