Comparing stock sales and asset sales of S corporations

The seller of an incorporated business generally prefers to dispose of stock, while the buyer prefers to purchase the assets directly from the corporation. From the buyer’s perspective, the acquisition of assets allows a fresh tax basis for depreciation purposes and also generally eliminates the buyer’s responsibility for claims and other actions against the corporation arising before the purchase. From the seller’s viewpoint, stock sales are attractive because of eligibility for installment reporting of gain on the disposition and potential benefits from reporting the entire gain as a capital gain, as opposed to reporting depreciation and other recapture items as ordinary income, which would occur upon a sale of assets.

While the issue of stock sale versus asset sale generally is more critical for a C corporation than for an S corporation (because of the probability of double taxation facing a C corporation and its shareholders upon sale and liquidation), there are still a number of significant issues to be considered by S shareholders.

Making installment sales

The availability of the installment method of reporting is an attractive element associated with the sale of S corporation stock. However, a special rule eliminates the tax advantage of installment reporting on the sale of stock if the sale price exceeds $150,000 and the year-end installment receivables balance from all installment sales (for more than $150,000) arising during the tax year exceeds $5 million. Interest on the tax deferral must be paid to the IRS in the year of sale and succeeding years until all installment receivables arising during the year are collected (Sec. 453A). If assets are sold directly by the S corporation, the installment method of reporting is not allowed for gains associated with inventory, depreciation recapture, and other ordinary income items (Secs. 453(b)(2) and 1245(a)(1)).

Another concern with installment sales occurs if the stock is sold to a “related person” whose stock would be attributed under Sec. 318(a) (other than attribution by stock option) or Sec. 267(b). Sec. 453(e) states that if the related person sells the stock within two years, all or part of the initial seller’s deferred gain will be recognized in the year of the second sale (unless the second sale is not for tax avoidance).

Example. Making an installment sale to a related party: T has a basis of $4,000 in his S corporation stock. He sells all of his stock to his daughter, G, on Dec. 1 of the prior year for $8,000 ($2,000 down and $3,000 payable on Dec. 1 of the following two years). T recognizes $1,000 of gain in the year of sale ($2,000 down payment received, multiplied by the 50% gross profit ratio). G sells the stock for $9,000 on March 15 of the current year. T recognizes $3,000 in that year, computed as shown in the table below.

Since T has reported the full amount of his $4,000 gain ($1,000 reported in the year of sale plus $3,000 in the current year), the $3,000 payment received in the following year will be tax-free.

Avoiding built-in gains tax by selling stock

Because of the corporation’s S status, both a stock sale and an asset sale generally result in single taxation at the shareholder level. However, if the S corporation was formerly a C corporation and is within the five-year built-in gains (BIG) tax recognition period, a sale of assets by the S corporation could trigger corporate-level BIG tax (Sec. 1374).

Selling a division, branch, or product line

When an S corporation sells an unincorporated division, branch, or product line, the general tax results to the corporation are the same as for any sale of assets comprising a trade or business. This is also the case when the business assets of a qualified Subchapter S subsidiary (QSub) are sold. The existence of the QSub is ignored for federal income tax purposes, and the QSub assets are simply treated as belonging to and being sold by the parent S corporation (Sec. 1361(b)(3)).

However, additional factors must be considered when cash or property is distributed to shareholders following an S corporation asset sale. A distribution treated as a redemption of the shareholder’s stock (or a redemption of a portion of each shareholder’s stock) in partial liquidation of an S corporation will qualify for sale or exchange treatment if the requirements of Secs. 302(b)(4) and (e) are met. This means that the corporation must have conducted two or more trades or businesses during the previous five-year period, and, following the liquidation, the corporation must continue to conduct at least one of those trades or businesses.

A distribution that does not qualify for partial liquidation sale or exchange treatment is governed by the usual S corporation distribution rules under Sec. 1368 and may be preferable to sale or exchange treatment. For example, if a corporation has little or no accumulated earnings and profit (AE&P) or the distribution is less than the accumulated adjustment account (AAA) balance, a Sec. 1368 distribution allows full stock basis offset at the shareholder level, while sale or exchange treatment allows only a partial offset of stock basis against the distribution. In contrast, if the S corporation has a large AE&P amount but a nominal AAA balance, a Sec. 1368 distribution will result in largely dividend income, while sale or exchange treatment allows a partial stock basis offset and capital gain treatment.

Under Sec. 311, the corporation will recognize gain upon a nonliquidating distribution of appreciated noncash property. However, loss is not recognized when depreciated property is transferred to shareholders in nonliquidating distributions. This is the case whether or not the distribution qualifies as a partial liquidation.

Making a Sec. 338(g) election

Sec. 338(g) allows a purchasing corporation that has made a qualified stock purchase of another (target) corporation to make an election to step up the basis in the target corporation’s assets, much as if the assets had been purchased instead of the stock. A qualified stock purchase is a transaction, or series of transactions, in which at least 80% of the value or 80% of the total voting power of the stock of the target corporation is acquired by another corporation within a 12-month acquisition period. The election to treat the stock purchase of a target corporation as an asset acquisition is made on Form 8023, Elections Under Section 338 for Corporations Making Qualified Stock Purchases (Regs. Sec. 1.338-2(d)).

There are two types of Sec. 338 elections. A Sec. 338(g) election is made only by the purchasing corporation, while a Sec. 338(h)(10) election is made jointly by the old target shareholders and the purchasing corporation. The instructions state that Form 8023 must be filed by the 15th day of the ninth month after the acquisition date to make a Sec. 338 election for the target corporation.

Under certain conditions, a 12-month automatic extension of time under Regs. Sec. 301.9100-3 can be obtained. If all the criteria are met, taxpayers will be granted an extension if (1) they relied upon a qualified tax professional who failed to make the election or failed to advise the corporation to make the election; (2) after exercising due diligence, they were not aware of the need to file the election; or (3) the IRS did not discover that the election was not made. Rev. Proc. 2003-33 provides details for obtaining the automatic 12-month extension of time.

This case study has been adaptedfrom PPC’s Tax Planning Guide: S Corporations, 35th edition (March 2021), by Andrew R. Biebl, Gregory B. McKeen, and George M. Carefoot. Published by Thomson Reuters, Carrollton, Texas, 2021 (800-431-9025; tax.thomsonreuters.com).