Tax Implications When Selling an S Corporation
Selling an S corporation can trigger various tax issues for both the seller and the buyer. The tax implications depend on whether the sale is structured as a stock sale or an asset sale, as well as other factors like the company’s tax basis, built-in gains, and any agreements between the parties. Here's an overview of the key tax issues:
1) Stock Sale-Buyer purchases the shares of S corporation directly from the shareholders.
Tax Implications for the Seller:
The sale proceeds are taxed as capital gains if the stock is held for more than one year.
Capital gains tax rates are typically lower than ordinary income tax rates, making this option favorable for the seller.
Tax Implications for the Buyer:
The buyer receives no step-up in the basis of the corporation’s assets.
The buyer inherits the S corporation’s tax basis, liabilities, and potential tax risks, such as built-in gains tax or unrecognized liabilities.
2) Asset Sale—The buyer purchases the individual assets of the S corporation instead of the stock.
Tax Implications for the Seller:
The corporation pays tax on the gain from the sale of assets (passed through to shareholders).
Shareholders pay taxes on the liquidating distribution of the remaining proceeds.
Double taxation can occur if there are built-in gains or significant accumulated earnings.
Tax Implications for the Buyer:
The buyer receives a step-up in basis for the assets, enabling higher depreciation and amortization deductions post-purchase.
This structure is often preferred by buyers.
3) Built-In Gains Tax
If the S corporation was previously a C corporation and switched to S corporation status within the last 5 years (recognition period), the sale of appreciated assets can trigger the built-in gains (BIG) tax.
How it Works:
The BIG tax applies to the appreciation of assets as of the date of conversion from C to S status.
The current federal BIG tax rate is 21% (corporate tax rate), and this tax is paid at the entity level.
4. Allocation of Purchase Price (Asset Sale)—In an asset sale, the total purchase price must be allocated among the assets sold. The allocation affects the tax treatment for both the buyer and the seller:
Buyer’s Perspective: Allocation impacts future depreciation and amortization deductions.
Seller’s Perspective: Ordinary income treatment applies to inventory, accounts receivable, and depreciation recapture on fixed assets. Capital gains treatment applies to goodwill, going concern value, and other intangible assets.
5. Depreciation Recapture—Depreciation recapture applies to the portion of the sale attributable to depreciated assets, such as equipment or real estate.
Tax Treatment: Recaptured depreciation is taxed as ordinary income, not capital gains, which can increase the seller’s tax liability significantly.
6. State Tax Implications
Many states impose their own taxes on the sale of S corporation assets or stock.
Some states, like California, may impose franchise taxes on S corporations, even if the federal government recognizes them as pass-through entities.
Sellers should carefully evaluate the state tax treatment of their sale proceeds.
7. Tax Impact of Installment Sales—If the sale is structured as an installment sale, the seller can spread out the capital gains tax liability over multiple years.
Key Risks:
Interest income on installment payments is taxed as ordinary income.
If the S corporation has appreciated assets subject to depreciation recapture, those taxes may need to be paid upfront.
8. Deductibility of Selling Expenses
Selling expenses, such as broker fees, legal fees, and appraisal costs, may reduce the taxable gain for the seller.
These expenses should be carefully documented to maximize tax deductions.
9. Section 338(h)(10) Election—In certain situations, the buyer and seller can jointly elect under Section 338(h)(10) to treat a stock sale as an asset sale for tax purposes.
Benefits:
The buyer receives a step-up in basis for the assets.
The seller is taxed on the gain as if it were an asset sale.
Considerations:
This election may result in higher taxes for the seller due to ordinary income treatment on some assets, so it requires negotiation between the parties.
10. Seller’s Basis in Stock—The tax impact on the seller depends on their stock basis in the S corporation:
Stock basis is increased by retained earnings, shareholder contributions, and profits.
Stock basis is decreased by distributions, losses, and deductions passed through to the shareholder.
A higher basis reduces the taxable gain on the stock sale.
11. Potential Tax on Excess Distributions—If the S corporation distributes sale proceeds to shareholders in excess of their basis, the excess is taxed as capital gain.
12. Buyer’s Considerations
Buyers prefer asset sales for:
Tax benefits (step-up in basis).
Avoiding inherited tax liabilities.
Sellers prefer stock sales for:
Simpler tax treatment.
Lower capital gains rates.
13. Key Strategies to Minimize Taxes
Optimize Structure: Negotiate for a stock sale if you're the seller, or consider a Section 338(h)(10) election if mutually beneficial.
Plan for Built-In Gains: If the S corporation recently converted from C status, consult with a tax advisor to plan around the recognition period.
Maximize Stock Basis: Document all contributions to S corporation and ensure proper basis calculations to reduce taxable gain.
Installment Sales: Consider spreading tax liability over multiple years through an installment sale.
Conclusion
The sale of an S corporation involves numerous tax considerations that vary depending on whether the sale is structured as a stock sale or asset sale. Sellers should prioritize strategies to reduce ordinary income taxes, avoid built-in gains taxes, and maximize after-tax proceeds.
