Federal Income Tax Considerations for Sellers of S Corporation Businesses
When contemplating the sale of a business operated as an S corporation[1], the shareholders should consider the federal income tax implications of the form of sale selected, along with other considerations such as state law, state taxes and the preferences of prospective purchasers. This article discusses certain federal income tax considerations in connection with such a sale including (1) alternative forms of the sale of an S corporation’s business, (2) the allocation of purchase price among assets and the importance of the “residual method,” and (3) the treatment of gain or loss resulting from the sale of various types of assets. [2]
The sale of an S corporation’s business may take the form of a stock sale or an asset sale.[3] In general, the total amount of gain recognized for federal income tax purposes by S corporation shareholders will be the same whether the sale takes the form of a stock sale or an asset sale.[4] The character of gains and losses may differ depending on whether a stock sale or an asset sale is undertaken, as discussed in more detail below. Many purchasers prefer an asset sale (whether an actual asset sale or a Deemed Asset Sale), and the primary determining factor in the tax treatment of an asset sale by an S corporation is usually the treatment of the sale of each business asset sold. The largest asset in many business sales is goodwill or going concern value, which generally is treated as a capital asset, subject to the rules discussed below.
S Corporation Stock Sale
The simplest construct from the perspective of a shareholder might be a sale of all of the stock of the S corporation.[5] In such a stock sale, shareholders would recognize gain or loss on the sale of their shares. Since stock is commonly held as a capital asset, the gain or loss would ordinarily be capital gain or loss, and would be long-term capital gain or loss to a shareholder whose holding period for the shares is longer than one year. The tax basis of each selling shareholder in such stock will need to be adjusted (before determination of the amount of gain or loss on the sale) for income or loss of the S corporation for the period during the year of sale during which such person was still a shareholder.[6]
In many cases, however, a purchaser will have a strong preference either for a sale of the S corporation’s assets, or for a Deemed Asset Sale.[7] Part of the reason for such a preference is that asset sale treatment affords the purchaser a stepped-up tax basis in the purchased assets and associated cost-recovery deductions.
S Corporation Asset Sale
An S corporation will recognize gain or loss when it sells its business assets. Any gain recognized by the S corporation will flow through and be taxed to its shareholders. The S corporation will ordinarily liquidate and distribute all the sale proceeds to its shareholders. This liquidation is technically a taxable transaction to both the S corporation and its shareholders, but in many cases, in keeping with the pass-through nature of the taxation of S corporations and their shareholders, neither will recognize additional gain or loss as a result of the liquidation.
The tax law generally treats a sale of a business as a sale of each individual asset of that business, rather than as a sale of a single unified asset. The purchase price for the business as a whole needs to be allocated among all the assets that comprise that business, and the difference between the amount of consideration allocated to an asset and such asset’s tax basis determines the amount of gain or loss realized on the sale of such asset. A seller might realize a gain with respect to some assets and a loss with respect to other assets, even if the business as a whole is sold for an overall gain. The character of any gain or loss realized with respect to a particular asset will likewise be determined by reference to the character and holding period of that particular asset.
Allocation of Purchase Price
In a sale of a business treated for tax purposes as a sale of assets, the seller must allocate the purchase price among the various assets in order to determine the amount realized from the sale of the various assets, and the amount and character of the seller's gain or loss on the sale. This allocation also determines the purchaser's tax basis in the various purchased assets, which is used to determine the amount of depreciation, amortization or other cost recovery deductions available with respect to the assets and the amount of income or loss realized by the purchaser on a subsequent disposition of one or more of the acquired assets.
Importance of “Residual Method”
The consideration for the purchase of the business assets must be allocated among such assets using the “residual method” required by IRC Section 1060 and applicable Treasury Regulations.[8] Although the operation of the residual method is a topic worthy of its own separate discussion, in general terms this method requires consideration for the sale of the business to be allocated sequentially to seven defined asset classes, based on the fair market value of the purchased assets in each class, until all of the consideration has been allocated. It is important to keep in mind that the final two asset classes in this system (to which consideration is allocated only after it has been allocated based on fair market value to all assets in the first five asset classes) are Section 197 Intangibles other than goodwill and going concern value (the sixth asset class) and goodwill and going concern value (the seventh asset class). This is important in part because a significant amount of the value of many businesses that is being purchased falls into these asset classes. Without going into all the details here, the seller and purchaser typically agree contractually to a specific asset allocation and agree to report this allocation consistently to the IRS.
Character of Gain or Loss as Capital or Ordinary
Once sale consideration has been allocated among the various assets and the amount of gain or loss realized from the disposition of each asset can be determined, one must determine how the gain or loss with respect to each asset is treated for tax purposes, that is, as capital gain or loss (and as short-term or long-term capital gain or loss), as Section 1231 gain, or as ordinary income or loss.
For federal income tax purposes, capital gains or losses generally result from the taxable sale or exchange of property that is defined as a capital asset. Gain from the sale or exchange of "section 1231 assets" may also be treated as long-term capital gain.[9] Gain or loss from the sale or exchange of assets that are neither capital assets nor section 1231 assets is ordinary income or loss. The sale or exchange of a capital asset or a section 1231 asset with respect to which prior cost-recovery deductions have been taken generally results in a portion of the gain being treated as "recapture" income that is treated as ordinary income rather than capital gain, with the portion not subject to recapture eligible to be treated as capital gain (that is, the recapture rules override the capital gain rules where applicable and can recharacterize what would otherwise be capital gain as ordinary income). In any case where a sale or exchange of an asset generally would result in capital gain, such treatment is subject to possible override by the recapture rules if applicable.
Goodwill and going concern value that attach to a group of assets that constitute a business generally are treated as capital assets. Certain types of property are excluded from capital asset status. For example, accounts or notes receivable acquired in the ordinary course of trade or business for services rendered or from the sale of inventory or dealer property are not capital assets. As another general example (and though each case needs to be examined in light of all its surrounding facts), contracts that represent the right to earn future income from the performance of services generally are not capital assets. Computer software often will be treated as either a capital asset or a section 1231 asset, although complex rules often apply in the case of self-created software.
Capital gains or losses are long-term if the taxpayer's holding period for the capital asset sold or exchanged is longer than one year, and short-term if the holding period is one year or less. Section 1231 assets are defined in part by having been held for more than one year, so while their holding period is crucial to their tax treatment, there is no such thing as "short-term section 1231 gain."
The holding period of property that is neither a capital asset nor a potential section 1231 asset generally does not affect the tax rate applicable to gain from the its sale or exchange. Long-term capital gain (that is, gain from the sale or exchange of capital assets and section 1231 assets) is currently subject to a preferential tax rate, whereas short-term capital gain and ordinary income are subject to ordinary income tax rates. The length of an asset's holding period (i.e., greater than one year vs. one year or less) generally is determined by reference to the date on which the property changes ownership, not with reference to the receipt of any payments that may be made beforehand (such as a down payment) or afterward (such as deferred installment payments of sales proceeds).
Because many purchasers of an S corporation business will have a preference for a transaction treated as an asset sale for federal income tax purposes, it is essential as part of the sale process for such a business for selling shareholders to consider the federal income tax treatment of asset sales, including the application of the residual method for allocating purchase consideration among assets and the tax treatment of gain or loss from the various types of assets that make up the business being sold. [1] An “S corporation” is defined in Section 1361 of the Internal Revenue Code of 1986, as amended (the “IRC”).
[2] This discussion assumes a taxable sale for cash of the business of an S corporation that does not have any built-in gains subject to the S corporation built-in gains tax.
[3] When certain specific conditions are met, a corporation purchasing at least 80% of the stock of an S corporation can make an election, jointly with all the shareholders of the S corporation, to treat its purchase of the S corporation’s stock as an asset sale for federal income tax purposes under Section 338(h)(10) of the IRC (a “Deemed Asset Sale”). A Deemed Asset Sale results in asset sale treatment for federal income tax purposes even though the stock and not the assets of the S corporation are actually sold. Although the details of such an election are beyond the scope of this discussion, the same general tax principles that relate to the taxation of an actual asset sale apply to a Deemed Asset Sale as well, and therefore this discussion treats actual asset sales and Deemed Asset Sales as a single category.
[4] The impact of state and/or local taxes may result in differing tax liabilities leading to different economic results to the seller and therefore should be considered as part of the overall tax cost of each potential form of sale.
[5] As discussed in more detail below, a purchaser’s preference may be to enter into either an actual asset sale or a Deemed Asset Sale. In addition, for certain shareholders, sale of the stock of an S corporation may implicate the net investment income tax.
[6] Additionally, there are various potential implications of such a sale to the S corporation itself, such as whether its election to be an S corporation survives the sale, the timing of any termination of the election, and other matters.
[7] A Deemed Asset Sale is treated for the S corporation’s shareholders as though the S corporation actually sold its assets and then liquidated, with the deemed sale of assets generally following the construct for an actual asset sale, with certain differences resulting from the special rules applicable to such elections.
[8] These rules are applicable in the case of an “applicable asset acquisition,” which in general terms is defined as the transfer of a group of assets if such assets constitute a trade or business in the hands of either the seller or the purchaser and (with certain limited exceptions) the purchaser's basis in the transferred assets is determined wholly by reference to the purchaser's consideration for the assets. Although at times the question whether an applicable asset acquisition has occurred arises, this discussion assumes that the requirements of an applicable asset acquisition are met. The same rules also apply to allocation of consideration in a Deemed Asset Sale (with certain differences).
[9] Gains and losses from section 1231 assets are subject to their own separate rules, which provide that for each taxable year, (i) if a taxpayer’s section 1231 gains exceed such taxpayer’s section 1231 losses, then such gains and losses are treated as long-term capital gains or losses, and (ii) if a taxpayer’s section 1231 gains do not exceed such taxpayer’s section 1231 losses, then such gains and losses are treated as gains and losses from sales or exchanges of non-capital assets. In general terms, the result of these rules is that if a taxpayer has net gains considering only the disposition of section 1231 assets, then those net gains are treated as long-term capital gains, and if a taxpayer has net losses considering only the disposition of section 1231 assets, then those net losses are treated as ordinary losses. The application of this system can involve considerable complexity when taking into account such issues as recapture, the disposition of multiple section 1231 assets, and gains and losses from dispositions of capital assets.
If you have any questions about this alert, or any other matters, do not hesitate to reach out to: Seth Lebowitz (Partner - Tax group) at 212.573.8152 or via slebowitz@sadis.com.
