Key Takeaways

  • S Corporation Sales Structure: Selling an S Corporation can be done through either a stock sale or an asset sale, each with different tax implications.
  • Capital Gains Tax: Proceeds from an S Corp sale are treated as capital gains, but different assets may be taxed differently.
  • Stock Basis and Tax Considerations: Shareholder stock basis impacts the tax liability of a sale.
  • Purchase Price Allocation: The way purchase price is allocated can impact tax treatment for both buyers and sellers.
  • Section 338(h)(10) Election: This election allows a stock sale to be treated as an asset sale for tax purposes.
  • Built-in Gains Tax: If an S Corp was previously a C Corp, there may be a built-in gains tax.
  • Successor Liability: Stock sales may carry more risk regarding unknown liabilities compared to asset sales.
  • Valuation Considerations: Determining a fair market value is key in negotiating sales price and tax reporting.

Selling S Corp stock can be a very involved process and may require you to pay capital gains tax after your stocks have been sold. 

Selling Stock vs. Selling Assets

When establishing their company, many business owners choose to form a corporation covered by the Internal Revenue Code Subchapter S. This may make the company eligible for an election.

Forming a business in this manner provides corporate-level asset protection and also allows the business to be taxed as a pass-through entity. Despite this benefit of being a pass-through entity, there are considerations related to taxes when selling an S Corporation. For instance, in terms of taxes, you must be careful about how you are structuring the sale of your S Corporation.

Essentially, to sell your S Corp, you have two options:

  1. Sell your S Corp stock.
  2. Sell your corporate assets while retaining the corporate structure.

Selling stock is the easiest method of structuring an S Corp sale. If you choose this solution, you will deduct the money received by the owner of the business from selling the stock from the S corporation share tax basis.

While it can be difficult to calculate a tax basis in an S Corporation, the basis of the business owner will typically be calculated based on how much capital the owner contributed to the company. You may need to make adjustments for:

  • S Corporation revenue that has been generated
  • The distributed profits the owner withdrew from the company

When the amount of money earned from the sale of stock is more than the owner's tax basis, the owner will need to pay capital gains tax for the sale.

There are multiple steps required when choosing an asset sale instead of a stock sale. For example, every asset that is being sold will need to be assigned a tax basis by the business owner. After this, the purchase price will need to be allocated. Depending on the assets sold, the beneficial capital gains tax may not apply to gains from the sale. If an asset does not have a tax basis, then gains from the sale will be subject to income tax rates instead of the capital gains tax. Also, if you are selling equipment that has depreciated in value, you may need to pay recapture-rates that may be higher than normal. This can result in the business owner paying higher taxes than they might otherwise.

To reduce the tax burden, it is usually preferable to sell an S Corp by selling stock instead of assets. However, people buying an S Corp may prefer an asset sale, as this type of sale can provide advantageous deductions for appreciation and may allow for a basis reset.

In certain situations, a tax provision can allow parties involved in the sale of a company to treat a stock sale the same as an asset sale. However, this usually requires advice from experts, as it can be very complicated. 

The sale of an S Corporation can be the final step in the successful development of a business. However, when selling your corporation, it's important to make sure the taxes are handled correctly so that you can maximize your profit after taxes. 

Successor Liability in a Stock Sale

One key difference between a stock sale and an asset sale is the transfer of liabilities. In a stock sale, the buyer inherits all known and unknown liabilities of the S Corporation, including debts, pending lawsuits, and tax obligations.

To mitigate successor liability risks, buyers often conduct thorough due diligence and may negotiate representations, warranties, and indemnification clauses in the purchase agreement. Sellers should also ensure that outstanding liabilities are clearly disclosed to avoid post-sale disputes.

Purchase Price Allocation in S Corp Sales

When selling an S Corporation, the allocation of the purchase price can have significant tax implications for both the buyer and the seller. The IRS requires that the purchase price be allocated among the corporation’s assets, which affects the tax treatment of the transaction.

For sellers, a greater allocation to goodwill and intangible assets results in lower tax rates since these qualify for capital gains treatment. Conversely, allocations to depreciated equipment may trigger depreciation recapture, leading to higher ordinary income tax rates.

For buyers, allocating more of the purchase price to tangible assets and depreciable property allows for larger tax deductions in subsequent years. Proper allocation planning can help optimize tax outcomes for both parties.

Capital Gains Taxes on the Sale of an S Corporation

The income earned by an S Corp is passed through, which means shareholders of the company will report this income in their personal tax returns. Similarly, when an S Corp is sold, the proceeds of the sale are passed through. The difference is that sale proceeds are not reported as ordinary income but as capital gains. This is according to the rules of the Internal Revenue Service.

The stock basis will determine an S Corporation's capital gains tax.

According to the IRS, a stock basis is your total capital investment in the corporation. Generally, this is how much you paid for:

  • Services or property
  • Debt
  • Cash

How undrawn profits are distributed can change your stock basis. For example, if your S Corporation undrawn profits are $50,000 in a single year, your stock basis will increase by the same amount. This increase is considered tax-free because you should have already reported and paid for these taxes on your return. This is true whether or not you have been given the money.

Fair Market Valuation of S Corporation Stock

Determining the fair market value of S Corporation stock is critical for structuring a sale and avoiding disputes with tax authorities. Various factors influence valuation, including:

  • Earnings and Revenue: Historical financial performance and future earning potential.
  • Industry Comparisons: Comparable sales of similar S Corporations in the market.
  • Asset Values: The book and market value of tangible and intangible assets.
  • Discounts for Lack of Marketability: Private S Corp stock often sells at a discount due to the difficulty of reselling.

Professional business valuation experts can help ensure a fair and defensible valuation, which is especially important for tax reporting and buyer negotiations.

Built-in Gains Tax on S Corporations

If an S Corporation was previously a C Corporation, a built-in gains (BIG) tax may apply upon sale. This tax is triggered when appreciated assets owned by the S Corp were previously held by the entity when it was a C Corporation.

The built-in gains tax is applied at the corporate level and is calculated on the difference between the asset’s fair market value and its adjusted tax basis at the time of the S election. The BIG tax is imposed at the highest corporate tax rate, significantly impacting net proceeds from a sale.

To minimize exposure to the built-in gains tax, sellers should consider strategies such as waiting out the 5-year recognition period or structuring the sale to allocate more value to goodwill rather than corporate assets.

Section 338(h)(10) Election – When a Stock Sale Becomes an Asset Sale

A Section 338(h)(10) election allows parties in a stock sale to treat the transaction as an asset sale for tax purposes, providing tax benefits for the buyer. By making this election, the purchasing entity can step up the tax basis of the acquired assets, potentially leading to increased depreciation and amortization deductions.

For the seller, however, this election may result in higher tax liabilities due to the reclassification of proceeds as a mix of ordinary income and capital gains rather than purely capital gains. Business owners considering this election should consult with a tax professional to assess whether it provides net benefits.

Frequently Asked Questions

  1. Can an S Corporation stock sale be treated as an asset sale?
    Yes, through a Section 338(h)(10) election, a stock sale can be treated as an asset sale for tax purposes, benefiting the buyer with a stepped-up tax basis while potentially increasing the seller’s tax liability.
  2. How does successor liability impact buyers in an S Corp stock sale?
    In a stock sale, buyers inherit all known and unknown liabilities of the S Corporation, including debts, lawsuits, and tax obligations. Due diligence and indemnification clauses can help mitigate these risks.
  3. What is the built-in gains tax in an S Corporation sale?
    The built-in gains tax applies when an S Corporation was formerly a C Corporation and has appreciated assets. If sold within 5 years of the S election, these assets may be subject to corporate-level taxation.
  4. How should the purchase price be allocated in an S Corp sale?
    The purchase price allocation affects tax outcomes for both buyers and sellers. A higher allocation to goodwill benefits sellers by reducing ordinary income tax, while buyers may prefer allocations to depreciable assets for future tax deductions.
  5. How is the value of S Corporation stock determined?
    S Corporation stock value is based on earnings, industry comparisons, asset values, and discounts for lack of marketability. A business valuation expert can help determine a fair and defensible price.

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