The Tax Planning Opportunity of Selling an S Corporation

Fall 2007

The entity of choice for many business owners is the S corporation. It has a number of statutory requirements—including a formal election—and limitations regarding shareholders.

If all the requirements are met, however, the S corporation structure allows for a pass-through of the corporate earnings to the shareholders, thus avoiding a double level of taxation: at the corporation level and then again at the shareholder level. The benefits of an S corporation continue to the point of owners considering an exit strategy through the sale of S corporation stock.

When shareholders sell their ownership interest in a corporation, including an S corporation, the shareholders generally recognize capital gain based on the selling price, reduced by their basis in the shares. The buyer will have the purchase price as its basis in the shares. However, there will be no step-up of the inside basis of the corporate-owned assets in a straight stock acquisition. This transaction normally results in the loss of potentially significant tax benefits to the buyer.

The buyer, in many circumstances, would prefer to purchase the assets owned by the corporate entity. The purchase of the assets results in an increase in the tax basis of the assets, based on the appropriate allocation of the purchase price to these assets. If the seller is a C corporation, the double level of tax will occur. The sale of S corporation stock, though, presents a unique planning opportunity for both the seller and the purchaser of the stock.

IRC Section 338(h)(10) provides an opportunity for the seller and buyer of S corporation stock, in a qualified stock purchase, to elect, from a tax standpoint, to treat the stock sale as an asset sale. The stock sale itself is ignored for tax purposes, and the S corporation is deemed to have sold its assets for an amount equal to the purchase price plus any assumed liabilities. From a seller’s standpoint, all gain from the deemed asset sale flows through the S corporation and is taxed to the individual shareholders on their individual tax returns. The deemed asset sale will, in most cases, result in the recognition of a combination of ordinary income and capital gain, as opposed to all capital gain on a straight stock sale transaction. The selling taxpayer will recognize ordinary income for items such as gain reflected on the deemed inventory sale, depreciation recapture, allocation of purchase price to accounts receivable for a taxpayer on the cash method of accounting, and possibly other items. The seller’s basis in its shares is increased by the amount of income recognized from the deemed sale of the assets. Immediately after the sale, the S corporation is then treated as having been liquidated.

The buyer has the unique opportunity of allocating, with the seller’s agreement, the purchase price to the corporate-owned assets and depreciating or amortizing the assets after the acquisition. This basis increase can be a significant benefit to the buyer, but at a cost to the seller. This tax concept, therefore, presents an important negotiating point in this type of transaction.

To determine the advisability of this type of transaction, compare the tax liability from a straight stock sale versus the tax liability from making a Section 338(h)(10) election. In the straight stock sale, the selling taxpayer would recognize a long-term capital gain that would be subject to the federal capital gain rate and state income tax based on state of residency. The Section 338(h) (10) election results in a combination of ordinary income and capital gain to the selling taxpayer. The comparison of these two tax liabilities will indicate the additional tax cost to the seller and potential increased tax benefit for the buyer.

The analysis of these tax costs and tax benefits could influence how much additional consideration the buyer may be willing to pay the seller for agreeing to make a Section 338(h)(10) election. Often, through appropriate negotiation, the seller can be made whole from a net cash after tax standpoint by getting an increased purchase price, while the buyer can get a significant tax benefit through the increase in basis of the underlying assets.

There are many important considerations that must be reviewed in analyzing a Section 338(h)(10) election. A few include the following:

• This is a joint election that must be made by the buyer and the seller, and must include all S corporation shareholders.
• For C corporations that converted to S corporations within 10 years prior to the date of sale, the built-in gains issue is a critical consideration. If the built-in gain tax applies to this transaction, there is a corporate-level income tax. The seller will incur an additional income tax liability.
• Consider the allocation of the purchase price to the various assets acquired. IRS Regulation Section 1.1060 provides a detailed set of rules as to how allocations are to be made based on the classes of assets purchased. This is important when determining the amount and character of the gain on the deemed asset sale and the category type of the purchased assets.
• Consider liabilities that may not have matured at the time of acquisition, such as a contingent liability for a pending lawsuit.
• Payments to seller’s employees may have a significantly different tax treatment if the payment is made before or after the purchase transaction.

This brief overview of the Section 338(h)(10) election points out some of the legal and tax complexities of this area. Advisors who are negotiating the sale or acquisition of an S corporation should be aware of this significant planning opportunity and be in a position to discuss it with their client, whether it be the buyer or the seller.

Larry S. Blair, CPA, JD, is a partner with the law firm of Metz Lewis LLC in Pittsburgh, and is a member of the Pennsylvania CPA Journal Editorial Board. He can be reached at lblair@metzlewis.com.

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