Comparing an S stock sale to an asset sale.

The seller of an incorporated business generally prefers to dispose of stock, while a buyer prefers to purchase corporate assets. From the latter's perspective, an asset acquisition allows a fresh tax basis for depreciation purposes; generally, it also 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 gain as capital gain; an asset sale would require reporting depreciation and other recapture items as ordinary income.

While generally, the issue of a stock sale versus an asset sale 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 on sale and liquidation), there are still a number of significant issues to be considered by S shareholders, one of which is installment sale treatment.

Making Installment Sales

The availability of the installment method of reporting is an attractive element of an S stock sale. However, a special rule eliminates the tax advantage of installment reporting on such a sale, if the sale price exceeds $150,000 and the yearend 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 sale year and succeeding years until all installment receivables arising during the year are collected; see Sec. 453A.

If the S corporation sells assets, the installment method is not allowed for gains associated with inventory, depreciation recapture and other ordinary income items, under Secs. 453(b)(2) and 1245(a)(1).

Related-party sales: Another concern occurs if the stock is sold to a "related person" (including a spouse, sibling, child or grandchild). Sec. 453(e) states that if a 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 purposes).

Example: Tom has a $4,000 basis in his S stock. He sold all of it to his daughter, Grettel, on Dec. 1, 2005, for $8,000 ($2,000 down and $3,000 payable on each of Dec. 1,2006 and 2007). Tom recognizes $1,000 gain in 2005 ($2,000 downpayment received x 0.50 gross profit ratio (GPR)). Grettel sells the stock for $9,000 on March 15, 2006. Tom recognizes $3,000 in 2006, computed as follows:

Sales price (Tom's sale)               $8,000(a)
Sale price (Grettel's sale)            $9,000(b)
Lesser of (a) and (b)                  $8,000
Less: payments Tom received            (2,000)
Amount realized                        $6,000
Gain recognized ($6,000 x 0.50 (GPR)   $3,000

Because Tom reports the full amount of his $4,000 gain in 2005 and 2006 ($1,000 in 2005 and $3,000 in 2006), the $3,000 payment he receives in 2007 will be tax free.

Avoiding Reporting Requirements

A stock sale avoids the reporting requirements that accompany the disposition of a group of assets constituting a business. Both the seller and the buyer are required to report details of the sale of a group of assets constituting a business, including disclosure of the sale price and allocation among various asset components, on Form 8594, Asset Acquisition Statement, for the period that includes the asset sale date; see Sec. 1060.

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 10-year built-in gain (BIG) tax recognition period, the S corporation's asset sale could trigger corporate-level BIG, under Sec. 1374.

Editor's note: This case study has been adapted from PPC's Tax Planning Guide--S Corporations, 19th Edition, by Andrew R. Biebl, Gregory B. McKeen, George M. Carefoot and James A. Keller, published by Practitioners Publishing Company, Ft. Worth, TX, 2004 ([phone]; ppc.thomson.com).

Editor:

Albert B. Ellentuck, Esq.

Of Counsel

King & Nordlinger, L.L.P.

Arlington, VA