Succession planning - Tax implications of buying or selling an S corporation

Updated: May 15, 2025

Note: Originally published in July 2023, this piece has been updated to reflect current tax strategies. It is part of our ongoing series on the tax impact of succession planning. For C corporation considerations, read this related article.

Selling or acquiring an S corporation is rarely straightforward. These transactions involve layered considerations, especially when it comes to tax treatment. At the heart of the deal structure are two primary approaches: an equity (or stock) sale and an asset sale. Each structure carries distinct tax implications, often putting the buyer’s and seller’s interests at odds.

The following outlines the key differences and considerations that can significantly impact how a deal is structured, and how much tax is ultimately paid.

Buying or Selling S Corporation Stock (Equity Sales)

Deal Structure

In a stock transaction, the buyer acquires a partial or full ownership share in the target company from the seller(s).  The entity continues ongoing, normal operations but with revised ownership. The buyer will, in effect, assume the business’s assets and liabilities without a step-up in basis.

The buyer’s basis in their acquired S corporation stock will be the amount paid. Their basis will increase and decrease each year as the S corporation passes through its income or losses or if the shareholder takes distributions.

Under a special rule that applies in rare circumstances, the buyer and seller can agree under Internal Revenue Code Section 338(h)(10) to treat what would otherwise be deemed a stock sale as an asset sale instead, which changes the sale’s tax implications for both the buyer and seller. The nuances of this election are outside the scope of this article.

Taxable Gain

The seller of S corporation stock will recognize gain on the difference between the purchase price and their adjusted basis in the stock. Their basis is equal to the amount they contributed to the S corporation, plus or minus pass-through items that have been reported to them over their ownership period. The gain is generally taxed for federal purposes at the preferential capital gains rate of 20%, plus any applicable resident state income tax. Having the entire gain be subject to the preferential capital gains tax rate is a meaningful tax factor for sellers, and is why this deal structure is most advantageous to them.

Gain recognized by shareholders who are actively involved in the operations of the sold S corporation is exempt from the 3.8% Net Investment Income Tax (NIIT), while those who are passively involved are subject to the additional tax.

Buying or Selling S Corporation Assets

Deal Structure

An S corporation asset sale structures the deal such that the buyer acquires the business’s assets rather than the owner(s) equity.

The buyer of the assets will receive a stepped-up basis in both the tangible and intangible corporation assets to their fair market values. The assets’ updated values are determined based on a combination of purchase price paid and corresponding liabilities assumed.

The acquired assets can generally be either immediately deducted or depreciated over their appropriate tax lives (including opportunities for bonus depreciation). Any prior depreciation taken on the assets by the seller is disregarded. The acquired intangible assets are typically amortized over a 15-year period. This additional depreciation is a powerful tax asset for S corporation buyers and is why purchasers will often look to structure deals as asset sales.

Taxable Gain

The seller of S corporation assets will recognize both ordinary and capital gain income, which is passed through to them based on how the purchase price is allocated across the business’s assets. Ordinary income is taxed at the seller’s regular tax rate, while capital gain income is generally taxed at 20%. If the seller was active in the business, their gain may be exempt from the 3.8% NIIT.

Importantly, ordinary income from the sale may also qualify for a 20% deduction under Section 199A, reducing the seller’s federal tax liability. However, this deduction is scheduled to expire after December 31, 2025, so completing a sale before year-end may offer additional savings. While many expect Congress to extend 199A, its future remains uncertain.

State Tax Exposure and PTE Elections

Unlike a stock sale, where gain is sourced only to the seller’s home state, ordinary income from an asset sale must be sourced across multiple states where the business operates. This can create unexpected tax bills in states that were previously insignificant from a tax standpoint.

To manage this exposure, state pass-through entity (PTE) elections can help by allowing the business to pay state tax on behalf of the owners, potentially reducing federal tax liability. But these elections are state-specific, time-sensitive, and easy to miss without advance planning.

Purchase Price Allocation Strategy

The mix of ordinary versus capital gain is determined by purchase price allocation, which is a negotiated process that splits the total sale price among various asset classes. Gains assigned to assets that generate ordinary income when used in the business (e.g., inventory, machinery, equipment) creates ordinary income. Conversely, gains assigned to less-tangible assets (e.g., goodwill) creates capital gain income. For consistency, both buyer and seller must report the agreed-upon allocation on IRS Form 8594.

It is typically most advantageous to the buyer to allocate more purchase price to ordinary income items as they generate more immediate tax deductions. The inverse is true for what is most advantageous to the seller. The allocation of the purchase price should be negotiated and agreed upon by both parties prior to the closing of the transaction and is usually one of the most important steps in compiling the deal.

Note: If your S corporation was previously taxed as a C corporation, built-in gains (BIG) tax may apply if appreciated assets are sold within five years of conversion.

We Can Help

At Elliott Davis, our high-net-worth team works closely with business owners to understand and execute the appropriate transaction structure whether they are buying or selling. We can work with you to understand the different options available, the tax implication of each, and help you determine the best path forward for you and your business.

Looking for more guidance on ownership transition? Check out Choosing Your Successor or Tax Implications of Buying or Selling in a Partnership.

The information provided in this communication is of a general nature and should not be considered professional advice. You should not act upon the information provided without obtaining specific professional advice. The information above is subject to change.