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

This article is a continuation in our series on the tax implications of the different structures used to buy or sell a business.  If you missed our article related to C-corporations, please check it out here.

This article will help you understand the tax implications for both buyer and seller in the purchase or sale of the stock or assets of an S-corporation.  S-corporations are known for their pass-through taxation and liability protection, but careful analysis and consideration are needed to ensure the correct outcome when an owner is looking to sell, or a buyer is looking to purchase an S-corporation.

Buying or Selling S-Corporation Stock

In a stock transaction for an S-corporation, the buyer acquires the ownership share of the company from the seller(s) and becomes the legal owner of the entity.  The entity continues to operate as it has but under new ownership.

The buyer will not receive a step-up in basis in a stock transaction and will inherit all the underlying assets and liabilities of the S-corporation that were in place at the transaction date.  The buyer’s basis in their S-corporation stock will be the amount that they paid for the stock.  Their basis will increase and decrease each year as the S-corporation passes through its income or losses or if the shareholder takes distributions out of the company. 

The seller will recognize gain on the difference between their purchase price and adjusted basis in the stock that they hold.  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 the years.  Understanding their tax basis is crucial for the seller in determining their gain on the sale of their stock.  The gain is generally taxed for Federal purposes at the capital gains rate of 20%, plus any state income tax for shareholders who live in jurisdictions with an income tax.  Depending on the level of involvement in the S-corporation, the selling shareholder(s) may also be subject to the 3.8% net investment income (NII) tax on passive activity.  If a shareholder can show active participation in the company, then the gain is exempt from NII tax.  However, if they are a passive investor then their gain could be subject to this additional tax.

Under a special rule, the buyer and seller can agree under Internal Revenue Code Section 338(h)(10) to treat the transaction as an asset sale instead.  This would change the tax implications for both the buyer and seller.  The buyer would get a step-up in basis in the underlying assets which would result in more ordinary deductions for the buyer.  Meanwhile, the seller would have some capital gain converted to ordinary income.  Generally, there is much negotiation around the purchase price if this election is made with the attempt to compensate the seller for the additional tax incurred.  The nuances of this election are outside the scope of this article.

Buying or Selling S-Corporation Assets

An asset transaction involves the transfer of the individual assets or group of assets of one business to another.  In some cases, a newly formed entity is created by the buyer and in other cases an existing business will purchase the assets and absorb them into their current operations.

The buyer of the assets will receive a step-up in basis in the tangible and intangible assets to fair market value based on the purchase price they paid for the asset which includes any assumed liabilities.  The tangible assets generally can be deducted as ordinary expense or through depreciation in a very short amount of time.  The intangible assets are amortized generally over a 15-year period from the date of the transaction.

The seller will have ordinary income and capital gain income passed through to them from the S-corporation as dictated by the purchase price allocation that is discussed below.  The ordinary income items will be taxed at the seller’s marginal tax rate.  The capital gain income will be taxed at the lower preferred tax rate that is usually 20%.  As mentioned above, the participation of the seller in the business will determine if any of the capital gain income will also be subject to the 3.8% NII tax.  If the seller lives in a state with an income tax the pass-through income will be taxed by that state.  Some states do allow for certain pass-through gains to be exempt from income.

One of the main points of contention in an asset deal involving an S-corporation is the allocation of the purchase price.  It is more advantageous to the buyer to allocate more purchase price to ordinary income items such as inventory or tangible property (such as equipment and furniture and fixtures).  The allocation of purchase price to ordinary income items allows the seller to take deductions for these items much earlier after the transaction than they do when the purchase price is allocated more to intangible assets.  On the other hand, the seller wants more of the purchase price allocated to intangible assets and goodwill so that more of the gain is taxed at the lower capital gains rates.  The allocation of the purchase price should be negotiated and agreed upon by both parties prior to the closing of the transaction.  Ultimately, the allocation of the sales price between asset types must be reported on the Form 8594 Asset Acquisition Statement when the buyer and seller file their federal tax returns for the year. The Form 8594 shows the final purchase price allocation between 7 different asset classes and typically the buyer and seller forms need to mirror each other for each asset class. We highly recommend that the purchase price allocation between the asset classes be discussed and agreed upon prior to closing the transaction in order to avoid potential conflicting information when the Form 8594 is filed.  We have seen business owners not spend enough time around this part of the transaction or leave the allocation schedules open-ended which ultimately could cause them to pay much more in tax than they had planned.

One other item that the seller needs to consider is the built-in gains tax (BIG) rules for S-corporations.  S-corporations that have previously been taxed as C-corporations may be subject to BIG tax if/when they sell appreciated assets within a five-year window of converting to an S-corporation.  The gain is based on the difference between the fair value of the asset(s) sold at the time of the S-election and the tax basis of the assets at the time of the S-election.  If an S-corporation is subject to BIG tax, then the tax is treated as if the assets were sold by a C-corporation and the entity pays the tax.  The ins and outs of this issue are beyond the scope of this article but should be considered when an S-corporation is trying to sell its assets.

Example:

Facts:

Company A has agreed to purchase Company B for $500,000; both companies are S corporations.  The shareholders of both companies want to understand the tax implications of both types of transactions.  They have agreed to a purchase price allocation of $400,000 for the equipment and $100,000 for goodwill.  The equipment of Company B has no tax basis due to prior depreciation taken.  The shareholders of Company B have zero basis in their stock of the company before the transaction.

For purposes of this example, it is assumed that the marginal tax rate on ordinary income is 37% and the S corporation income would qualify for the Section 199 (Qualified Business Income) deduction, resulting in a net marginal Federal rate on ordinary income of 29.6%.   It is also assumed that neither the income from the S corporation activity nor the sale of assets would be subject to the 3.8% Net Investment Income Tax (NIIT).  The lower tax rate on capital gains related to the sale of the underlying goodwill is ignored due to immateriality.  An effective state tax rate of 4% is applied, net of Federal tax benefit, if any.

The table below summarized the tax implications of this transaction:

Asset Transaction

Stock Transaction

*Note: The tax savings of depreciation and amortization will be received over time based on the tax law in effect at the time of the transactions.  For 2023, the depreciation on the stepped-up basis would be the bonus depreciation in year one and the remaining over the tax recovery period of the assets.  For amortization of goodwill and intangibles, the deduction will be received over a fifteen-year period. The above example also assumes that the shareholders in each transaction are non-passive investors and therefore are not subject to the additional 3.8% NII tax

We can help

At Elliott Davis, our closely held business and transaction advisory services teams have years of experience working with customers 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.

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.