By James M. Kehl, CPA
Weil, Akman, Baylin & Coleman, P.A., Timonium, MD
The application of the installment sale rules to S corporation liquidations may result in an unexpected acceleration of gain to S corporation shareholders. This commentary will illustrate the application of these rules by providing examples comparing (i) the tax results realized by an S corporation that sells its assets in an installment sale and does not liquidate until the installment note is collected with (ii) the tax results realized by an S corporation shareholder who sells his or her stock, consents to a §338(h)(10) election, and receives an installment note as partial consideration in the sale.
Assume that X was incorporated in 2000, and has been an S corporation for its entire existence. X is owned 100% by shareholder A, who has a basis of $30,000 in the X corporation stock. On December 31, 2010, X has the following balance sheet:
Fair Market Value
X sells its land to an unrelated party for $50,000 consideration consisting of a $10,000 cash payment and a $40,000 note, which is due in 4 years and bears adequate stated interest that is payable annually. The S corporation reports the sale using the installment method. The realized gain and gross profit are $30,000 ($50,000 sales price minus $20,000 basis for the land). The gross profit percentage is 60% ($30,000 gross profit/$50,000 contract price). The installment sale gain reportable in the year of sale is $6,000 ($10,000 payment received x 60%). X passes this gain through to A, who reports the gain and increases his stock basis from $30,000 to $36,000. A then takes a distribution of $20,000 (the cash on hand of $10,000 plus $10,000 cash received in the sale), which reduces A's basis in the X corporation stock from $36,000 to $16,000.
For the next 3 years, X receives interest on the installment note and immediately distributes the interest to A. In year 4, the $40,000 note is paid, and X passes the installment sale gain of $24,000 (60% gross profit percentage times $40,000) through to A. A reports the $24,000 of income, which increases A's stock basis in X from $16,000 to $40,000, and then receives a liquidating distribution from X of $40,000. The liquidating distribution is tax-free because it is equal to A's basis in the X corporation stock. Ignoring the interest paid on the note, the results are that A has received $60,000 and reported total taxable gain of $30,000 ($6,000 in year of sale and $24,000 in the year the note was paid). These are the results one would expect.
Now, contrast the results described above with the results that occur if the unrelated buyer is a qualified corporate purchaser that purchases A's stock in X for $60,000, payable $20,000 in cash with the balance represented by a 4-year, $40,000 note. Further, assume that X adopts a plan of complete liquidation under §331 on the date of the sale and the parties make a valid §338(h)(10) election.
As a result of the §338(h)(10) election, X is treated as selling its assets for $60,000 in a single transaction to a new corporation. Under the §338(h)(10) regulations, the aggregate deemed sales price of $60,000 for X corporation's assets is allocated among the assets as follows: $10,000 to the cash and $50,000 to the land. A recognizes no gain or loss on the sale of its stock in X.1 In addition, X reports the sale of the land on the installment method.
Through this point in the analysis, the tax results realized in the second example are the same as those previously described. That is, X passes a gain of $6,000 through to A (60% gross profit percentage x $10,000 cash payment). A, in turn, reports the gain of $6,000 on his personal income tax return, which increases A's stock basis in X from $30,000 to $36,000. Further, X is treated as receiving the $60,000 of consideration in the asset sale, which consists of $20,000 of cash and the $40,000 note, and then distributing the consideration to A in a complete liquidation. Since the $40,000 installment obligation was received by X in a sale that occurred within the 12-month period beginning on the adoption of the plan of complete liquidation and X's liquidation was completed within 12 months after adoption of the plan, A's receipt of the installment note is not treated as a payment for A's stock in X.2 One also might expect A to receive a tax-free distribution of $20,000, reduce his basis in the S corporation stock from $36,000 to $16,000, and report the remaining taxable gain during the year the $40,000 installment note is paid. However, those are not the tax consequences of the transaction described in the second example.
Section 453(h)(2) states that, if an installment obligation is not treated as received as payment for stock under §453(h)(1) and, by reason of the liquidation, a shareholder receives property in more than one taxable year, the shareholder's basis in the stock of the liquidating corporation is to be allocated among the property received. Furthermore, Regs. §1.453-11(d) provides that a shareholder who receives liquidating distributions in more than one taxable year must "reasonably estimate the anticipated aggregate distributions" and "must reasonably estimate the gain attributable to distributions received in each taxable year." Example 10 of Regs. §1.338(h)(10)-1(e) illustrates this principle when it describes the tax consequences of a distribution to a shareholder who receives a qualifying installment note and real estate in a liquidation for which an election under §338(h)(10) has been made.
Applying the rules described in the preceding paragraph, in the second example, A's $36,000 basis in the stock of X must be allocated as follows: $12,000 to the cash distributed ($36,000 total basis x $20,000 cash/$60,000 total cash and installment note) and $24,000 to the installment note ($36,000 total basis x $40,000 installment note/$60,000 total cash and installment note). Therefore, when the $20,000 cash is distributed to A in the year of X Corporation's liquidation, A recognizes a gain of $8,000 ($20,000 cash received minus $12,000 of allocated basis). When the installment note of $40,000 is paid, A recognizes the remaining gain of $16,000 ($40,000 note collected minus $24,000 allocated basis).
To summarize, in the §338(h)(10) transaction, A recognizes a gain of $6,000 from the installment sale of property plus $8,000 of additional gain from the $20,000 cash distribution, for a total gain of $14,000 in the year of the liquidation; A recognizes the remaining gain of $16,000 in the year the installment note is paid. In contrast, if there is a sale of the property by X Corporation and X does not liquidate until the installment note is paid, A recognizes gain of $6,000 in the year of sale and $24,000 in the year the note is paid. Consequently, in the second example, i.e. the §338(h)(10) transaction, A recognizes $8,000 of gain sooner than if the property had been sold and the S corporation not liquidated until after the installment note was collected.
Given the typical preference of taxpayers to defer gain as long as possible, tax advisors evaluating a transaction of the type described in the two examples should be aware that, with careful planning, it may be possible to achieve the same tax result in the §338(h)(10) transaction as in the a case in which the S corporation sells its assets and liquidates after the installment note is collected. Specifically, consider the result if the §338(h)(10) transaction in the second example is modified as follows:
Prior to adoption of the plan of liquidation, X corporation makes a $10,000 distribution to A. This distribution is tax-free to A because it is treated as a return of stock basis. After the distribution, X owns land with a tax basis of $20,000 and a value of $50,000 and A has a $20,000 basis in the X stock.
Then, X corporation accepts an installment note from the buyer with modified terms, so that the $10,000 payment is due after the adoption of the plan of liquidation and the sale of A's stock in X. In other words, on the date of X corporation's deemed liquidation that occurs in connection with the §338(h)(10) election, the only asset that A will receive in the deemed liquidation is the $50,000 installment note. A's $20,000 tax basis in the X corporation stock will be allocated entirely to the note. The gross profit on the installment sale remains $30,000 ($50,000 contract price minus $20,000 basis), and the gross profit percentage continues to be 60% ($30,000 gross profit/$50,000 note). Consequently, when $10,000 of the note principal is collected, A will report income of $6,000 ($10,000 x 60%) and when the installment note is paid off, A will report the remaining income of $24,000 (60% x $40,000).
If the steps outlined above are taken, the same tax results will be achieved in the §338(h)(10) transaction as in the case in which X corporation sells its land, distributes its cash, and then delays its liquidation until the installment note is collected. However, without an understanding of the interplay between the rules governing installment sales and §338(h)(10) transactions, there is substantial risk that the taxpayer will not obtain the best tax outcome.
For more information, in BNA's Tax Management Portfolios, see Starr and Sobol, 731 T.M., S Corporations: Operations, and in Tax Practice Series, see ¶4280, Basis of Stock and Debt.
1 Regs. §1.338(h)(10)-1(d)(5)(iii).