Tax Consequences of an S Corp Installment Sale of Assets

An S corporation selling its assets through an installment sale involves a transaction where the business receives payments from the buyer over a period of years. This structure is defined by the receipt of at least one payment after the tax year in which the sale occurs. The primary appeal of this method is tax deferral, allowing the recognition of gain and its corresponding tax liability to be spread over the same period payments are received. While this method can defer a large portion of the tax liability, not all gains qualify for this treatment, and certain income must be recognized immediately in the year of the sale.

Calculating and Characterizing the Gain at the Corporate Level

The first step in understanding the tax outcome of an asset sale is to determine the total gain. This process begins by allocating the total purchase price among the various assets being sold. A buyer and seller will agree on this allocation in the purchase agreement, as different assets receive different tax treatment. Assets commonly sold include tangible property like machinery and buildings, as well as intangible assets such as goodwill or customer lists.

Once the price is allocated, the S corporation calculates the gain for each asset by subtracting its adjusted tax basis from the sales price allocated to it. The sum of these individual gains constitutes the total gain on the sale. From this, the corporation determines its gross profit percentage, calculated by dividing the gross profit from the sale by the total contract price. This percentage dictates the portion of each principal payment that must be recognized as gain.

A portion of the gain may not be eligible for deferral and must be recognized as ordinary income in the year of the sale due to depreciation recapture rules. One rule applies to tangible personal property, such as equipment, and requires that any gain attributable to previously claimed depreciation be taxed as ordinary income. Another rule applies to real property but recaptures only the amount of depreciation taken in excess of the straight-line method.

The gain that must be recognized immediately due to depreciation recapture is reported in the year of the sale. Any remaining gain, often classified as a Section 1231 gain, is treated as long-term capital gain. This capital gain portion is what qualifies for reporting under the installment method. Gains from the sale of assets like inventory are also ineligible for installment reporting and are taxed as ordinary income in the year of the sale.

S Corporation Level Taxes on the Sale

While S corporations are pass-through entities that typically do not pay federal income tax themselves, there are exceptions, such as the Built-In Gains (BIG) Tax. This corporate-level tax applies to S corporations that were previously C corporations. The tax is designed to prevent C corporations from avoiding corporate-level tax on appreciated assets by converting to an S corporation before a sale.

The BIG tax is imposed if the S corporation sells assets that had appreciated in value at the time of the C-to-S conversion. This tax applies to dispositions of such assets that occur within a 5-year recognition period beginning on the first day the S election is effective. The tax is calculated at the highest corporate tax rate, which is 21 percent, on the net recognized built-in gain for the year.

The installment sale method has a unique interaction with the BIG tax. If an S corporation sells an asset with a built-in gain during the 5-year recognition period and receives payments under an installment note, the gain is subject to the BIG tax as the payments are received. This holds true even if some or all of the payments are received after the 5-year recognition period has expired.

To calculate the BIG tax on an installment sale, the corporation applies the built-in gain rules as if the entire gain had been reported in the year of the sale. However, the tax itself is only triggered as installment payments are received. The amount of gain from each payment that is subject to the BIG tax is determined by the gross profit percentage, limited to the total built-in gain that existed on that asset at the time of the S corporation conversion.

Shareholder-Level Tax Consequences

After accounting for any corporate-level taxes, such as the built-in gains tax, the remaining gain and interest income from the installment sale pass through to the S corporation’s shareholders. The character of the gain, whether ordinary or capital, is determined at the corporate level and retains that character when it flows to the owners. Each shareholder is notified of their pro-rata share of these items on Schedule K-1.

Shareholders are responsible for reporting their portion of the gain as the corporation receives payments. This is done using Form 6252, Installment Sale Income. On this form, the shareholder will report their share of the gross profit and contract price. As each payment is made to the corporation, the shareholder will use the gross profit percentage to calculate the portion of the payment that represents taxable gain for that year.

Beyond the principal payments on the installment note, the buyer will also pay interest. This interest income is a separate component of the transaction and is also passed through to the shareholders. Each shareholder reports their pro-rata share as ordinary interest income on their personal tax return, and this interest is taxable in the year it is received by the corporation.

Liquidating the S Corporation After the Sale

A common strategy following an asset sale is for the S corporation to liquidate and distribute its remaining assets, including the buyer’s installment note, to its shareholders. Under general tax rules, the distribution of an installment obligation is treated as a disposition, which would typically accelerate the recognition of all remaining deferred gain at the corporate level. This would defeat the purpose of the installment sale deferral.

However, an exception allows an S corporation to distribute an installment obligation to its shareholders as part of a complete liquidation without triggering the immediate recognition of the deferred gain. For this exception to apply, the S corporation must adopt a plan of complete liquidation and complete the liquidation within the 12-month period beginning on the date the plan is adopted. The installment sale itself can occur before or after the plan is adopted.

Under this provision, the shareholders do not recognize gain upon receiving the note itself. Instead, they effectively step into the shoes of the corporation and continue to report the gain using the installment method as they personally receive payments from the buyer. The shareholders treat the payments received on the note as if they were payments for their stock in the liquidating corporation, allowing the tax deferral to continue uninterrupted at the shareholder level.