When an S corp seeks to wind up its affairs by selling assets in an installment sale and then liquidating, the distribution of the note along with other property (e.g., cash retained or downpayment) can trigger unintentional acceleration of tax on the deferred gain.
The Internal Revenue Code provides that an S corp may distribute an installment note to its shareholders in liquidation without triggering tax on the deferred gain from the note. However, for those seeking to take advantage of this provision, there is a trap for the unwary. The trap results from a requirement that the shareholders’ basis in their stock be allocated among the assets received pro rata based on relative value.
For example, consider an installment sale without liquidation. Assume an S corp has one shareholder with a tax basis in her stock of $1 million, and the S corp’s only asset is land with a basis of $1 million, which it sells for $2 million consisting of $1 million cash plus a $1 million note. Under the installment sale rules, the S corp would be taxable on $500,000 of gain. The gain increases the shareholder’s basis to $1.5 million. The S corp could distribute the $1 million to the shareholder with no additional tax (since the cash distributed does not exceed the shareholder’s tax basis).
By contrast, if the S corp distributed the cash and the note to the shareholder in liquidation, only ½ of the shareholder’s basis is allocated to the cash, and she would have taxable gain to the extent the cash exceeded ½ of her basis (i.e., $750,000). Thereby triggering tax on an additional $250,000 gain.
This unpleasant result can often be avoided using a “one-day” note. This structure pays 100% of the price with an installment note. The portion of the purchase price that otherwise would have been paid in cash at closing is paid “one day“ after (or shortly after) the S corp liquidates. The deferred gain in the note is not taxable on the distribution, and when the first payment is made, only $500,000 (rather than $750,000) of gain is subject to tax.
Bottom Line: If an S corp will receive an installment note in the asset sale and then liquidate, using a ” one-day” note can avoid accelerating tax upon liquidation.
“The trick is to stop thinking of it as ‘your’ money.” – IRS auditor