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

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Photo of James Duffy James Duffy

Jim is a partner in Taft’s Tax practice and practices principally in the areas of federal tax law; tax credit financing; individual, partnership and corporate tax planning; M&A; tax-exempt organizations and general commercial and corporate law.

Jim has been actively practicing in the

Jim is a partner in Taft’s Tax practice and practices principally in the areas of federal tax law; tax credit financing; individual, partnership and corporate tax planning; M&A; tax-exempt organizations and general commercial and corporate law.

Jim has been actively practicing in the area of the New Markets Tax Credits (NMTC) program since its inception in 2001. He has organized community development entities (CDEs) and represented CDEs, borrowers and other parties in structuring and closing numerous NMTC transactions. Jim also advises clients regarding Qualified Opportunity Zone matters.

Jim advises LLCs, partnerships, corporations and individuals in connection with the formation of new companies, mergers and acquisitions, formation of joint ventures, like-kind exchanges, ownership succession planning, and general business operations. These clients are involved in a variety of industries, including banking, venture capital, real estate, construction, consulting and investing.

Jim also advises charitable and non-charitable tax-exempt organizations, including health care entities, schools, religious and civic organizations. In addition to advising management of these organizations with respect to matters pertaining to general operation and maintenance of tax-exempt status, Jim has assisted clients in forming, restructuring and dissolving tax-exempt organizations, as well as forming donor- advised funds.

Prior to joining the firm, Jim worked at the law firm of Lewis Rice and Fingersh in St. Louis, Missouri, where he concentrated his practice in federal and state taxation. He also clerked for the Hon. Robert P. Ruwe of the U.S. Tax Court in Washington, D.C.