Stock Purchase & Assets Sale

[Taxizen]

The client approached me with this question.

He will buy the stock of the company (C corp) with depreciated assets (basis -0-) and change the entity to S corp and will sell the business in two years.

Let's assume the stock purchase price is $50,000.

When he sells the business for $50,000 by aseets sales, he will have $50,000 of ordinary income (depr recapture). But his basis becomes $50,000 after adjustment ($50,000 stock purchase + $50,000 oridnary income - $50,000 distribution). Since he close the busienss, he will end up with capital loss of $50,000 (0 - $50,000). Net result is 0.00 in the long run.

In this scenario, the seller saves taxes on ordinary income (depr recapture), the buyer has no tax effect.

Are there any problems in this scenario?

Any experience comment is appreciated.

[jainen]

>>When he sells the business for $50,000 by assets sales, he will have $50,000 of ordinary income (depr recapture)<<

No, HE won't. The corporation will have income that it will pass through on the K-1 prior to the liquidating distribution of all cash. Unless the corporation distributes the property in liquidation at FMV and he then sells the zero basis assets. Or he might just be selling the stock. Anyway, he can't mix & match.

[Taxizen]

>>When he sells the business for $50,000 by assets sales, he will have $50,000 of ordinary income (depr recapture)<<

No, HE won't. The corporation will have income that it will pass through on the K-1 prior to the liquidating distribution of all cash. Unless the corporation distributes the property in liquidation at FMV and he then sells the zero basis assets. Or he might just be selling the stock. Anyway, he can't mix & match.

Yes, I mixed it.

But, by selling all assets, all gains pass through to K-1 which is ordinary income (right?). Prior to liquidating the business, his basis becomes $100,000 (50,000 + 50,000). When he liquidates and receives cash $50,000, then he will end up with $50,000 capital loss (50,000 - $100,000). The original seller saves taxes by selling stock rather than all assets. Good strategy to save taxes right?

[jainen]

>>his basis becomes $100,000 (50,000 + 50,000)<<

This is not a partnership. Gain or loss within a corporation does not affect a shareholder's basis in the stock. He gets taxed on the $50,000 gain that is passed through, and then presumably breaks even on the liquidation which he treats as a sale of stock.

[Taxizen]

>>his basis becomes $100,000 (50,000 + 50,000)<<

This is not a partnership. Gain or loss within a corporation does not affect a shareholder's basis in the stock. He gets taxed on the $50,000 gain that is passed through, and then presumably breaks even on the liquidation which he treats as a sale of stock.

As I know, separately stated items of income and gains such as interest, dividends, capital gains, rental income, tax emempt income, etc. increases the stcok basis. am I wrong?

[jainen]

>>increases the stcok basis<<

Yes, I stated that wrong. The flaw in the plan is not the shareholder's basis in stock, but the C-corp's basis in the assets. Since it is less than FMV at the time of S-corp election, their sale generates an additional 35% built-in gains tax.

[Taxizen]

>>increases the stcok basis<<

Yes, I stated that wrong. The flaw in the plan is not the shareholder's basis in stock, but the C-corp's basis in the assets. Since it is less than FMV at the time of S-corp election, their sale generates an additional 35% built-in gains tax.

That is a good point. However, what if he structure assets sales as follows: all assets are sold for zero and goodwill is $50,000 since all assets are depreciated and market value is zero.

Is the S corp still subject to built in gain tax?

[jainen]

>>what if he structure assets sales as follows: all assets are sold for zero and goodwill is $50,000 since all assets are depreciated and market value<<

In that case, based on what was stated in the original post, I would withdraw from the engagement.

[Taxizen]

This is tax plan. It has not happened yet.

Is there any comment on this plan?

[kcjenkins]

My comment would be that you are asking us about filing a fraudulent return, so of course we would not advise that.

You told us that the assets could be sold as an asset sale for $50K and now you say that they are worthless? Come on, that plan stinks to high heaven. He should buy the assets only, not the corp, is the best advice to give him. Not only because of the valuation of the assets, but also because when you buy a corp, you are buying any hidden problems that the corp might turn out to have. If all it has of value is the real estate or the equipment, just buy those. Especially when you plan to sell it in just a few years. There is no LEGAL way to get around the BIG tax in the situation you presented.

[Taxizen]

I agreed that I explored the tax plan beyond the point. However, if there is a loophole in tax matter, it should be corrected by the tax law. As an accountant, I have to inform what the tax consequences are if the taxpayer follows this way or that way.

I appreciate your responses up to now.

[jainen]

>>if there is a loophole in tax matter, it should be corrected by the tax law<<

Now, that's just a political opinion so you are welcome to it. But your next sentence violates ethics code and law. Your last scenario only works if the taxpayer doesn't get caught, and that is not "a loophole."

[OldJack]

Without looking at detail numbers at date of S-corp election and the tax deduction effect, Lets look at it this way:

The 1120S for the year of sale would report a built-in gain of $50,000 and the S-corp would have to pay the C-corp tax on page 1 of the 1120S tax form AND the Shareholder 1120S-K1 would also report a $50,000 pass thru gain the shareholder who would have to report (probably on their attached form 4797) on the 1040 as ordinary income. That is the old double tax and there is no way to get around it.

Therefore, the corporation paid ordinary income tax rates (since there is no Corp capital gains tax rate), and the shareholder paid ordinary income tax rate on the same gain. Any liquidating capital loss would be limited to capital gain offset (not the ordinary gains) or a max of $3,000 per year deduction. How would you think there is any tax savings for your client?

[kcjenkins]

I agreed that I explored the tax plan beyond the point. However, if there is a loophole in tax matter, it should be corrected by the tax law. As an accountant, I have to inform what the tax consequences are if the taxpayer follows this way or that way.

I appreciate your responses up to now.

I have to disagree partially with the bolded statement above. An accountant can ethically only inform the client of LEGAL OPTIONS, and reporting asserts which you told us have a FMV of $50K. as having no value is not such an option. Removing the wolf at the door by calling it a dog is not an option you can ethically advise.

[Taxizen]

I have to disagree partially with the bolded statement above. An accountant can ethically only inform the client of LEGAL OPTIONS, and reporting asserts which you told us have a FMV of $50K. as having no value is not such an option. Removing the wolf at the door by calling it a dog is not an option you can ethically advise.

I don't have correct data. I just assumed the tax scenarios. That's why I told you I explored the matter beyond the point. Now, we get to the point how we value assets at FMV and who decides it

[Taxizen]

Without looking at detail numbers at date of S-corp election and the tax deduction effect, Lets look at it this way:

The 1120S for the year of sale would report a built-in gain of $50,000 and the S-corp would have to pay the C-corp tax on page 1 of the 1120S tax form AND the Shareholder 1120S-K1 would also report a $50,000 pass thru gain the shareholder who would have to report (probably on their attached form 4797) on the 1040 as ordinary income. That is the old double tax and there is no way to get around it.

Therefore, the corporation paid ordinary income tax rates (since there is no Corp capital gains tax rate), and the shareholder paid ordinary income tax rate on the same gain. Any liquidating capital loss would be limited to capital gain offset (not the ordinary gains) or a max of $3,000 per year deduction. How would you think there is any tax savings for your client?

As I know, the BIG treatment (35% tax rate on the company level) increases the basis of assets. So, there is no ordinary income tax on the same gain. I am not sure about this. Any comment would be appreciated.

I thought about limitation of $3,000 per year. In addition to the BIG tax, this is another disadvantage on the seller's side.

[OldJack]

As I know, the BIG treatment (35% tax rate on the company level) increases the basis of assets. So, there is no ordinary income tax on the same gain. I am not sure about this. Any comment would be appreciated.

I thought about limitation of $3,000 per year. In addition to the BIG tax, this is another disadvantage on the seller's side.

Read my post again. Read form instructions. The corp has to report the sale of depreciable assets on form 4797 attached to the 1120S. Such gain flowing thru 4797 reports on the 1120S and the K-1 for shareholder taxation as ordinary income. The corp pays the Big Tax on the 1120S page 1 as calculated on form 1120S, Sch-D (Sch-D gain is taxed at ordinary income tax rates). Unless you wait 10 years for the sale you get double tax on the same gain. That results in taxes as though you were still a C-corp plus the shareholder's tax. Of course since the BIG is calculated on FMV of assets at date of S-corp election, the Built-In-Gain may be a different amount than the gain calculated on the date of sale.

In the old days a C-corp could avoid the double tax by simply liquidating with only the shareholder paying a tax. When they repealed the old law, they created the BIG tax as it had to be this way or every C-corp would simply elect S-corp status prior to liquidating. I am sure about this as I have years of experience doing it!

The BIG tax itself has nothing to do with increasing asset basis, however, it does involve the tax calculation as basically it is a tax deduction. The k-1 pass thru gain is what increases the shareholder's tax basis.

Since your client is purchasing stock, selling assets and liquidating the corp, you may have a C-corp retained earnings that may result in ordinary dividends when money is taken out. You best make sure you understand the entire detail tax situation before you advise a client.

[jainen]

>>make sure you understand the entire detail tax situation<<

...which you will never accomplish trading forum posts with jainen. Everything he says is a what if an' it ain't gonna work.

[OldJack]

>>make sure you understand the entire detail tax situation<<

...which you will never accomplish trading forum posts with jainen. Everything he says is a what if an' it ain't gonna work.

Well... Old Supreme ATX Master, you finally gave me another thing to disagree with you! After carefully reviewing a years worth of Jainen posts, on this forum, I can clearly say Jainen knows something that will help somebody!

I will add that the Small Business Quickfinder Handbook gives a very simple example and explanation of the BIG tax on page D-6 and D-7. Another example of how the Quickfinder tax books are so much better than all the other so called tax books. No I have no connection with Quickfinder.