If you own an S corporation and decide to sell it, the tax treatment of the sale to you as the business owner depends on how the sale is structured. "Selling a business" can mean selling all the assets of the business to another company so that nothing is left of the business but the name; or, it can mean selling all the shares of stock in the business, so that you no longer have any ownership interest in the business itself.
What is a Sub Chapter S Corporation?
An S corporation is a small business that files a Form 2553 to elect sub chapter S status, which means that the income of the corporation, as well as the losses, deductions and credits, pass through the corporation to the shareholders. The shareholders report the income and losses on their personal tax returns rather than on the corporate tax return, avoiding double taxation. A company can only file as an S corporation if there are 100 shareholders or fewer with only one class of stock. Further, none of the shareholders of an S corporation can be partnerships, corporations or non-resident aliens.
If the shareholders want to sell the S corporation, they can choose to either sell the assets of the business or sell their stock in the business.
Sale of Corporate Stock
If an S corporation's shareholders sell all their stock, the income is taxed as a capital gain. Your capital gain is the amount you made on the sale minus any amounts you contributed to the capital asset (the cost basis). If you're a shareholder of an S corporation, the stock basis must be reduced by the amount of any distributions you've received that were not included in your personal income, because your distributions are considered return of the capital you invested.
For example, if you contributed $10,000 to your S corp in 2017 but received $8,000 in distributions, your cost basis is only $2,000, and if you sell your stock, the proceeds in excess of $2,000 are taxed as gains. You must also decrease your basis by certain types of the S corporation's losses, certain nondeductible expenses, and certain deductions for depleting oil and gas wells.
Your basis in stock cannot be reduced below zero.
If you've owned your stock for more than one year, any gain on the sale is considered a long-term gain. If you've owned your stock for less than one year, the gain is a short-term gain.
Capital gains can be reduced by capital losses. Capital losses occur when you dispose of assets for less than the price you paid for them. For example, if you buy stock for $100 and sell it for $150, your capital gain is $50; but if you sell different stock that same year, and the basis for that stock was $100 but you sold it for $75, you had a $25 capital loss, which reduces your total capital gain for the year to $25 (the $50 gain on the one stock, minus the $25 loss on the second stock).
Capital gains tax has the benefit of typically being much lower than income tax assessed against wages. As of the 2017 tax year, capital gains are taxed at no more than 20 percent, depending upon your tax bracket. Individuals in the lowest two tax brackets do not pay capital gains tax, and in the middle brackets, the tax is 15 percent. Therefore, if you are the sole shareholder of an S corporation and you sell all your stock, you will be taxed on the proceeds as capital gains to the extent that it exceeds any capital losses.
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Sale of Corporate Assets
If the sale of the S corporation is an asset sale, the taxes must be calculated individually for each asset. To do so, each asset is classified into different classes of assets. Examples of classes of assets include most commonly Class I (cash and bank accounts), Class III (receivables), Class IV (inventory) and Class V (equipment, fixtures, furniture, buildings, land and any other assets not specified in another class). You must then figure out the cost basis for each asset sold and calculate the actual gains on each asset to determine the taxable amount. Generally, the profit is taxed as capital gains.
Certain assets, like accounts receivable, do not have a tax basis, as nothing was contributed to obtain them, and the sale of these assets is taxed as ordinary income and not as capital gains.
Some profits from certain tangible assets subject to depreciation, such as equipment and real estate, may be taxed as ordinary income to recapture depreciation. Your depreciation deductions reduce your taxable income, so when the asset is sold at a profit, that depreciation must be recaptured. To recapture depreciation, the portion of the profits that were claimed as depreciated in prior years is taxed as ordinary income, and the rest as capital gains.
For example, if you purchased a building for $100,000 in 2014 and claimed a depreciation deduction of $10,000 in 2015 and $15,000 in 2016, your total depreciation deduction is $25,000 when you sell the asset in 2017. If you sell the asset in 2017 for $175,000, your total gain is $75,000, of which $25,000 will be taxed as ordinary income (the depreciation recapture) and $50,000 will be taxed as a long-term capital gain.
- Tax Policy Center: How Are Capital Gains Taxed?
- IRS.gov: Tax Topic 409 - Capital Gains and Losses
- IRS.gov: Sale of a Business
- IRS.gov: Publication 544 (2017) - Sales and Other Dispositions of Assets
- IRS.gov: Publication 550 (2016) - Investment Income and Expenses
- IRS.gov: Form 2553 - Election by a Small Business Corporation