S‑Corp Exit Taxes — Stock Sale vs. Asset Sale

When an S corporation owner exits, the deal can be structured as either a sale of the corporation’s stock (the shareholder sells shares) or a sale of the corporation’s assets (the corporation sells assets and then typically distributes proceeds). The federal and state tax consequences differ materially across these structures for both seller and buyer. Below is a detailed comparison of the key mechanics, tax results, and available elections, with links to governing authorities.

Stock sale by the S‑corporation owner

• Seller tax result:

  • A direct sale of S‑corporation stock by the shareholder generally produces capital gain or loss measured by the amount realized less the shareholder’s stock basis. Stock basis is maintained under S‑corporation rules (adjusted annually for flow‑through items and distributions). See Internal Revenue Code (IRC) section 1367 and IRS Publication 551 (Basis of Assets) for basis rules and adjustments:

    • IRC § 1367 IRC § 1367: https://www.law.cornell.edu/uscode/text/26/1367

    • Publication 551: https://www.irs.gov/publications/p551

  • The installment method is generally available to report gain over time (unless excluded, e.g., marketable securities). See IRC § 453 IRC § 453 and IRS Publication 544 (Sales and Other Dispositions of Assets):

    • IRC § 453 IRC § 453: https://www.law.cornell.edu/uscode/text/26/453

    • Publication 544: https://www.irs.gov/publications/p544

• Corporation tax result:

  • A stock sale by the shareholder does not itself trigger corporate‑level tax. However, an S corporation may owe entity‑level tax in limited cases (e.g., built‑in gains tax or passive investment income tax when applicable). See IRS S Corporations overview:

    • IRS S Corporations: https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations

• Buyer tax result:

  • Buyer acquires the shares. There is no step‑up in the corporation’s underlying asset basis (no “inside” basis increase), which may reduce post‑closing depreciation/amortization benefits and carries forward historical tax attributes and potential contingent liabilities. See Publication 551:

    • https://www.irs.gov/publications/p551

Optional elections to mimic asset sale in a stock deal

• Section 338(h)(10) election:

  • If the buyer makes a qualified stock purchase, the buyer and the S‑corp shareholders can jointly elect under IRC § 338(h)(10) IRC § 338(h)(10) to treat the stock acquisition as if the target sold its assets in a deemed sale and then liquidated, with the buyer treated as acquiring assets with a stepped‑up basis. See Treasury regulations:

    • Reg. § 1.338(h)(10)‑1: https://www.law.cornell.edu/cfr/text/26/1.338(h)(10)-1

    • Reg. § 1.338‑0 (overview): https://www.law.cornell.edu/cfr/text/26/1.338-0

• Section 336(e) election:

  • Alternatively, under IRC § 336(e) IRC § 336(e), the seller (or S‑corp shareholders) can elect to treat a qualified stock disposition as a deemed sale of assets by the target, followed by a deemed liquidation. See regulations:

    • Reg. § 1.336‑2: https://www.law.cornell.edu/cfr/text/26/1.336-2

These elections allow buyers to obtain an asset step‑up while sellers execute a stock sale. They also import the asset‑sale tax consequences (e.g., potential depreciation recapture at the corporate level) into the stock transaction by deeming an asset sale.

Asset sale by the S corporation

• Corporation tax result:

  • The S corporation recognizes gain or loss on each asset sold; the character depends on the asset (e.g., capital gain vs. ordinary income). Depreciation recapture rules (e.g., IRC § 1245 IRC § 1245, § 1250) convert part of the gain into ordinary income where applicable. See Publication 544 and the Code:

    • Publication 544: https://www.irs.gov/publications/p544

    • IRC § 1245 IRC § 1245: https://www.law.cornell.edu/uscode/text/26/1245

    • IRC § 1250 IRC § 1250: https://www.law.cornell.edu/uscode/text/26/1250

  • These recognized items generally flow through to shareholders. Also check exposure to S‑corp built‑in gains or passive income taxes where applicable (see IRS S Corporations page):

    • https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations

• Shareholder tax result on distributions:

  • If proceeds are distributed without a complete liquidation, the distribution is governed by IRC § 1368 IRC § 1368: first against the accumulated adjustments account (AAA) as a tax‑free reduction of stock basis, then as a dividend to the extent of accumulated earnings and profits (AE&P), and finally as gain to the extent distributions exceed stock basis. See:

    • IRC § 1368 IRC § 1368: https://www.law.cornell.edu/uscode/text/26/1368

    • Reg. § 1.1368‑1: https://www.law.cornell.edu/cfr/text/26/1.1368-1

    • Reg. § 1.1368‑2: https://www.law.cornell.edu/cfr/text/26/1.1368-2

  • If the asset sale is followed by a complete liquidation, shareholders are treated as exchanging stock for liquidating distributions under IRC § 331 IRC § 331 (generally capital gain or loss), and the corporation recognizes gain or loss on property distributed in liquidation under IRC § 336 IRC § 336. See:

    • IRC § 331 IRC § 331: https://www.law.cornell.edu/uscode/text/26/331

    • IRC § 336 IRC § 336: https://www.law.cornell.edu/uscode/text/26/336

  • Noncash property distributed in complete liquidation is treated as sold at fair market value by the corporation; shareholders recognize capital gain/loss on the liquidation. See IRC § 336 IRC § 336 and Publication 544:

    • https://www.law.cornell.edu/uscode/text/26/336

    • https://www.irs.gov/publications/p544

• Buyer tax result:

  • Buyer receives a step‑up in the basis of acquired assets to fair market value and allocates purchase price among assets under the purchase‑of‑business allocation rules, enhancing future depreciation/amortization. See Publication 551:

    • https://www.irs.gov/publications/p551

Installment sale nuances for asset sales

• If the S corporation sells assets for an installment note, the installment method applies to the corporate‑level gain, subject to IRC § 453 IRC § 453 limitations (e.g., inventory and certain securities). See:

  • IRC § 453 IRC § 453: https://www.law.cornell.edu/uscode/text/26/453

  • Publication 544: https://www.irs.gov/publications/p544

• If the corporation liquidates and distributes installment obligations to shareholders, special rules apply:

  • IRC § 453(h) IRC § 453(h) generally allows the shareholders to treat payments received under such obligations as received for stock in a liquidating § 331 exchange, reported over time. See IRC § 453(h) IRC § 453(h):

    • https://www.law.cornell.edu/uscode/text/26/453

  • For S corporations, IRC § 453B(h) IRC § 453B(h) provides that no gain or loss is recognized by the distributing S corporation on installment obligations distributed in complete liquidation (for subchapter C purposes), and the character of shareholder income follows subchapter S principles. See IRC § 453B IRC § 453B and regulations:

    • https://www.law.cornell.edu/uscode/text/26/453B

Buyer vs. seller preferences: key tax tradeoffs

• Buyer preferences:

  • Buyers often prefer asset purchases (or stock purchases with a § 338(h)(10) or § 336(e) election) to secure a stepped‑up asset basis and avoid historical tax exposures embedded in the entity. See Publication 551 for allocation/step‑up implications:

    • https://www.irs.gov/publications/p551

• Seller preferences:

  • Sellers often prefer stock sales: gain is typically capital (subject to basis), the transaction is simpler, and there is usually no depreciation recapture at the shareholder level. Conversely, asset sales can produce ordinary income via recapture for the corporation (which flows through to shareholders) and may trigger the S‑corp built‑in gains tax if applicable. See Publication 544 and IRS S Corporations:

    • https://www.irs.gov/publications/p544

    • https://www.irs.gov/businesses/small-businesses-self-employed/s-corporations

Distributions and AAA mechanics after an asset sale

• Nonliquidating distributions after an asset sale:

  • Apply IRC § 1368 IRC § 1368 ordering: AAA first (tax‑free to the extent of basis), then AE&P dividends, then gain to the extent distributions exceed stock basis. See:

    • IRC § 1368 IRC § 1368: https://www.law.cornell.edu/uscode/text/26/1368

    • Reg. § 1.1368‑1: https://www.law.cornell.edu/cfr/text/26/1.1368-1

    • Reg. § 1.1368‑2: https://www.law.cornell.edu/cfr/text/26/1.1368-2

  • For examples and timing rules, see Reg. § 1.1368‑3:

    • https://www.law.cornell.edu/cfr/text/26/1.1368-3

• Complete liquidation after an asset sale:

  • Shareholders recognize capital gain or loss on liquidating distributions under IRC § 331 IRC § 331; the corporation recognizes gain or loss on distribution of property to shareholders under IRC § 336 IRC § 336. See:

    • IRC § 331 IRC § 331: https://www.law.cornell.edu/uscode/text/26/331

    • IRC § 336 IRC § 336: https://www.law.cornell.edu/uscode/text/26/336

Redemptions and alternative exit paths

• If the corporation redeems the owner’s shares instead of a third‑party sale, IRC § 302 IRC § 302 determines whether the redemption is treated as an exchange (capital) or as a dividend; facts (ownership reduction, attribution, termination of interest) control the characterization. See:

  • IRC § 302 IRC § 302: https://www.law.cornell.edu/uscode/text/26/302

  • Reg. § 1.302‑1: https://www.law.cornell.edu/cfr/text/26/1.302-1

• Dividend‑type redemptions are taxed under IRC § 301 IRC § 301; partial liquidations and complete liquidations follow §§ 302(e) and 331 rules, respectively. See:

  • IRC § 301 IRC § 301: https://www.law.cornell.edu/uscode/text/26/301

  • IRC § 331 IRC § 331: https://www.law.cornell.edu/uscode/text/26/331

California considerations (brief)

• California generally conforms to federal characterization of gains and losses and uses apportionment rules for multistate business income. If there is California source or apportionable business income, California may tax flow‑through gains from an asset sale and capital gains on stock sales according to its apportionment/allocation rules. See California Schedule R (Apportionment and Allocation of Income) instructions (Form 100/100S Schedule R):

  • FTB Schedule R (Form 100/100S) booklet: https://www.ftb.ca.gov/forms/2024/2024-100-r.pdf

Summary comparison

• Stock sale (no election):

  • Seller: generally capital gain on stock; installment reporting may be available (IRC § 453 IRC § 453).

  • Corporation: no asset step‑up; no corporate‑level recognition solely due to stock sale; monitor built‑in gains/passive income regimes (IRS S Corporations).

  • Buyer: no asset step‑up; inherits entity attributes (Publication 551).

• Asset sale:

  • Corporation: recognizes gain/loss and any recapture; items flow through; potential entity‑level tax on built‑in gains (Publication 544; IRS S Corporations).

  • Shareholders: taxed on flow‑through; distribution governed by § 1368 or § 331 if liquidating (IRC §§ 1368, 331).

  • Buyer: asset step‑up with purchase price allocation (Publication 551).

• Stock sale with asset‑sale election:

  • With § 338(h)(10) or § 336(e), parties can make a stock deal tax‑equivalent to an asset sale: target deemed to sell assets and liquidate; buyer gets stepped‑up basis (Reg. § 1.338‑0; Reg. § 1.336‑2; Reg. § 1.338(h)(10)‑1).

Practical decision drivers

• If maximizing buyer’s future deductions (via asset basis step‑up) is critical, an asset sale or a stock sale with a § 338(h)(10)/§ 336(e) election is often preferred. Expect corporate‑level recognition and potential ordinary recapture. See Publication 544; Reg. § 1.338‑0; Reg. § 1.336‑2:

  • https://www.irs.gov/publications/p544

  • https://www.law.cornell.edu/cfr/text/26/1.338-0

  • https://www.law.cornell.edu/cfr/text/26/1.336-2

• If minimizing seller tax (capital gain, avoiding ordinary recapture) and simplifying the transaction is paramount, a pure stock sale may be preferred, subject to buyer’s willingness to accept no asset step‑up. See Publication 551:

  • https://www.irs.gov/publications/p551

• Coordinate post‑sale distributions with AAA and § 1368 ordering, or complete liquidation under §§ 331/336 to finalize the exit tax profile (IRC §§ 1368, 331, 336):

  • https://www.law.cornell.edu/uscode/text/26/1368

  • https://www.law.cornell.edu/uscode/text/26/331

  • https://www.law.cornell.edu/uscode/text/26/336

This essay is not tax advice. Always consult a qualified tax professional for your specific situation.