Editor: Albert B. Ellentuck, Esq.
Unlike an asset sale, a taxable stock sale does not result in the recognition of taxable income or loss at the corporate level. The differences between the basis and fair market value (FMV) of corporate assets are deferred instead of recognized immediately, as they are in an asset sale. Although the selling shareholders may recognize taxable gain on the sale of their shares, the double-taxation problem is deferred and becomes the responsibility of the buyer (for the corporate portion of the double taxation).
In a taxable stock sale, the corporation’s tax attributes (net operating loss (NOL), capital loss, and tax credit carryovers and certain built-in losses) come under the control of the buyer. However, these tax attributes can be subject to severe restrictions after a corporate ownership change under Secs. 382 and 383. In an asset sale, the selling corporation’s tax attributes remain under the control of the seller, and these attributes can be used to offset income and gains resulting from the asset sale.
Nontax issues may dictate a preference for an asset sale or a stock sale. Purchasers generally try to avoid acquiring stock because the target corporation may have contingent or undisclosed liabilities the purchaser will inherit if stock is acquired. However, if a target has valuable nonassignable assets (such as a license agreement or a favorable lease), acquiring stock may be more appealing to the purchaser.
For a selling shareholder, a taxable stock sale (as opposed to an asset sale by the corporation or a tax-free reorganization) makes sense in the following situations:
- Double taxation will erode the proceeds the seller nets from an asset sale by the target followed by a liquidation of the target.
- The seller can shelter gains from the stock sale with NOLs or capital loss carryovers.
- The seller can recognize a loss (perhaps an ordinary loss under Sec. 1244, as discussed below) on the sale of the target’s stock.
- A tax-free reorganization is unattractive because the seller wants cash, or a limited market exists for the stock of the acquiring corporation.
For a buyer, a taxable stock purchase makes sense in the following situations:
- The target holds depreciated assets (basis greater than FMV) so the issue of stepping up the basis of the assets is not applicable.
- The target’s tax attributes have value even after application of the Secs. 382–383 limitation rules. If the buyer makes a direct asset purchase, the target’s tax attributes do not come under the buyer’s control.
- Unwanted assets and/or unknown or contingent liabilities are unimportant to the buyer.
- The target has many assets, making the transfer of title to those assets a complex and costly matter, or has favorable contracts or permits that are nonassignable.
Tax Consequences to Seller
If the stock has been held for more than 12 months, its sale usually generates a long-term capital gain or loss for the shareholder. If the stock is sold at a gain, the seller may be able to exclude some of the gain under Sec. 1202. If the stock is sold at a loss, the seller can treat some or all of a loss as ordinary rather than capital under Sec. 1244.
In a stock sale for cash, the seller recognizes gain or loss equal to the difference between the amount realized (the sales proceeds) and the basis in the stock sold (Secs. 1001(a) and (b)). If property is included in the sale price, the amount realized by the seller includes the property’s FMV (Sec. 1001(b)). If stock is sold at a loss, the loss will be disallowed if the related-party rules apply.
Claiming an Ordinary Loss on Sale of Sec. 1244 Stock
Sec. 1244 allows certain shareholders to treat losses from the sale of qualified corporate stock as ordinary rather than capital losses. The maximum deductible ordinary loss is $50,000 per year, or $100,000 if the shareholder files a joint return, further limited to the shareholder’s taxable income before considering the loss. (The $100,000 annual limitation for married taxpayers filing joint returns applies whether one or both spouses sustain a Sec. 1244 loss.) Any loss in excess of the annual limitation is a capital loss.
Example 1: J is a single filer who incurs a $75,000 loss on the sale of Sec. 1244 stock in 2013. She can claim a $50,000 ordinary loss on the sale and a $25,000 capital loss. If she has no capital gains in 2013, her capital loss deduction is limited to $3,000 with the balance available for carryover.
In this example, J’s ordinary loss deduction is allowed in full in 2013 if she has adequate taxable income. If not, the loss creates an NOL. Because any loss treated as ordinary under Sec. 1244 (taking into account the annual dollar limitations) is considered a loss from the taxpayer’s trade or business, a Sec. 1244 loss is allowable in calculating the taxpayer’s NOL deduction under Sec. 172. Any resulting NOL can generally be carried back to the two preceding tax years and then forward to the next 20 years following the loss year. The NOL deduction created by a Sec. 1244 loss is allowed in full in the carryback or carryforward year, without regard to the $50,000 or $100,000 annual loss limitation.
Gains and losses on Sec. 1244 stock are not netted before applying the annual dollar limitation, and the annual dollar limitation can apply to the sale of Sec. 1244 stock of the same corporation in different (e.g., succeeding) tax years.
Example 2: K, a single individual, started a new business on Jan. 1, 2008, by contributing $100,000 in exchange for 1,000 shares of common stock qualifying as Sec. 1244 stock. She sold 200 shares of stock on Feb. 1, 2013, for $40,000, resulting in a $20,000 gain. During the second half of 2013, the corporation’s business begins to deteriorate. K sells 600 shares for $10,000 on Nov. 1, 2013, resulting in a loss of $50,000, and the following year she sells her remaining 200 shares of stock for $2,000, resulting in a loss of $18,000.
In 2013, K recognizes a $20,000 long-term capital gain from the Feb. 1, 2013, sale and a $50,000 Sec. 1244 ordinary loss from the Nov. 1, 2013, sale. In 2014, she can claim an additional $18,000 ordinary loss from the sale of her remaining Sec. 1244 stock.
The corporation cannot have capital receipts in excess of $1 million on the day the stock is issued for the stock to be considered Sec. 1244 stock. This test is applied each time new stock is issued. If new shares are issued in exchange for cash or property transferred to the corporation and the $1 million capital receipts limit is not exceeded, the new stock is Sec. 1244 stock.
Excluding Gain From Sale of Qualified Small Business Stock
Sec. 1202 allows taxpayers (other than corporations) to exclude a certain percentage of gain from the sale or exchange of qualified small business stock (QSBS) that has been held for more than five years. QSBS is stock originally issued after Aug. 10, 1993, by a C corporation with aggregate gross assets not exceeding $50 million at any time from Aug. 10, 1993, to immediately after the issuance of the stock (Secs. 1202(c) and (d)). The taxpayer must have acquired the stock at its original issue or in a tax-free transaction. In addition, the corporation must meet an active business requirement whereby 80% or more of its assets are used in one or more businesses other than those specifically excluded. Ineligible businesses include certain personal service activities, banking and other financial services, farming, mineral extraction businesses, hotels, and restaurants (Secs. 1202(c)(2) and (e)).
Sec. 1202(b)(1) limits the amount of gain eligible for exclusion to the greater of (1) 10 times the taxpayer’s aggregate adjusted basis in the stock that is sold, or (2) $10 million reduced by any eligible gain taken into account in prior tax years for dispositions of stock issued by the corporation. Any gain in excess of the limitation amount is taxed under the normal rules for capital gains.
Eligible sellers can exclude 50% if the QSBS was acquired before Feb. 18, 2009, or after Dec. 31, 2013; 75% if the QSBS was acquired after Feb. 17, 2009, and before Sept. 28, 2010; and 100% if the QSBS was acquired after Sept. 27, 2010, and before Jan. 1, 2014. Given the satisfaction of the five-year ownership requirement, QSBS sold during 2013 will be eligible for the 50% gain exclusion. For 2014 sales, stock purchased before Feb. 18, 2009, will qualify for the 50% exclusion, while stock purchased after Feb. 17, 2009, will qualify for the 75% exclusion.
This case study has been adapted from PPC’s Tax Planning Guide—Closely Held Corporations, 26th Edition, by Albert L. Grasso, R. Barry Johnson, Lewis A. Siegel, Richard Burris, Mary C. Danylak, James A. Keller, and Brian Martin, published by Thomson Tax & Accounting, Fort Worth, Texas, 2013 (800-323-8724; ppc.thomson.com).
Albert Ellentuck is of counsel with King & Nordlinger LLP in Arlington, Va.