Sale of S Corporation Under Installment Agreement

[Hamacher]

My client is going to be selling the assets of his S Corporation for $500,000 to be received in equal installments over the next 5 years at a rate of 10%. He is going to receive $150,000 for the inventory, $200,000 for the machinery and equipment and $150,000 for goodwill. The inventory has a book value of $25,000 and the machinery and equipment has been fully depreciated with an original cost of $100,000. My client of course has been talking to a friend of his who is suppose to be a CPA. He is telling the client that because he is an accrual basis tax payer that he will have to recognize ALL of the income in year one. It's my understanding that he will have to recognize all of the income related to the sale of the inventory in year of sale and will report the remaining income (on sale of machinery and equipment and goodwill) at capital gain rates over the life of the note. Am I correct on the timing of the income and the treatment (i.e. ordinary vs capital)?

Last question... They are not selling the building, which is in the company name. They will continue to rent that to the buyers. There is no problem with keeping the company active for this purpose... right? I know if they were a C Corp. there are some undesirable taxes that can apply if its not an operating entity.



Thanks in advance.

[Hamacher]

One more question.

I almost forgot... I assume the sale of the machinery and equipment will be treated as a capital gain with $100,000 subject to recapture at 25% rates and the remaining $100,000 at 15%. Is this correct as well.

[Bees Knees]

Even for an accrual method taxpayer, the installment method trumps the accrual method.

The accrual method is ignored for a sale structured under the installment method. The installment method is actually required, unless the taxpayer elects not to have it apply.

You are also correct in your thinking on ordinary income verses capital gain. Only the capital gain is recognized under the installment method. The portion of gain representing ordinary income is recognized in the year of sale.

Your error comes in the calculation of the gain on the machinery and equipment. Original basis = $100,000. Sale = $200,000. Machinery and equipment is fully depreciated.

Gain equals $200,000.

The $100,000 of gain representing depreciation recapture is ordinary income, not capital gain subject to 25%. The 25% rate only applies to unrecaptured 1250 gain (real property gains from prior depreciation).

The other $100,000 of gain is capital gain, subject to the 15% rate.

[Matt Sova]

Gain

As Bees stated, the gain on the machinery related to depreciation recapture is ordinary income. Also, even though it is an installment sale, 100% of the depreciation recapture is taxed in the year of the sale.

[Hamacher]

Thanks...

Thanks guys!