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Lev, Tax Advisor
Category: Tax
Satisfied Customers: 29797
Experience:  Taxes, Immigration, Labor Relations
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S Corp & Excess net passive income
, The business was

Customer Question

Customer: S Corp & Excess net passive income
JA: Thanks. Can you give me any more details about your issue?
Customer: The business was sold on a contract for 1.5 m in the s corp. It was a business so it qualifies as a sec 1231 gain. It's on an installment sale and payable for 5 years. I'm thinking we have an issue unless we liquidate and pick up the gain immediately.
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Submitted: 1 year ago.
Category: Tax
Expert:  Lev replied 1 year ago.

In order to qualify for section 1231 gain - it should be asset sale - so please confirm that is the sale of business assets.
Then - we need to verify who sells business assets? Are they sold by S-corporation OR assets are distributed and sold by shareholders?
Then - we need to have a list of assets - and the price assigned to each asset.
Correspondingly - we need to know the basis of each asset, and separately calculate the gain or loss on each item separately.

And finally - we need to know the type of each asset for properly classify the gain/loss as ordinary income or capital gain.

Regarding installment sale - that is a different issue. We report the sale transaction in the year of sale - but there are two option - either to recognize the full gain OR to use the installment reporting method and spread the taxable income over 5 years.

Regarding S-corporation shares - that is also separate issue - we need to know if you plan to liquidate the corporation? If year - that transaction is reported as the sale - and we need to know the adjusted basis if S-corporation shares.

So - there is a complicated reporting issue and if you wish to discuss - we might need to go step-by-step.

Customer: replied 1 year ago.
The asset sale was the sale of business, all was goodwill (1.3 M) and covenant not to compete (100,000). Sold by the corporation. Zero basis. There is a small consulting business left in the corp, gross income 20k annually.
The current year the corp has 48,000 in interest income and sec 1231 (or CG income) of 254,000.
Total stock basis by the individual shareholder is 233,000.
Expert:  Lev replied 1 year ago.

So far based on your information - the corporation is NOT liquidated - and S-corporation will continue to report on K1 to the shareholder will will keep track of adjusted basis.

As we mentioned above - the gain or loss on each asset (or a group of similar assets) is figured separately.
The sale of self-created intangible assets is taxed as ordinary income. So the goodwill which was not previously purchase and amortized - is a section 197 self-created intangible asset - and the gain is taxed as ordinary income.

Specifically - see section 197

(c) Amortizable section 197 intangibleFor purposes of this section;

(1) In generalExcept as otherwise provided in this section, the term "amortizable section 197 intangible" means any section 197 intangible;

(A)which is acquired by the taxpayer after the date of the enactment of this section, and

(B) which is held in connection with the conduct of a trade or business or an activity described in section 212.

(2) Exclusion of self-created intangibles, etc.The term "amortizable section 197 intangible" shall not include any section 197 intangible

(A)which is not described in subparagraph (D), (E), or (F) of subsection (d)(1), and

(B) which is created by the taxpayer.

This paragraph shall not apply if the intangible is created in connection with a transaction (or series of related transactions) involving the acquisition of assets constituting a trade or business or substantial portion thereof.

Expert:  Lev replied 1 year ago.

Regarding covenant not to compete... that is also section 197 intangible...
see here
(9) Covenants not to compete and other similar arrangements. Section 197 intangibles include any covenant not to compete, or agreement having substantially the same effect, entered into in connection with the direct or indirect acquisition of an interest in a trade or business or a substantial portion thereof. For purposes of this paragraph (b)(9), an acquisition may be made in the form of an asset acquisition (including a qualified stock purchase that is treated as a purchase of assets under section 338), a stock acquisition or redemption, and the acquisition or redemption of a partnership interest. An agreement requiring the performance of services for the acquiring taxpayer or the provision of property or its use to the acquiring taxpayer does not have substantially the same effect as a covenant not to compete to the extent that the amount paid under the agreement represents reasonable compensation for the services actually rendered or for the property or use of the property actually provided.

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