How are C corporations taxed differently than S corporations when sold?

C corporation sales face potential double taxation: the corporation pays corporate tax on gain from an asset sale, then shareholders pay capital gains tax on the liquidating distribution. S corporations avoid double taxation because income passes through to shareholders, resulting in only one level of tax.

Should I choose an asset sale or stock sale when selling my business?

Buyers generally prefer asset sales for the step-up in basis, while sellers of C corporations prefer stock sales to avoid double taxation. S corporation and partnership sellers have more flexibility because pass-through taxation applies regardless of structure. Entity type should be considered long before any sale.

The Tax Consequences of Selling a Business: C Corp vs. S Corp vs. Partnership | Lynch Law

When a business owner decides to sell, the entity structure — C corporation, S corporation, or partnership/LLC — determines not just how the transaction is structured but how much of the sale price ends up in the seller's pocket after taxes. The difference between a well-structured and a poorly structured sale can be hundreds of thousands or even millions of dollars in tax liability. Understanding the tax consequences across entity types is essential for business owners contemplating an exit, and ideally, this analysis should inform entity selection long before any sale is on the horizon.^[1]

C Corporations: The Double Tax Problem

C corporations face the most disadvantageous tax treatment on a sale. If the sale is structured as an asset sale — where the corporation sells its assets and distributes the after-tax proceeds to shareholders — two levels of tax apply. The corporation pays corporate income tax on the gain from the asset sale (currently 21% federal). When the after-tax proceeds are distributed to shareholders as a liquidating distribution, the shareholders pay capital gains tax on the difference between the distribution and their stock basis (currently up to 23.8% federal, including the net investment income tax).

The combined effective rate on an asset sale from a C corporation can exceed 40% — far higher than the rate that would apply to a sale from an S corporation or partnership. This double-tax problem is the primary reason that C corporation status is generally disfavored for operating businesses that may eventually be sold.^[2]

A stock sale avoids the corporate-level tax. When the shareholders sell their stock directly to the buyer, the corporation does not realize any gain — only the shareholders pay tax, at capital gains rates, on the difference between the stock sale price and their stock basis. However, buyers generally prefer asset sales because an asset purchase gives the buyer a stepped-up basis in the acquired assets, which can be depreciated or amortized. This creates a fundamental tension: sellers want stock sales (one level of tax); buyers want asset sales (stepped-up basis). The negotiation of this tension often determines the structure of the deal and the effective price.

The § 338(h)(10) election offers a middle ground in certain situations. This election allows a stock sale to be treated as an asset sale for tax purposes, giving the buyer the benefit of a stepped-up basis while allowing the seller to avoid the mechanical double taxation of an actual asset sale. However, § 338(h)(10) is available only for S corporations and certain affiliated C corporation groups — it does not solve the double-tax problem for a standalone C corporation.

S Corporations: One Level of Tax

S corporations are generally taxed at only one level. The corporation itself does not pay federal income tax (with limited exceptions). Instead, income and gains pass through to the shareholders and are taxed on their individual returns. In an asset sale, the S corporation sells its assets and recognizes gain, which passes through to the shareholders and is taxed at their individual capital gains rates. The after-tax proceeds are distributed to shareholders tax-free (to the extent of their stock basis, which has been increased by the passed-through gain).

The effective tax rate on an asset sale from an S corporation is significantly lower than from a C corporation — roughly 23.8% (the maximum federal capital gains rate including NIIT) compared to over 40% for a C corporation. This single-level-of-tax advantage is one of the primary reasons that S corporation status is attractive for operating businesses.

S corporation stock sales and asset sales are treated similarly from the seller's perspective, because in either case the gain is taxed at capital gains rates at the shareholder level. The § 338(h)(10) election is available for S corporations, allowing a stock sale to be treated as an asset sale for tax purposes. This election benefits the buyer (stepped-up basis) without significantly changing the seller's tax result, making it a powerful negotiating tool in S corporation transactions.^[3]

Partnerships and LLCs

Partnerships and LLCs taxed as partnerships offer the most flexibility in structuring a sale. A partner can sell their partnership interest (analogous to a stock sale), or the partnership can sell its assets (an asset sale). In either case, the gain is taxed at only one level — the partner level.

An interest sale is straightforward: the selling partner recognizes gain equal to the difference between the sale price and the partner's outside basis in the partnership interest. The gain is generally capital gain, except to the extent attributable to "hot assets" under IRC § 751 — unrealized receivables and substantially appreciated inventory — which are taxed as ordinary income. The hot-assets rule is a significant planning consideration and can create unexpected ordinary income in a partnership interest sale.

An asset sale by the partnership results in the partnership recognizing gain on the sold assets, which passes through to the partners. The character of the gain (ordinary or capital) depends on the nature of the assets sold. After the sale and distribution of proceeds, the partnership is liquidated and the partners recognize any remaining gain or loss on the liquidating distribution.^[4]

The buyer's preference in a partnership transaction is typically an asset purchase (or a § 754 election by the partnership in connection with an interest purchase), which provides a stepped-up basis in the partnership's assets. The § 754 election is unique to partnerships and provides a mechanism for adjusting the inside basis of partnership assets to reflect the purchase price paid by the new partner — achieving a result similar to an asset purchase without requiring the partnership to actually sell its assets.

Planning Considerations

The entity structure decision should be made with the eventual exit in mind. A business owner who forms a C corporation for a business that will eventually be sold is building in a double-tax cost that could have been avoided with an S election or partnership structure. Converting from C corporation to S corporation can mitigate this cost, but the built-in gains tax under § 1374 imposes a corporate-level tax on appreciated assets for five years after the conversion. Planning ahead — ideally at formation — is the most effective strategy.

For business owners who are already in a C corporation, the options include converting to S corporation status (accepting the five-year built-in gains exposure), using a § 338(h)(10) election if the buyer is a corporation, negotiating a stock sale to avoid the corporate-level tax, or using installment sale techniques to spread the tax burden over time. Each option has trade-offs, and the right approach depends on the specific facts — the type of assets, the amount of built-in gain, the buyer's structure, and the seller's overall tax situation.

Regardless of entity type, every business sale should be planned with tax counsel involved from the earliest stages. The tax structure of the deal — asset sale versus stock/interest sale, allocation of purchase price, treatment of contingent consideration, noncompete agreements, and employment arrangements — can have a dramatic impact on the after-tax proceeds to the seller. Getting these decisions right is as important as negotiating the headline price.^[5]

References

^[1] IRC § 11 (corporate income tax rate: 21%); IRC §§ 1(h), 1411 (individual capital gains rate: up to 20% plus 3.8% NIIT for a combined maximum of 23.8%).
^[2] IRC § 336 (recognition of gain on liquidating distribution by a C corporation); § 331 (treatment of liquidating distribution to shareholders as exchange of stock). The combined effective rate exceeds 40% when both levels of tax are applied.
^[3] IRC § 338(h)(10) (election to treat stock sale as asset sale for tax purposes; available for S corporations and certain affiliated groups). The election gives the buyer a stepped-up basis in the acquired assets while maintaining single-level taxation for the S corporation seller.
^[4] IRC § 741 (gain on sale of partnership interest: generally capital gain); § 751 (hot assets: ordinary income treatment for gain attributable to unrealized receivables and substantially appreciated inventory).
^[5] IRC § 1374 (built-in gains tax for S corporations that converted from C corporation status: corporate-level tax on built-in gains recognized within five years of conversion). See also IRC § 754 (partnership election to adjust inside basis following transfer of partnership interest).