When an S corporation sells its assets, often part of the purchase price is paid via a promissory note issued by the buyer. These promissory notes are part of the purchase price and reported on the installment sale method in Sections 453, 453A, and 453B. Under that method, gain on the sale is recognized over time as installment payments are made. There is often a required interest component that is taxed at ordinary income rates. When the S corporation has sold all of its assets, it often wishes to liquidate and distribute the installment note to its owners. Absent a special rule, this plan would be problematic because the disposition of an installment note generally results in acceleration of the built-in gain of the note. Distribution in liquidation of an S corporation is generally treated as a deemed sale of the assets of the corporation.

Section 453(h), however, states where a sale is for an installment note, the S corporation adopts a plan of complete liquidation, and the installment note is received during the 12-month period beginning on the adoption of the plan of liquidation, the receipt of the installment note by the shareholders is tax-free initially. When payments are made on the note, they are treated as made in exchange for the stock of the S corporation.

Section 453B(h) provides where 453(h) applies, no gain is recognized by the S corporation on liquidation. Instead, the gain is recognized by the shareholders on the receipt of the payments on the note as if the S corporation had received such payments. In other words, Section 453B(h) does not require immediate gain but lets the shareholders step into the shoes of the S corporation after the S corporation is liquidated and defer the gain until the payments are made.

Some taxpayers have attempted to use this technique to determine state taxes based on the jurisdiction of the individual shareholder rather than the original S corporation. However, some states have adopted carve-out provisions to disallow this technique. In Caprio v. New York State Dept. of Taxation and Finance, 25 N.Y.3d 744 (2015), for example, the New York Court of Appeals upheld the state’s right to pass a statute to prevent, retroactively, Sections 453(h) and 453B(h) from allowing the non-New York shareholders of a liquidated S corporation to avoid New York income taxes upon the payment of a distributed installment note.

John G. Hodnette is a partner with Fox Rothschild, LLP in Charlotte.

January 5, 2026/by TAX