In my prior post, Installment Sale Notes Owned by S Corporations, I discussed sales of S corporation assets in exchange for a promissory note, invoking the installment sale method of Section 453. Buyers commonly use the installment sale method for earnouts, which provide additional contingent consideration based on the performance of the business after the sale. When the S corporation liquidates after closing, distributing closing cash and the earnout right to the S corporation shareholders, the Section 453 rules have an unexpected trap. That often arises where there is a stock sale and Section 338(h)(10) election, which is treated as an asset sale by the S corporation followed by its deemed liquidation. For more on Section 338(h)(10) elections, see my prior blog post Basics of 338(h)(10) Elections.

The Section 453 tax trap is caused by the installment sale rules’ requiring the shareholders to allocate the tax basis of their S corporation stock among the cash distributed and the earnout right, despite the earnout potentially never being paid. That stretching of the basis triggers liquidation gain for the shareholders that would not otherwise exist. If the earnout is never paid, the shareholders recognize a long-term capital loss but are not able to carry the loss back to the liquidation year to offset the liquidation gain. Rather, they can only utilize the capital loss to offset future capital gains. Fortunately, there are a few ways to avoid this tax trap.

First, the S corporation can choose not to liquidate until after the resolution of the earnout. For example, where an F reorganization under Rev. Rul. 2008-18 is utilized, the new S corporation can sell its interest in its disregarded subsidiary and continue to hold the earnout right. By not liquidating, the trap is never triggered, and the S corporation can wait until earnout obligations are paid to make distributions to its shareholders. Where a 338(h)(10) election is made, however, this option is not available because the election itself causes a deemed liquidation.

Second, because the trap is triggered by the payment of cash at closing, one way to avoid the trap is for the parties to close with only an installment obligation. They can then liquidate the S corporation (as discussed in my prior blog post) and have the non-contingent portion of the installment obligation paid soon after closing. This short-term note technique requires the note to bear at least the AFR rate of interest and for third-party lenders to consent to the structure. By deferring the gain from the cash portion of the sale until after the liquidation of the corporation, the parties avoid the tax trap. For a fuller discussion of this alternative, see the article published by the NCBA Tax Section on September 29, 2011, in the Tax Assessments September 2011 issue: “The One Day Note Solution to the Section 453B(h) Tax Trap — Is It Viable under the Economic Substance Doctrine?” by C. Wells Hall III. The article is available for section members via the Tax Section’s Community library.

Third, the seller can opt out of the installment sale treatment by election. In that case, the seller is required to recognize the fair market value of the earnout at closing rather than deferring recognition until payment of the earnout. However, a low valuation of the earnout may be appropriate given its contingent nature, limiting the consequence of the election out of the installment sale method.

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

April 7, 2026/by TAX