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The shareholders would pay tax on gain equal to the difference between the sales price and their basis in their shares.Assuming that the shares are long-term capital gain property, the shareholders would face only a 15% federal tax.In considering these alternatives, both corporate and shareholder tax attributes such as net operating or capital loss carryovers should be considered.Described above is how inside gain (gain at the entity level) and outside gain (gain at the owner (shareholder) level)cause double taxation of C corporation earnings on the sale of corporate assets.The buyer of the C corporation shares would have a basis in those shares equal to the amount paid (assuming FMV was paid), Thus, the difference between that historic basis and the FMV of those historic assets remains subject to tax upon disposition or carries a tax cost in the form of reduced future depreciation or amortization.Financial accounting recognizes this by requiring a deferred tax liability to be set up in the accounts of the post-acquisition entity.Such an approach may reduce the taxable income of the C corporation to an acceptable level and result in the earnings being taxed only once at the shareholder-employee level. Moreover, while in some businesses high amounts of compensation as a percentage of corporate income may be reasonable (e.g., where personal services are the principal contributor to income, such as in a dental practice), in other businesses where capital is a principal contributor to income (e.g., rental real estate or manufacturing and sales with large capital investment), compensation that is a high percentage of pre-tax corporate income may be more difficult to justify.
A usual approach to managing the inefficient taxation of C corporation operating income has been to pay as much of the income as possible to shareholder-employees in the form of compensation, which, unlike dividends, is deductible. 162 allows a deduction for compensation that is (among other things) “reasonable.” Where a large percentage of corporate earnings is paid as compensation, particularly where the compensation is proportionate to shareholdings, the reasonableness of it may be difficult to defend.
Outside gain is gain the shareholders have on the distribution of the after-tax sales proceeds from the sale of corporate assets.