Carolyn Sprinchorn
Carolyn Sprinchorn
Thomas Wechter
Thomas Wechter

Using the "one-day note" in S corporation stock sales

"One-day note" in an S corp. stock sale treated as an asset sale with a deemed liquidation replicates tax consequences of the S corp.'s not liquidating.

August 23, 2012
by Carolyn Sprinchorn, J.D., and Thomas R. Wechter, J.D.

The “one-day note” is a popular planning technique for a Sec. 338(h)(10) installment sale of the stock of an S corporation where the S corporation is deemed to have liquidated. Under this technique, the deemed distribution of a one-day note from the S corporation to its shareholders mirrors the favorable tax treatment of an S corporation’s selling its assets in exchange for an installment note and remaining in existence, distributing the payments on the note to its shareholders.

Before regulations under Secs. 453, 453B, and 338(h)(10) were issued, practitioners hoped that the same treatment would result whether or not the S corporation remained in existence. However, the regulations provide otherwise where the S corporation receives and distributes an installment note plus other property or cash as part of the sale of its assets. This is the case whether that sale is only deemed to have occurred under Sec. 338(h)(10) or was an actual sale of the S corporation’s assets. This article explains why this is so and how the one-day note is used to produce the same tax consequences where the S corporation does not liquidate.

One-day note

The one-day note strategy arose in response to the difference in treatment depending on whether the S corporation liquidated or stayed in existence, collected the proceeds of the installment note, and distributed those proceeds to its shareholders. The significance of the one-day note is that amounts under the one-day note are payable after the S corporation liquidates, eliminating entity-level gain in the year of sale.

The tax consequences of an election under Sec. 338(h)(10) replicate, in many respects, the tax consequences of an asset sale. This is explicitly true with respect to the receipt of installment notes in exchange for stock under Regs. Sec. 1.338(h)(10)-1. The rules relating to installment notes received by shareholders from the purchaser in exchange for stock under a Sec. 338(h)(10) election are the same as the rules governing installment notes received by S corporations in exchange for assets, and subsequently distributed to shareholders in liquidation. However, where other property or cash in addition to the installment note is received by the shareholder under a Sec. 338(h)(10) deemed asset sale, the tax consequences are different than if the S corporation received the installment note and the other property and stayed in existence rather than liquidating.

The following examples illustrate this difference in treatment, depending on whether the S corporation remains in existence or is liquidated (or deemed liquidated).

Examples: Assumptions

A simple example demonstrates the divergent treatment afforded depending on whether the S corporation remains in existence or liquidates. Assume the existence of an S corporation with assets having a value of $1,000 and an adjusted basis of $400. Assume further that the S corporation has a single shareholder, holding stock with a value of $1,000, and an adjusted basis of $400.

S corporation stays in existence

In the first example, the S corporation sells its assets for $400 cash and a long-term note, with adequately stated interest, of $600. Under Sec. 453(c), the amount of the cash payment that is income to the S corporation is that portion of the cash payment received in that year that the gross profit realized bears to the total contact price (the S corporation’s “gross profit ratio”). In calculating its gross profit ratio, the S corporation divides its “gross profit” (i.e., selling price less adjusted basis), by the “contract price” (i.e., selling price reduced by any qualifying indebtedness), with a resulting gross profit ratio of 60%. In the year of the sale, the S corporation recognizes $240 of gain and the shareholder’s stock basis is increased by the $240 gain. As a result, the shareholder’s stock basis is $640. Upon distribution of the cash, the shareholder’s basis in the stock is reduced by $400, leaving the shareholder with a remaining basis of $240.

In the year that the long-term note is payable, the S corporation recognizes gain of $360 (60% x $600), which passes through to the shareholder, increasing the basis to $600. Upon distribution of the $600 of cash, the shareholder’s basis in the stock is reduced to zero.

To summarize the tax consequences to the shareholder where the S corporation does not liquidate, the shareholder recognizes $240 of gain in the year of sale and $360 of gain in the year of the payment of the long-term note.

S corporation liquidates

In the second example, the facts are the same as in the first example, except the S corporation liquidates, distributing the $400 cash and the $600 long-term note to the shareholder. In the year of sale, the S corporation recognizes $240 of gain, which passes through to the shareholder, resulting in an increased basis of $640 for the shareholder.

According to Regs. Sec. 1.453-11(a)(3), upon the liquidation of the S corporation, the shareholder includes both the cash and the issue price of the note in the computation of selling price in computing the gross profit ratio. That computation is the selling price of $1,000 less the basis of the stock of $640 (which was recently increased to reflect the entity-level gain passed through to the shareholder), divided by the selling price of $1,000 ([$1,000 - $640] / $1,000), which equals 36%. As a result of including the cash in the selling price for these computations, the shareholder’s basis is effectively allocated between the cash and the note in the liquidating distribution.

In the liquidation of the S corporation, the shareholder has gain of $144 (36% x $400) on the receipt of the cash. As a result, in the year of the sale, the shareholder has total gain of $384. Upon the subsequent payment of the note, the shareholder recognizes additional gain of $216.

The treatment under the second example, where the S corporation liquidates, is not only different than the treatment where the S corporation remains in existence, it is contrary to the usual S corporation distribution rules governing shareholder basis recovery. Many commentators felt that the usual installment sale rules regarding the calculation of the gross profit ratio should be turned off for purposes of a liquidating distribution, without having the cash treated as part of the “selling price.” Under these rules, the shareholder’s basis in his stock would first have been applied to the cash received, with the remainder used to calculate the shareholder’s gross profit ratio for the note. However, the regulations under Secs. 453 and 453B dictate that the shareholder’s “selling price” is inclusive when applied to the shareholder’s liquidating distribution.

One-day note, then S corporation liquidates

The one-day note strategy is illustrated in the final example. Negotiating for receipt of a one-day note in the amount of any cash that was to be part of the sale eliminates any gain at the entity level by causing the S corporation to receive only notes in exchange for the S corporation’s assets. It additionally allows the S corporation to distribute all of its assets without having to distribute any items other than the notes to the shareholder, thereby allowing the shareholder to avoid the negative tax consequences of having to calculate the “selling price” by reference to the note received plus the cash.

In this example, the S corporation sells its assets for a $400 one-day note and a $600 long-term note and then liquidates, distributing both notes to the shareholder.

The S corporation does not recognize any gain in the year of sale. Upon the receipt of the notes, the shareholder calculates the gross profit ratio as the amount of the notes less the adjusted basis of the shareholder’s stock divided by the selling price ([$1,000 - $400] / $1,000), which equals 60%. Upon the payment of the short-term note, the shareholder recognizes gain of 60% x $400, or $240. When the long-term note is paid, the shareholder recognizes gain of 60% x $600, or $360.

The following table summarizes the tax results of the examples and illustrates how the use of a one-day note, where the S corporation liquidates or is deemed to liquidate under a Sec. 338(h)(10) election, results in the same tax consequences as where the S corporation stays in existence:


Gain in Year of Sale

Gain/Long-Term Note

Total Gain

S corp. stays in existence




S corp. liquidates




S corp. liquidates with one-day note





The one-day note strategy allows shareholders to receive the same favorable tax consequences of keeping the S corporation in existence even where a Sec. 338(h)(10) election has been made and a liquidation is deemed to have occurred.

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Carolyn Sprinchorn, J.D., LL.M. (Tax), is a special counsel and Thomas R. Wechter, J.D., LL.M. (Tax), is a partner with Duane Morris LLP in the Chicago office. Sprinchorn concentrates her practice in state and local taxation. Wechter concentrates his practice in tax planning for individuals, corporations, and partnerships and in tax controversy matters in front of the IRS and before the Tax Court, U.S. Court of Federal Claims, and the district courts.