Sale of business & phantom shares - ordinary deduction?

S-Corp sells it assets for $5 million. The primary assets are it's intangibles. These are allocated $4.5 million of the deal and will be taxed as a capital gain.

The S-Corp has phantom share agreements with several key employees which will give them 20% ($1 million) of the deal.

On the day of closing, the S-Corp receives the $5 million and immediately pays out the $1 million to the employees.

Is the $1 million deducted against ordinary income or does it reduce the $4.5 million capital gain?

Ordinary income deduction. W-2 compensation to employees.

That's what I was thinking. Since the employees pick it up as ordinary income then the deduction should also be ordinary.

But that's not always true.

Take, for example, if this was a stock deal and the employees had unvested options. The 80% owner would recognize 80% of the capital gain and the 20% employees would have ordinary income. In other words, for the 80% owner, their capital gain is the net amount after paying the compensation.

But phantom stock is not stock or options.

For clarification, I assume you mean the options for 20% vest coincident with the sale of the company (change in control)

For clarification, I assume you mean the options for 20% vest coincident with the sale of the company (change in control).
Yes

I know am mixing apples & oranges.

The $1 million feels like an expense of the sale and should reduce the capital gain. The same as the attorney and accountant fees that are being paid in the deal.

The $1 million feels like an expense of the sale and should reduce the capital gain.

No way. This is an asset deal and we have a quick-vest under the phantom/SAR plan. This is compensation.

Take, for example, if this was a stock deal

If the S-election terminates as a result of such stock deal, the last day of the last S year will be the day before closing…which means the S doesn’t get any deduction (is my recollection).

Thank you sjr & Jeff.

Besides obviously being compensation, treating it as compensation is the most efficient because it reduces IRS revenues. (The additional employment taxes are less than the double tax on a capital transaction.)