As a business owner, transitioning into retirement can be difficult. However, it also presents a significant financial opportunity if executed correctly. The goal of most S-corporation owners transitioning into retirement would be to either pass on the business to family members, or to sell the business to help fund their retirement. Selling an S-corporation can be costly, but the payoff can be significant. Before you begin your contract negotiations, be sure to understand the different types of sales and the tax implications of each.
One type of sale that can be negotiated is a stock sale. This is where the buyer purchases all of the stock of the S-corporation, taking on all of the assets and liabilities of the company. This means that the entity itself continues to exist as it did before. It is just the ownership of the stock that is changing.
Stock sales are usually preferred by sellers of S-corporations. Unfortunately, they rarely take place in the real world. If you negotiate a stock sale as the seller, you are essentially just selling stock that you have held for a long period of time. For tax purposes, this is a fantastic outcome because any gain on the sale will be a long-term capital gain. Currently, the highest capital gains tax rate is 20%.
To calculate your total capital gain, you will need to know your basis in the company. This should be calculated each year with your corporate tax return on a basis worksheet. If it isn’t, ask your accountant if they can help you tie down the number. You then subtract this basis from the sales price to get your capital gain. It’s a pretty straightforward way to sell a company. However, as you’ll see from the buyer’s perspective, it is not a perfect outcome.
The reason that stock sales rarely happen for S-corporations is because it is usually an unfavorable outcome for the buyer. When you purchase an S-corporation, you are generally looking for some tax write-offs in the early stages since there is a large cash outlay. When you purchase the stock of an S-corporation, the purchase price is your new basis in the company. You don’t get to depreciate your basis in the company. It goes on your books as an investment, and can later be used to offset a future sale of the stock. Since S-corporations are not usually short-term investments, most buyers are looking to get some tax write-offs while they are investing money in the early stages.
Another important note is that the buyer inherits the company’s basis in all of its assets. If this were an asset sale, the buyer would get a step-up in basis based on the fair market value of the assets. However, since it is just the ownership of the company that’s changing, the basis in the company’s assets remains the same, providing no increased depreciation deductions for the new owner.
Asset sales are when a buyer purchases all of the assets of a company and forms a new company to take its place. The former company is eventually dissolved, having no more assets or liabilities once the sale is completed. Here’s a look at how this works from each side of the transaction.
When negotiating an asset sale, the buyer and seller must agree on an allocation of the purchase price to the different assets. For tax purposes, there are some assets that are treated as capital assets. These assets will be given the favorable capital gains treatment for the seller. A portion of the price will also likely be allocated to the depreciable assets of the company. It is important to note that while these may be considered capital assets, the seller may have to add back any prior depreciation taken, which will be taxed at ordinary income tax rates for most assets. Aside from this, there are other assets that will always be taxed as ordinary income. These will be discussed in detail below.
The goal of the seller should be to allocate as much of the purchase price as possible to capital assets. By doing so, more of the gain on the sale will be taxed at the seller’s capital gains tax rate, rather than ordinary income tax rates.
From the buyer’s side, the same negotiation process takes place. However, it makes more sense for the buyer to allocate more of the purchase price to the physical assets of the company, such as furniture and equipment. The amount allocated to these assets will be considered the fair-market value for tax purposes. This allows the buyer to create a “step-up” in basis of the assets, which means there will be more depreciation to be taken in the short-term. Since the buyer’s goal is usually to obtain more tax write-offs in the first few years, it is common for buyers to allocate as much of the purchase price as possible to these types of assets.
An important thing to keep in mind is that both parties must agree on the allocation. At year-end, both taxpayers will have to file form 8594. This is how each side reports the sale and purchase of assets to the IRS. It is the IRS’s way of ensuring that the asset allocation of the buyer and seller match. If they don’t match, you can expect to receive an IRS letter seeking clarification.
Common Types of Assets & Tax Treatment
When allocating the price for an asset sale, it is important to know which assets receive capital gains treatment and which do not. Please note that although many sales are structured similarly, each case is unique. The IRS can take different positions depending on the facts and circumstances of each sale.
Any amount allocated to accounts receivable will receive different tax treatment depending on the seller’s accounting method. If the seller is a cash-basis taxpayer, any sales of accounts receivable will be treated as ordinary income to the seller because the income has never been recognized. If the seller is an accrual-basis taxpayer, they will simply zero out their accounts receivable balance on their books, as the income has already been recognized.
If the seller is a cash-basis taxpayer, they likely do not track inventory on their corporate tax returns. If that’s the case, the purchase of their inventory will be treated as ordinary income. If they are an accrual basis taxpayer, they will use the amount allocated to inventory to zero out that account on their books. Any excess/shortfall will be treated as an item of income/expense. The purchaser will expense the inventory if they are cash-basis. If they are an accrual-basis taxpayer, they will put the inventory on their books as an asset.
These assets are generally considered capital assets. However, from the seller side, it is important to note that you will likely have to add back any depreciation you took on these assets when selling. The add-back of this depreciation is generally treated as ordinary income. This is true for most section 1231 and section 1245 property, which is essentially all assets besides real property. For real property sales, there are special rules involved, but the maximum tax rate is generally 25% under current laws.
From the buyer’s side, most fixed assets & equipment can be depreciated over 5-7 years. The basis for depreciation will be the fair-market value paid for the assets. This is why buyers have motivation to allocate more of the purchase price towards these assets. They can recover their costs more quickly through depreciation deductions.
Sometimes when a company is sold, the buyer will want the owner to stay on as an employee for a specified period of time. This is generally referred to as an employment contract. Any amount of the sale price that is allocated to this contract should be treated as ordinary income to the seller and deductible to the buyer. Note that if an employment agreement is negotiated in the contract, you should assign some value to it when allocating the price.
Covenant Not To Compete Contract
This one is tricky. Many buyers will negotiate something of this nature in the contract to ensure the owner doesn’t just start up another company down the street and steal business from the buyer. If this is included in the contract, some value should be assigned to it when allocating the price. The tax treatment of this item depends on the purpose of it. If the purpose of the covenant is just to smoothly transition or facilitate the sale of goodwill to the buyer, then there is an argument to made that it should be treated as a capital asset and given favorable tax treatment for the seller.
To determine this, it helps to consider the seller’s intentions after the sale of the company. For example, if the seller is 80 years old and planning to retire, it is not likely that the reason for the covenant was to prevent the seller from starting another company and steal business. It is more likely that the buyer wanted the owner to stick around to facilitate a smooth transition. If this is the case, there may be an argument for capital gains treatment for the seller.
However, if the purpose is truly to prevent the seller from starting a company and competing, then the amount paid for the covenant is really preventing future income for the seller. In this situation, it should be treated as ordinary income from the seller’s side.
For S-corporation sales, the amount allocated to goodwill is generally whatever is left after allocating any other items. All other items should be agreed upon based on their fair-market value. Whatever remains will usually get plugged as the figure for goodwill. Goodwill is treated as a capital gain item for the seller. There is generally no basis in the goodwill, so the full amount allocated will normally be treated as a capital gain. The buyer is then required to amortize this amount, usually over a 15-year period. Since this is a much slower recovery period, most buyers will try to allocate a smaller amount to goodwill.
Clearly, there is a lot that goes into buying or selling an S-corporation. There are more assets that may be allocated in an asset sale that weren’t covered here, and every sale is different. Throughout the process, it is critical to consult with attorneys and accountants to ensure you get the results you are looking for. For more information or planning help, contact me!