I have previously discussed tax opportunities for selling the business by a C corporation. I would like now to switch our focus to options available to S corporations.
One of the options for an S corporation to sell its business is to sell its underlying assets. This is often a preferred option by a potential buyer as it provides a step up in acquired assets. Unlike a C corporation, the S corporation is a pass-through entity and its federal taxable income is only taxed at a shareholder level. Thus, double taxation is usually avoided with some limited exceptions.
As asset sales are taxed at the individual shareholder level, allocation of gain among various classes of assets such as cash, receivables, depreciable property, and intangibles becomes particularly important as there may be a material difference between ordinary income and capital gain tax rates depending on the shareholder’s tax bracket.
Your bias will obviously be toward allocating more sales proceeds toward capital assets such as intangibles and goodwill that are taxed at much lower capital gain rates, yet the buyer’s preference will be toward allocating more proceeds to assets that are currently deductible, such as a consulting agreement, or to assets with shorter depreciation life such as computer and office equipment. Such opposite biases create grounds for negotiation and may require certain compromises by both sides.
IRS prescribed allocation rules require that intangibles and goodwill receive the “residual value”. A Proper appraisal of the value of sold assets from a valuation expert is highly recommended in these circumstances.
S corporation – sale of stock
Finally, the sale of stock of an S corporation will result in capital gain treatment, but the qualified small business stock gain exemption is not available for owners of an S corporation. Further, the sale of stock vs assets may not be necessarily preferred by a buyer who will receive a rollover basis in underlying assets of the business. If the assets are mostly depreciated, the buyer will be unable to get a step up basis which will affect its ultimate cash flow. As a result, some compromise by the seller may be needed.
Finally, this overview would not be complete if I did not touch upon an installment option. If at least one payment from the sale is received after the close of the taxable year in which the disposition occurred, the gain can be spread out over the years in which payments are received. An installment option allows for the deferral of tax on the gain, but it is applicable to capital assets only. Thus, you will have to pay tax on the gain from the sale of inventory, accounts receivable, property held for one year or less, personal property subject to depreciation recapture in the year of sale even if cash proceeds are received in subsequent years.
As you can see there are various sale options and each has its own benefits, drawbacks, and complications. Many factors will impact your sale options; therefore, early planning is key. This post is meant to be a broad overview of sale options and should not be viewed as a substitute for receiving professional tax advice. Considering and planning for your exit options at the time you are forming your business may allow you to avoid costly mistakes related to the type of entity chosen.