By Daniel Castellano, CPA
By Daniel Castellano, CPA
Daniel Castellano, CPA
Among the many outcomes of the pandemic is time for reflection. You’ve worked hard all of your life, building your construction company into the success that it is today. And in this moment of reflection, you may begin to assess your options, including the possibility of retirement. But what to do with the company? There are several options, with inevitable consequences.
You could liquidate the business. But you risk taking a significant discount on its value, especially in this business climate.
You could pass it along to a family member. However the track record for second generation owners is not very favorable. How about selling to your key personnel? The concern is that there are no guarantees they will be able to manage the business, buy you out, and still prosper financially.
You could establish and fund an ESOP (employee stock ownership) over a period of time. It’s a better option since the buyout can usually be accomplished with pre-tax dollars.
Or – you could sell the business to an interested third party. It is this that has the most varied options and the one we’ll review here. There are tax implications to both the buyer and the seller on a sale of an S Corporation to a third party. In basic form, the options include:
For our purposes, we will focus on a sale by a “flow through” entity (S Corp, LLC, etc.) that has generated goodwill during its existence, through customer and vendor relationships, and has a bonding program and bank lines of credit in place. We will also assume that there is an agreed upon transaction price and payment terms.
In a stock sale, gain is recognized to the Seller by the excess of the purchase price over the Seller’s tax basis. Tax basis is the seller’s original capital contribution, increased by profits retained in the business and decreased by dividend distributions. The seller is afforded long term capital gain treatment on the sale and the buyer’s cost of the purchase is generally only recovered upon selling the stock of the acquired company at a future date.
If the payment terms of the deal are for an installment sale, one in which the Seller obtains a promissory note from the buyer to be paid over a certain amount of time, taxes are paid as the note payments, both principal and interest, are received. The interest portion is treated as ordinary income. The amount of capital gain recognized each year is the principal portion of the payments received multiplied by the gross profit percentage of the entire transaction. A stock sale is usually preferred by the Seller.
An asset sale is generally preferred by the Buyer and can eliminate hidden liability issues. An asset sale requires an allocation of the price of the various assets being purchased, including goodwill. This allocation must be specified in the purchase and sale agreement and requires both the Seller and the Buyer to report the allocation on their respective tax returns.
Taxation to the seller can be a combination of capital gain (sale of goodwill) and ordinary income (sale of inventory, accounts receivable, etc.). If there is an allocation of the purchase price to a consulting services agreement, it is treated as an ordinary business expense to the Buyer and ordinary income to the Seller.
Stock Sale Treated as an Asset Sale
In a stock sale the Buyer may try to negotiate that the transaction contains a special election under Internal Revenue Code 338H10 so that it is treated as an asset sale. Under this election the S corporation shareholders are deemed to be receiving the sales proceeds in liquidation of the S Corporation. The Buyer gets tax deductions and the Seller, although paying one level of tax, receives ordinary income tax treatment on the sale of inventory and receivables, together with depreciation recapture. This is obviously beneficial to the Buyer and may call for renegotiation of the purchase price downward to level the playing field.
Other Considerations for Sellers
Net Investment Income Tax. This is in addition to the capital gains tax and generally raises the Federal tax rate from 20% to 23.8%. However, if the Seller materially participates in the business, the 3.8% surtax is not applicable.
Section 199A “QBI” Deduction. This is attributable to ordinary income recognized on the sale by the Seller and can reduce the marginal Federal income tax rate from 37% to 29.6%.
According to a recent study from Barlow Research Associates, the average small business owner is 60 years old. Of these, 40% are considering closing their businesses. As you reflect on the possibilities, you need to consider whether a sale is a viable option.