7 Considerations When Selling an S-Corporation
As an S Corp owner, you have likely invested significant time, effort, and resources into building your business. However, there may come a time when you need to consider selling your S Corp.
Whether it's to retire, pursue new opportunities, or for other reasons, selling an S Corp is a complex process that requires careful planning and consideration.
In this article, we will discuss seven key considerations to keep in mind when selling an S Corp.
Table of Contents:
Let's dive into it!
1. Valuation of the S Corp
Valuing an S Corp is an essential first step when considering selling your business. A proper valuation can help you determine the fair market value of your S Corp and set a realistic asking price.
There are several methods to value an S Corp, including asset-based valuation, income-based valuation, and market-based valuation. Each approach has its advantages and disadvantages, so it's essential to choose the right method for your business. Consider consulting with a business valuation expert to ensure that your S Corp is valued correctly.
An asset-based valuation involves determining the fair market value of your business's assets, including equipment, property, and inventory. This approach is useful for businesses that have a significant amount of assets.
In contrast, an income-based valuation uses the S Corp's cash flow, profitability, and revenue to estimate its value. This approach is appropriate for businesses that generate significant revenue and have consistent cash flow.
A market-based valuation compares your S Corp to similar businesses in your industry, using multiples of earnings, revenue, or assets. This approach is ideal for businesses with a lot of competition.
2. Tax Implications
Capital Gains Tax
Capital gains tax is a tax on the profit made from the sale of your business. When you sell your S Corp, and if the deal is structured correctly, you will likely have a capital gain or loss on the majority of the sale, depending on the difference between your basis in the business and the sale price. Basis refers to the value of your investment in the business, including your initial investment and any additional investments or losses.
The capital gains tax rate varies based on how long you've owned the S Corp. If you've owned the business for more than one year, the sale will be considered a long-term capital gain, and the tax rate will be either 0%, 15%, or 20%, depending on your income level.
Net Investment Income Tax (NIIT)
And, don't forget about the 3.8% Medicare surtax, also known as the Net Investment Income Tax (NIIT), which is a tax on certain investment income. It was introduced as part of the Affordable Care Act (ACA) and applies to individuals, estates, and trusts with high levels of investment income.
The NIIT is calculated as 3.8% of the lesser of an individual's net investment income or their modified adjusted gross income (MAGI) over certain thresholds. For individual taxpayers, the threshold amounts are:
$250,000 for married couples filing jointly
$200,000 for single taxpayers
$125,000 for married taxpayers filing separately
Net investment income includes income from sources such as interest, dividends, capital gains, rental income, and passive income from businesses.
If you've owned the business for one year or less, the sale will be considered a short-term capital gain, and the tax rate will be the same as your ordinary income tax rate.
It's important to note that the tax code allows for a step-up in basis for inherited S Corps, which means that the value of the business at the time of inheritance becomes the new basis. This can reduce or eliminate the capital gains tax owed if the business is sold shortly after the inheritance.
Double Taxation via the Built-In Capital Gains Tax
When selling an S Corporation, the built-in capital gains tax is the tax liability that arises from the appreciation of the S Corporation's assets before it converted to an S Corp. This tax liability is based on the difference between the fair market value of the assets at the time of conversion to an S Corp and their original cost basis.
When a C Corporation converts to an S Corp, the C Corp's assets are deemed to have been sold at fair market value, and any gains on those assets are subject to the built-in capital gains tax. This tax liability remains with the S Corp even if the assets are sold at a later date.
The built-in capital gains tax rate is typically the highest capital gains tax rate in effect at the time of the sale of the assets. For example, if the built-in gain occurred in 2019, and the assets were sold in 2023, the built-in capital gains tax rate would be the rate in effect in 2019.
However, there are certain circumstances in which the built-in capital gains tax may be reduced or eliminated. For example, if the S Corp has held the assets for a significant amount of time and the assets have appreciated significantly, the built-in gain may be offset by losses incurred after the conversion to an S Corp.
An installment sale is a potential option for reducing the tax impact of selling an S Corp.
In an installment sale, the buyer pays the purchase price over a period of time rather than all at once. This allows the seller to spread out the capital gains tax owed over several years, which can reduce the tax burden.
However, there are specific rules for installment sales, and they may not be appropriate for all situations. Consult with a tax expert to determine if an installment sale is the right option for your business.
Maintaining confidentiality during the selling process is critical to protecting your business's value. If competitors, customers, or employees find out that you're considering selling your S Corp, it could damage your business's reputation and hurt its value. Consider creating a non-disclosure agreement (NDA) to ensure that potential buyers keep information about your business confidential.
An NDA is a legal document that prohibits the recipient from disclosing confidential information about your business. The document outlines what information is confidential and what the recipient can and cannot do with that information. An NDA is typically signed before any information about your business is shared with potential buyers.
4. Timing of the Sale
Choosing the right time to sell your S Corp can significantly impact its value. Factors to consider include market conditions, industry trends, and the financial health of your business.
The timing of selling your S-Corp may also depend on how much you to receive in order to retire and allow for you to maintain your lifestyle upon retirement.
Preparing your business for sale can take several months if not years, so plan ahead and give yourself plenty of time to get your business ready.
It's essential to keep in mind that the selling process can take a long time, sometimes up to a year or more. So, it's essential to prepare your business for sale in advance. Ensure that your financial records are up-to-date and that your operations are running efficiently. S-Corps that have clearly defined processes and well documented procedures and workflows often fetch higher prices.
Address any potential issues or red flags that may arise during the selling process, and address them before you put your S Corp on the market. This could include resolving any legal disputes or addressing any customer complaints.
5. Finding the Right Buyer
Finding the right buyer for your S Corp is essential to ensuring a smooth transition of ownership. Consider working with a business broker or investment banker to identify potential buyers.
You should also qualify potential buyers to ensure that they have the financial resources and experience to successfully run your business.
When looking for a buyer, consider the buyer's experience, financial strength, and reputation. You want to ensure that the buyer has the necessary resources and knowledge to maintain and grow your S Corp.
A buyer with a strong reputation in your industry can also help ensure the continued success of your business.
6. Due Diligence
Due diligence is a critical step in the selling process. It involves a thorough investigation of your business's financial and legal records, as well as an assessment of its operations, assets, and liabilities.
Preparing for due diligence can take several months, so make sure you have all the necessary documents and information ready in advance.
During the due diligence process, potential buyers will examine your financial records, contracts, customer relationships, and other key aspects of your business. Be prepared to answer questions and provide detailed information about your business.
Consider hiring an accountant or lawyer to assist with the due diligence process and ensure that you are providing accurate and complete information.
7. Contracts and Negotiations
The purchase agreement is the final step in the selling process.
It outlines the terms and conditions of the sale and specifies the rights and obligations of both parties. Negotiating the purchase agreement can be a complex process, so it's important to work with a qualified attorney to ensure that your interests are protected.
The purchase agreement should include details on the purchase price, payment terms, and any contingencies that may be involved in the sale.
Be prepared to negotiate on these terms, and don't be afraid to walk away from a deal if the terms aren't favorable. A good attorney can help you negotiate the best possible deal and ensure that the purchase agreement protects your interests.
Selling an S Corp is a complex process that requires careful planning and consideration. By following these seven key considerations, you can increase your chances of a successful sale and maximize the value of your business.
Don't hesitate to seek professional advice and guidance throughout the process to ensure that you make the best decisions for your business and your future.
With the right preparation and approach, selling your S Corp can be a positive and rewarding experience.
Are you selling an S-Corp? Do you need help planning on what to do with your proceeds to make your money last?
Disclosures: Covenant Wealth Advisors is a registered investment advisor with offices in Richmond and Williamsburg, VA. Past performance is no guarantee of future returns. Investing involves risk and possible loss of principal capital. The views and opinions expressed in this content are as of the date of the posting, are subject to change based on market and other conditions. This content contains certain statements that may be deemed forward-looking statements. Please note that any such statements are not guarantees of any future performance and actual results or developments may differ materially from those projected. Please note that nothing in this content should be construed as an offer to sell or the solicitation of an offer to purchase an interest in any security or separate account. Nothing is intended to be, and you should not consider anything to be, investment, accounting, tax, or legal advice. If you would like accounting, tax, or legal advice, you should consult with your own accountants or attorneys regarding your individual circumstances and needs. No advice may be rendered by Covenant Wealth Advisors unless a client service agreement is in place. Hypothetical examples are fictitious and are only used to illustrate a specific point of view.