Buying an S Corporation

Before we get going, if you’re not familiar with an asset sale vs. stock sale, check out the article to get an overview of the two structures. The choice between these two sale structures is the cornerstone of an s-corp acquisition, and we’re going to explain which structure is more favorable for the buyer. Looking to sell an s-corp instead? Check out selling an s-corp to get the same detailed information for when the shoe is on the other foot.

As you may already know, one of the things that can make an s-corp sale or purchase tricky is the fact that each of the two structures typically benefit opposing sides of the transaction. For simplicity’s sake, as a buyer, you’re typically going to want an asset sale, but it’s a good idea to know why this structure is more beneficial for you than a stock sale.

We’re going to break down how an asset sale vs. stock sale works for the buyer and explain why you would prefer one over the other. Each business transaction is unique, and we recommend giving our s-corp accountants a call for tailored help with your particular acquisition.

Things to Note Before We Dive Into Buying an S-Corp

First up, ensure that the corporation up for sale actually has s-corp filing status. It seems obvious, but just because it’s a small business, doesn’t mean it is automatically an s corporation. The asset vs. stock sale question is different for sole-proprietorships, LLC’s or partnerships.

One more thing to note, if the business is an s-corp subsidiary (QSub), then the sale is actually already treated as an asset sale for federal tax purposes since an s-corp subsidiary is considered a division of the parent s-corp. Here at s-corp.biz, our focus is on s-corps, and for this article, we’ll be assuming the acquisition is of an s-corp.

What Does an S-Corp Asset Sale Mean for the Buyer?

To give you a quick refresher, an asset sale is when the seller retains their legal ownership of the s-corp, and the buyer purchases individual assets. Often called a ‘cash-free, debt-free’ sale. The assets are evaluated individually and allocated to different “classes” that make up the purchase price.

Typically speaking, an asset sale is the preferred structure for a buyer in an s-corp transaction. The reason behind this preference is two fold, but the primary benefit for buyers is that IRS guidelines allow buyers to “step-up” the s corporation’s depreciable basis in assets. If you’re unfamiliar, depreciation is a method that allows a company to deduct a portion of an asset’s cost each year for an IRS-prescribed number of years, which reduces the company’s owed taxes over time.

How Does an S-Corp Asset Sale Benefit the Buyer in Terms of Taxes?

This “step-up” works in the buyer’s favor because they can allocate higher values for assets that depreciate more quickly, such as equipment, which has a 3-7 year life, and lower values on assets with slower depreciation, such as goodwill, which has a 15 year life. The price and nature of each asset will also have an effect; many small assets under $5k may be able to be fully deducted by the buyer immediately without having to depreciate them over time, while some assets (like vehicles) have special rules allowing large first-year deductions up to 25k or more.

Immediately deducting a large amount of the purchase price is how these transactions play out in practice, and it’s a huge benefit to the buyer, which increases the company’s cash-flow during the critical first years following the transaction.

How Does an S-Corp Asset Sale Benefit the Buyer in Terms of Liability?

Another benefit for buyers in an asset sale is the decreased risk of the buyer inheriting potential liabilities. An example of this could be a negligence lawsuit that originates from the previous owner. Another example that is very common in small businesses is the previous owner illegally paying employees as independent contractors. The new owner would not want to be liable for fines from the IRS for the mischaracterization of employees as independent contractors. In the case of an asset sale, this liability would not affect the new owner.

One thing to consider as a buyer is that asset sales can run into problems if the assets fall into a category that makes them difficult to reassign to the purchasing party or have legal ownership. Some examples of these types of assets may be permits, leases, contracts and intellectual property.

What Asset Allocation Benefits Buyers in an S-Corp Acquisition?

Hopefully you remember from our last article, Asset Sale vs. Stock Sale, that in an asset sale, the buyer and seller allocate the assets to different classes or “buckets” that are laid out by the IRS, and this is attached to their respective tax returns for the year of the sale/purchase. The allocation must be consistent between the buyer and seller.

However, it’s important to realize that different classes have varying tax implications, and allocating higher amounts to certain classes is more beneficial to the buyer, while an opposite distribution usually benefits the seller. Take a look at the table below to see an overview of the different “classes” and the buyer’s general perspective towards which classes are preferred for a higher or lower allocation amount.

Download our Buyer’s Asset-Allocation PDF for a detailed look at all of the assets that fall under each class.

IRS Class	Assets	Buyer’s Preference
Class I	Cash and most general deposit accounts	No preference
Class II	Securities	No preference
Class III	Accounts Receivable	No preference
Class IV	Inventory	Highly preferable because it provides an immediate deduction against ordinary income.
Class V	All other tangible assets that don’t fall under one of the above classes i.e. personal property and real estate	Personal Property- highly preferable because it provides an immediate deduction against ordinary income, although sales tax may have to be paid on these purchases. Real Estate- less preferable because of a long depreciation term.
Class VI	Non-compete covenants and all other intangible property that does not fall under Class VII	Typically less preferable because it is deducted over 15 years.
Class VII	Goodwill and going concern value	Less preferable because it is deducted over 15 years.

What Does an S-Corp Stock Sale Mean for the Buyer?

To jog your memory, in a stock sale, the buyer purchases shares of the s-corp directly and obtains ownership in the s-corp’s legal entity. Individual assets don’t require deep analysis and any assets that the buyer doesn’t want are typically paid off or distributed before the sale closes. An s-corp stock sale is usually less preferable for buyers, but it is usually favored by the seller. The reason an s-corp stock sale is typically less desirable for the buyer is really just because it lacks the same perks as an s-corp asset sale.

How Does an S-Corp Stock Sale Affect the Buyer in Terms of Taxes and Liability?

Unlike in an asset sale, in a stock sale, the buyer can’t “step-up” the depreciable basis in assets or deduct their purchase price immediately. Therefore, the buyer can’t re-depreciate specific assets. Instead, the buyer simply “steps into the shoes of the seller,” and the depreciable basis in assets doesn’t change. The s-corp just keeps depreciating the assets as it was previously. From a tax standpoint, this makes the deal less attractive for the s-corp buyer.

As for liability, a stock sale has more risk for the buyer. Like we talked about previously, an asset sale mitigates the buyer’s liability since the previous owner retains ownership of the s-corp’s legal entity. In a stock sale, the buyer doesn’t have this protection. Although in certain cases, these liabilities can be mitigated through representations, warranties, and indemnifications in the stock sale agreement.

If the s-corp has a large number of assets that pose issues with reassignment or legal ownership (intellectual property, government contracts etc.), then a stock sale combined with using other mentioned methods to mitigate liability for the buyer could actually be a beneficial approach.

Key Takeaways for Buying an S-Corp

An asset sale is typically better for the buyer.
An asset sale allows the buyer to improve cash-flow by “stepping up” the s-corp’s depreciable basis in assets.
An asset sale reduces the buyer’s risk for inherited liabilities.
If a large number of the s-corp’s assets are challenging to reassign (intellectual property, contracts, permits, leases etc.), a stock sale could be beneficial for both parties.
Most sellers will favor a stock sale because it provides better benefits for the selling party.

Buying an s corporation is not just a big decision, it comes with a whole lot of legal stuff to navigate. Hopefully you’ve gotten a better understanding of the jist, but give us a call to jump into the nitty gritty. Business acquisitions are no joke and you’ll definitely need an s-corp accountant in your corner along the way to make sure you’re securing the best deal and using the best s-corp tax strategies available.