Selling an S Corporation

If you’re an s-corp owner, then you’re likely already familiar with What an S Corporation Is, and now you’ve decided that the time has come to sell your small business. The idea of selling their s-corp can make some small business owners just as nervous as when they first started their business. Luckily, we’re here to offer guidance as you begin the process.

In this article, we’re going to dive into which sale structure, asset sale vs. stock sale, is more beneficial for sellers and why. On the flip side and trying to buy an s-corp? Check out Buying an S-Corp for advice on that side of the deal.

We won’t lie to you, s-corp acquisitions can get pretty complex depending on the specifics of the business and the deal. Once you’ve decided to get the ball rolling, it’s definitely a good idea to call an s-corp specialized accountant to talk logistics. In the meantime, we hope this article offers some insight into which structure benefits you, the seller, most.

Each structure usually favors one side of the sale party more, but because we hate being dragged through legal jargon before finding the answer just as much as you do, we’ll give you the easy answer upfront – as the seller of an s-corp, in most cases, a stock sale is going to be preferable for you.

That doesn’t mean you should stop reading though. It’s important to understand how an s-corp stock sale works, why it is usually more attractive for sellers over an s-corp asset sale, and how to use it to your advantage.

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

We promise this isn’t meant to sound sarcastic, but make sure your s-corp is actually an s-corp with active s-corp filing status. It’s a pretty common misunderstanding to think that “s-corp” is synonymous with “small business,” but that’s not the case. S-corp is a special tax election, and it matters a lot when it comes to selling your business.

As we said above, a stock sale is usually more advantageous for the seller, but the stock sale vs. asset sale stuff isn’t the same for sole-proprietorships, LLC’s or general partnerships. If you’re looking to sell another small business entity type, we’re still happy to help, but moving forward, we’re going to assume this sale is of an s-corp.

One more thing, if the small business being sold isn’t the actual s-corp, rather it’s 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.

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

For a quick recap, in an s-corp stock sale, the buyer directly purchases shares of the s-corp and obtains ownership in the s-corp’s legal entity. In addition to the stock purchase, assets are typically included in the transaction. If the buyer doesn’t want certain assets, those are usually sold or distributed before the deal closes.

What Does an S-Corp Stock Sale Mean for the Seller in Terms of Taxes?

The first reason a stock sale is generally preferred by the seller is because of taxes, everyone’s favorite subject right? In an s-corp stock sale, proceeds from the sale are taxed at the rate of capital gains, as opposed to ordinary income rates, and the capital gain tax rate is significantly lower than that of ordinary income. This tax difference is a huge motivator for sellers to desire a stock sale. The only thing that makes taxes better is saving money on them.

What Does an S-Corp Stock Sale Mean for the Seller in Terms of Liability?

As for liability, a stock sale offers the seller better protection because any future liability or lawsuits associated with the s-corp will follow the business, without implicating the previous owner.

One thing to note is that the liability protection a seller has is not always guaranteed across the board. The stock purchase agreement may include representations, warranties, and indemnifications to mitigate liability for the buyer. Although the liability responsibilities will be specific to the deal, a stock sale usually still offers more protection for the seller.

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

Another little refresher, in an asset sale, the seller keeps ownership of the s-corp’s legal entity. The buyer purchases only the desired assets, and this type of sale structure is often referred to as a ‘cash-free, debt-free’ sale because the seller typically retains long-term debt obligations and cash is not usually included in the assets.

What Does an S-Corp Asset Sale Mean for the Seller in Terms of Taxes?

An asset sale is less preferable from a seller standpoint because it generates higher taxes for the seller. Generally speaking, ordinary income tax rates are significantly higher than capital gains tax rates, and in an s-corp asset sale, “hard” assets can be subject to ordinary tax rates, although intangible assets such as “goodwill” will still be taxed at capital gains rates. This isn’t too frequent, but another thing to consider is that if the s-corp being sold was formerly a C corporation, additional tax could be triggered by the IRS’s built-in-gains (BIG) rule.

What Does an S-Corp Asset Sale Mean for the Seller in Terms of Liability?

Another factor that makes an asset sale less enticing for sellers is the liability. The reason an s-corp stock sell is preferable is the same reason an s-corp asset sale is less preferable. In an asset sale, future liability or lawsuits can affect the seller since they are still the owner of the s-corp entity.

Lastly, this isn’t specific to the seller, but an asset sale has the potential to run into problems for both sides if certain assets are difficult to reassign or have legal ownership issues. Examples of these assets include permits, leases, government contracts, and intellectual property.

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

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 seller, while an opposite distribution usually benefits the buyer. Take a look at the table below to see an overview of the different “classes” and the seller’s general perspective towards which classes are preferred for a higher or lower allocation amount.

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

IRS Asset Class	Type of Assets	The Seller’s Perspective
Class I	Cash and general deposit accounts (Including savings and checking accounts, but does not include certificates of deposit held in banks, savings and loan associations, and other depository institutions).	No Preference
Class II	Actively traded personal property such as publicly traded stock and U.S. Government securities Certificates of deposit Foreign currency	No Preference
Class III	Accounts Receivable	No Preference
Class IV	Stock in trade Inventory	Low amount in allocation is preferred because it minimizes ordinary income
Class V	All other tangible assets that do not fall under one of the above classes (Includes furniture, fixtures, real estate, vehicles, equipment etc.)	The seller’s preference may depend on the type of assets falling under this class. For personal property assets such as furniture, fixtures etc., a low amount in allocation is preferred because it minimizes gain that will treated as ordinary income. For real estate assets, a high amount in allocation is preferred because it provides long-term capital gain treatment.
Class VI	Non-compete agreements Workforce in place Business books and records, operating systems, any other information base etc. Licenses, permits, etc. Franchise, trademark, or trade name (exception for certain professional sports franchises) All other intangible property that does not fall under Class VII	Low amount in allocation is typically preferred because it is taxed as ordinary income over the term of the agreement.
Class VII	Goodwill and going concern value	High amount in allocation is preferred because it is taxed as long-term capital gain.

Key Takeaways for Selling an S-Corp

A stock sale is typically better for the seller.
A stock sale saves the seller money in taxes because proceeds are taxed at a capital gains rate.
A stock sale usually offers better liability protection for the seller.
Most buying parties will favor an asset sale because it provides better benefits for the buyer.

Deciding to sell your S corporation is a big decision, and that’s before you even start to factor in the negotiations and legality. Now that you understand the basics behind how each deal structure affects the seller, give us a call, and we can help you navigate the specifics for your s-corp. Having an s-corp-dedicated CPA firm makes all the difference in ensuring that the process is as smooth as possible, with the best possible outcome.