Your owner has built a successful construction company and has decided it’s time to hang up their tool belt and sell the business. You’ve found a buyer and agreed on a price. How much cash will be deposited into their brokerage and savings accounts once the sale is completed? While the details of the purchase and sale agreement will dictate the tax implications, consulting with experienced professionals early may help maximize the after-tax proceeds.
This article will explore various tax implications to owners of S corporation pass-through entities when selling their businesses.1
Stock Sale or Asset Sale
A business sale is usually structured as either a stock sale or an asset sale.
Stock Sale
From a tax perspective, stock sales are simpler as the seller relinquishes their shares in the corporation in exchange for the proceeds. The seller recognizes a capital gain on the excess of the purchase price over their stock’s tax basis, which is then taxed at capital gain rates ranging from 0-20%2 depending on the seller’s total taxable income.
Generally, the seller’s tax basis is the amount previously paid for the stock plus the accumulated earnings.3 In most cases, this amount is the accumulated adjustments account, plus the original capital contribution, plus the additional paid-in capital contributed to the company.
Consider Bob, the owner of the S corporation Builder, Inc., who is selling all 100 shares of his company to Tim for $10 million; $1 million of the purchase price is allocated to a consulting agreement payable to Bob over three years. Therefore, Bob receives a $9 million stock sale price for his shares in the company ($10 million - $1 million consulting agreement).
Assuming that Bob’s original tax cost (contribution) for capital stock was $5,000 as well as $995,000 in accumulated earnings leaves him with a total cost basis of $1 million. He will recognize a long-term capital gain of $8 million ($9 million stock sale price - $1 million stock basis).
And, assuming he has no offsetting capital losses, he will pay $1.6 million in federal taxes on the capital gain ($8 million x 20%). Depending on where he lives and where the business is located, state and/or local income taxes may also apply. A 3.8% surtax may also apply (as discussed later).