Business owners looking to sell their S corporation may start to get tangled up in all the details, especially if they are a first-time seller. This can lead to overlooking one key part of the sales process: tax planning. The decisions you make in structuring the sale will have a direct effect on later tax implications and how much of a profit you actually end up making. With the help of a Certified Tax Planner, you can create a plan to allocate your business assets in the most tax-advantaged way and receive the biggest possible payout from your S corporation sale.
The most common type of business sale is when an entity sells its business assets. In this scenario, both the seller and buyer are required to submit Form 8594 (Asset Acquisition Statement) to the IRS to report the increase or decrease in value of the assets sold. An S corporation could hold a diverse array of assets, and each one needs to be allocated to a specific asset “class” on the IRS form. The IRS treats each asset class separately in determining if you experienced a gain or loss and assessing taxes accordingly.
For example, cash in the bank is an asset. However, selling cash for cash does not result in a gain or loss. If an S corporation has $100 in the bank and that $100 is transferred to the new business owner, then $100 of the sales price is going to be allocated to cash, which is not subject to any special taxation rules.
An S corporation might have accounts receivable, notes receivable, or tax receivable. These represent money that customers owe the company for services that have already been performed or products that have already been provided. Since the sale has already occurred, these are taxed at an ordinary income tax rate, which taxpayers likely want to avoid since it can be as high as 37%.
The business may also have fixed assets, such as manufacturing equipment, furniture, vehicles, or other tangible assets. These are taxed at the often lower capital gains rates, but they can also be subject to depreciation recapture. Depreciation refers to the decrease in value of an asset over time, such as the wear-and-tear on manufacturing equipment as it is used. Taxpayers are allowed to deduct the estimated cost of that depreciation from their taxes, and as they do, the value of the asset is adjusted over the years.
When the asset is sold, the current value of the asset considering depreciation (which is called tax basis or adjusted cost basis) is used to determine whether there has been a gain or loss. So if a business has fixed assets that are fully depreciated (the asset has reached the end of its usefulness) and that asset is sold at a gain, that is known as “depreciation recapture” and can be taxed at ordinary income tax rates of up to 25%.
When the sale of a business results in capital gain, the entity can report this on its tax return using Form 1120-S (U.S. Income Tax Return for an S Corporation) and Schedule K-1 (Partner’s Share of Income, Deductions, Credits, etc) to report separately stated items to the owners. Additionally, Form 4797 (Sales of Business Property) can be used to report any recapture or types of long-term capital gains, including section 1231 or 1245 gains. Under section 1231, when a business sells property at a gain, they can apply the lower capital gains tax rate. Section 1245, on the other hand, applies to property that has allowable or allowed depreciation or amortization (debt paid off in equal installments over time), and this is taxed at ordinary income rates.
With an asset sale, part of the planning process involves deciding how to allocate the sales price. The sales process will involve reviewing the balance sheet, or the official statement of your company’s assets, liabilities, and shareholder equity. The balance sheet might include items like accounts or notes receivable, accounts or notes payable, and corporate debts. The sales price of the business will be reduced by anything allocated to liabilities. So if the new owner is going to assume $10,000 of accounts payable (money owed by the business to its suppliers), we would then take that $10,000 out of the purchase price. That amount becomes tax-free because we are simply reducing the sales price. This points to one of the basic tax strategies for the sale of an S corporation—to optimally allocate the sales price among different asset classes so that they become more tax-advantaged.
So who decides on this allocation? This depends on what has already occurred in the sales process. Ideally, the buyer and seller would have a signed agreement in place determining the allocation of the purchase price. If no agreement is ever drawn up and signed, the decision falls to the IRS, and they will likely allocate the sales price so that it results in the biggest assessment of tax. Therefore, a key tax planning move is to solicit expert advice on how to allocate the purchase price and get an optimal agreement in place before the sale is finalized.
For further guidance on tax planning for the sale of your S corporation or other business, reach out to Certified Tax Planner today!