Legal Deal Structure and Entity Type

The type of entity you have will also impact the structure of your transaction, so it needs to be considered well in advance of starting the sales process. One of the primary considerations when structuring the sale of your business is taxes. Federal and state taxes can dramatically impact your net proceeds. 

The type and amount of taxes you must pay depend on whether your company is structured as a partnership, corporation, LLC, or other type of entity. Tax implications can have a significant impact on the financial elements of the transaction for both the buyer and the seller. You should always consult with a qualified attorney or tax professional when considering how to structure your transaction. But a review of the concepts discussed here will give you a head start. 

Single and Multi-Member LLCs

Single-member LLCs are pass-through entities – there is generally no tax on the LLC itself. The sale of an LLC can be structured as a sale of assets or a stock sale – although technically, it’s a sale not of shares of stock but rather “membership interests” in the LLC. Regardless, the sale is treated and taxed as an asset sale, though some rare exceptions exist. Therefore, tax rates depend on how the purchase price is allocated. LLCs may also be subject to higher self-employment taxes than S Corporations, so I recommend consulting with your CPA prior to the sale.

If you’ve elected for your LLC to be taxed as a C Corporation, different rules apply.

Partnerships

If your business is structured as a partnership, the sale can only be structured as an asset sale. A partnership is a pass-through entity, which means that only the members pay taxes – the entity itself does not pay taxes. Taxes are paid at both capital gains rates and ordinary income tax rates, depending on how the purchase price is allocated.

S Corporations

If you own an S Corporation, the sale can be structured as an asset sale or a stock sale as follows:

• Asset Sale: If it’s structured as an asset sale, your tax rates will primarily be determined by how you allocate the purchase price. 
• Stock Sale: If it’s structured as a stock sale, most of the proceeds will be taxed at capital gains tax rates, with some minor exceptions – amounts paid directly to the owners, such as consulting fees, are subject to income taxes. 

S Corporations aren’t taxed twice at the federal level, which is their primary advantage over C Corporations. State income taxes may also vary from state to state. 

Some states, such as California, only have income tax rates and don’t have capital gains tax rates. For that reason, it’s crucial to investigate your state’s tax laws to ensure you minimize the tax implications of your sale.

If your S Corporation was recently converted from a C Corporation, the IRS has created a 10-year look-back period for this situation, and the transaction will be treated as if you were still operating as a C Corporation. If this might apply to you, I recommend consulting a CPA.

C Corporation

Your business is a C Corporation unless you or your shareholders have filed Form 2553 with the IRS electing to be taxed as an S Corporation. If the sale is structured as an asset sale, the C Corporation will sell its assets, and you will face two levels of taxation – once at the corporate level when the corporation sells its assets, and again at the individual level when the corporation distributes the proceeds to its shareholders in the form of a dividend.

There are three primary methods of avoiding double taxation:

1. Structure a portion of the sale as the sale of the owner’s personal goodwill, which is not a personal asset. Check out the legal case, Martin Ice Cream Co., 110 T.C. 189 (1998).
2. Structure the sale as a stock sale, which is primarily subject to capital gains tax rates.
3. Allocate part of the purchase price to non-competition, consulting, and earnout agreements, which may be subject to income tax rates if paid directly to the owner.

If your business is structured as a C Corporation, I recommend consulting with a CPA experienced in structuring the sale of companies well in advance of the sale. You have many options, such as structuring some of the sale as a bonus or salary – or negotiating the sale as a stock sale.