How Your Entity Affects Deal Structure

Does the type of entity impact the structure of the sale for a business? 

Yes, the type of entity you have impacts the structure of the transaction and needs to be considered well in advance of starting the sales process. 

One of the primary considerations when determining how to structure the sale of your business is taxes. When selling your business, federal and state taxes can dramatically impact how much of the proceeds end up in your pocket. 

The type and amount of taxes that must be paid are directly impacted by whether your company is a sole proprietorship, partnership, or corporation.

The section that follows provides general information about the main differences among the various types of entities as they pertain to business sales. You should always consult with a qualified attorney or tax professional when considering a business-sale structure, but a review of the concepts discussed here will give you a head start. 

The type and amount of taxes that must be paid are directly impacted by whether your company is a sole proprietorship, partnership, or corporation.

Sole Proprietorships 

If your business is structured as a sole proprietorship, the sale can only be structured as an asset sale. Selling a sole proprietorship is treated as the sale of a collection of assets that are owned by an individual, which is you. 

The tax you pay will be based on capital gains tax rates for some assets and ordinary income tax rates for other assets. This will be determined by how you allocate the sale price.

Single and Multi-Member LLCs

Single-member LLCs are pass-through entities – there is no tax on the LLC itself. Sales of these entities can be structured as a sale of assets or as a stock sale, although it is technically a sale of the membership interests in an LLC.

Regardless, the sale is generally treated and taxed as an asset sale, and the 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 have 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 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 Corporation

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

• Asset Sale: Your tax rates will primarily be determined by the allocation of the purchase price. 
• Stock Sale: The majority of the proceeds will be taxed at capital gains tax rates, with some minor exceptions. Amounts paid directly to the owners, such as non-competition agreements or consulting agreements, are subject to income taxes. 

If your business is structured as an S Corporation, there is no double taxation at the federal level, which is the primary advantage of an S Corporation over a C Corporation. State income taxes may also vary from state to state. For example, some states (hello, California) only have income tax rates and don’t have capital gains tax rates.

If your S Corporation was recently converted from a C Corporation, the sale might be structured as if you were still operating as a C Corporation. The IRS has created a 10-year look-back period for this situation. If this might apply to you, I recommend consulting a CPA and engaging in advanced tax planning before the sale or attempting to structure your sale as a stock sale.

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. You will then face two levels of taxation, also known as double 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 two primary methods of avoiding double taxation:

• 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 of Martin Ice Cream Co., 110 T.C. 189 (1998). www.casetext.com/case/martin-ice-cream-co-v-commissioner
• Structure the sale as a stock sale, which is primarily subject to capital gains tax rates, although non-competition, consulting, and earnout agreements may be subject to income tax rates if they’re 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 available to you, such as structuring some of the sale as a bonus or salary, or negotiating the sale as a stock sale. But some of these options must be implemented well in advance of selling your business.

Key Points

• Tax implications can have a significant impact on the realized value of a business for both you and the buyer. 
• Consider how a sale is going to be structured from the outset and attempt to agree on the allocation of the purchase price as early as possible. 
• Keep in mind that advanced planning is essential to maximize the price of your business.

Learn More

If you’d like to learn more about the importance of due diligence and how it can impact your final price, check out the M&A Talk episode titled Preparing Your Company for Due Diligence with Anthony Nitsos in the Resources section of our website at morganandwestfield.com.

“It isn’t the mountain ahead that wears you out – it’s the grain of sand in your shoe.”

– Robert Service, British-Canadian Poet

Conclusion

Due diligence is the graveyard of deals. Less trustworthy buyers may be looking to chip away at the offer price with each and every finding, while sellers struggle to operate their business during the sale. In many cases, a little bit of preparation will stretch a long way. Taking the time to understand a buyer’s motives during due diligence and actually solving issues within your business before the buyer finds them will save you time, money, and trouble. A grasp of the intricacies of the other mechanics of the transaction will allow you to understand a buyer’s qualms and soothe them before they can spin out of control.