Selling an S Corp? Here’s What You Should Know

If you’ve decided to sell your S corp, it’s crucial to conduct the sale of the business in a manner that rewards you financially.

The tax implications of selling an S corp can be significant. This guide walks you through selling a business to minimize or defer some of these taxes.

Key Takeaways

• Selling an S Corp is complicated, but you may experience significant tax savings by making informed decisions when structuring the S corp sale.

• To sell an S corp, you must determine the value of the business, choose a selling method, and finalize contracts and negotiations.

• Goodwill, or the intangible assets of your business, can significantly affect tax treatment with the sale of an S corp.

How to Sell an S Corp

Selling an S Corp can be a complicated process, and there are various methods for doing so. The following outlines everything you need to know about selling this business type.

1. Determine the Value of the S Corp

Your first step in the sale of a business is determining the fair market value. There are three main methods of valuing an S corp, each with advantages and disadvantages.

Given the tax implications of selling a business, choosing the ideal valuation method for your situation is essential. A CPA can help review tax laws, assess the value of your S corp, and determine the best valuation method.

Asset-based valuation

Asset-based valuation determines the fair market value of the business’s assets. This process involves calculating the combined value of all tangible and intangible assets and deducting liabilities. The result is the fair market value of the business.

Asset-based valuation is ideal for companies with significant business assets. Tangible capital assets include property, equipment, and investments like stocks, bonds, and options. Intangible assets include intellectual property, trademarks, and branding.

Income-based valuation

Income-based valuation uses the S corporation’s cash flow, profitability, and revenue to determine company value. The value is determined based on past, current, or expected future cash flows.

Income-based valuation is best for companies that have experienced a healthy revenue stream and consistent cash flow. If sales have been low or inconsistent, consider another valuation method.

Market-based valuation

With a market-based valuation, your company's worth is compared to similar businesses in your industry. This method analyzes earnings, revenue, and assets to consider the current market prices of comparable companies that have recently sold or are available for sale.

The market-based valuation method uses price-related indicators, including sales and book values. Book values refer to what the S corporation shareholders would receive if the company were to undergo liquidation.

The market-based valuation method is best for leading companies in their industry.

2. Choose a Selling Method

Once you determine the fair market value for your business, you are ready to choose a sales method. We’ll dive into each below.

Sale of Stock

In a stock sale, the buyer purchases the S corp stock, taking on all the assets and liabilities of the company. With this process, the ownership of the stock changes, but the company essentially remains the same.

Here are the steps to a stock sale for a company with Subchapter S status:

1. Prepare and execute a contract outlining the terms for a sale of stock between you and the buyer.

2. Outline a stock transfer agreement that contains the names of the current owners of shares and the buyers, the number of shares being transferred, and the amount paid for the shares.

3. Sign the stock transfer agreement as the seller to execute the sale.

4. Record the S corporation stock sale and revise the stock ledger to reflect the new ownership. 

5. Distribute Schedule K-1s to new and former shareholders to report share of income.[1]

6. Finalize the sale with a Schedule D (1040) tax form to report any stock gains or losses.[2] 

Sellers are subject to capital gains tax if there is a long-term capital gain on the stock. If the stock is worth more at the time of sale than when you bought it, you must pay capital gains tax.

To calculate your capital gains, you subtract your tax basis, or how much you originally spent on the stock, from the stock’s current worth. If there is a gain, you owe tax on that amount, minus any transaction costs from the sale. 

You can learn more about capital gains later in this article.

Sale of Assets

In an asset sale, the buyer purchases all your company assets and forms a new company. Some assets are capital assets and may receive favorable capital gains tax treatment. 

Long-term capital gains, consisting of assets owned for a year or more, are taxed significantly lower than ordinary income.

On the other hand, assets added back to prior depreciation will be taxed at ordinary income tax rates. This is known as depreciation recapture and is calculated by comparing the adjusted cost basis of the asset with the sale price. When an asset is sold for more than its market value but less than its initial purchase price, it’s treated as ordinary income and taxed accordingly.

The asset sale process can be complicated and involves several steps. Each asset sold is treated separately for partnerships, LLCs, and sole proprietors. Here’s a breakdown of the steps in this process:

1. Assign a tax basis to each asset by taking the asset’s original purchase price and adding or subtracting changes from the initial value. If the asset doesn’t have a tax basis, then it is subject to income tax rates.

2. Allocate a purchase price for each asset. Generally, the purchase price of each asset is determined based on fair market value. Some sellers find that getting a third-party appraisal helps with a more accurate allocation of purchase prices.

3. Determine how much capital gains will need to be paid versus income tax if you, as the seller, receive a profit from selling the business.

Installment Sale

If the sale of your business is financed and you receive at least one payment after the tax year of the sale, you can consider making an installment sale. This allows you to defer some of the tax due on capital gains until you receive payment in future years. Only income from capital gains can qualify for installment sale treatment.

According to the IRS, under the installment method, you “include in income each year only the part of the gain you receive or are considered to have received.”[3] The U.S. Small Business Association (SBA) states that you aren’t able to use installment sale reporting for the sale of inventory or receivables.[4]

3. Finalize Contracts and Negotiations

The final step in the S corp sales process is the purchase agreement. This must be carefully structured and outlined to protect the owner’s interests. 

The agreement should include the buyer and seller information, outline the terms and conditions of the sale, and specify the obligations and rights of the seller and buyer.

The purchase agreement must also contain the purchase price, selling method, sale inclusions and exclusions, important disclosures, payment terms, and any contingencies, such as if there will be an installment sale.

Tax Implications of Selling an S Corp

Depending on how you set up the sale of your S corp, you can face significant taxes on the sale of the business. With careful tax liability planning, you can minimize or defer some of the taxes you owe the IRS.

Familiarize yourself with the following tax situations and learn how you can maximize tax benefits during the sale of a business.

Sale of Goodwill

One aspect that affects tax treatment with the sale of an S corp is what is known as goodwill. Generally, goodwill represents the intangible assets that keep customers returning to use your services.

In the sale of an S corporation, goodwill is the amount paid above and beyond the fair market value of the company’s assets. With most businesses, there is value beyond the physical business assets. These intangible assets are often the reason why someone buys a business rather than starts a new one.

Intangible assets are built up over time. Examples of goodwill include the following:

• Brand reputation

• Reputation for quality workmanship

• Company prestige

• Intellectual property

• Employee relations

• Loyal customer base

• Excellent customer service

• Brand recognition

• Robust earning capacity

• Well-known and respected business name

Goodwill is derived once all assets have been allocated. It is calculated by taking the company purchase price and subtracting the difference between the value of the liabilities and assets and the fair market value. The sale of goodwill represents the amount that is left over. 

Regarding goodwill tax, these intangible assets are considered capital gains and are generally taxed as capital assets.

Some goodwill is considered “going-concern value.” This refers to the value of a business continuously operating successfully and aligned with its intended purpose after its sale. Going-concern value is usually not subject to allocation for tax purposes.

Capital Gains Taxes

Capital gains taxes are taxes paid on the profits you make from selling your business. A capital gain results when a capital asset is sold at a price higher than the basis or original purchase price.

Capital gains can be long- or short-term. Short-term gains are on assets you’ve held for less than a year. They are taxed at the federal income tax rate. 

Long-term capital gains are assets you’ve held for more than a year. They are taxed at the lower capital gains tax rates, which are 0%, 15%, or 20%, depending on your income level.

Determining capital gains and the tax consequences takes the following process:

1. Compute your basis, which equals the purchase price and any commissions or fees you paid.

2. Calculate your realized amount, which is the sale price minus any commissions or fees paid.

3. Subtract the basis from the realized amount to find the capital gain or loss.

4. Determine tax by multiplying a capital gain by the correct tax rate. If there is a capital loss, you can use the loss to offset any gains and reduce the tax basis burden.

Capital gains affect other factors during the sale of an S corp, including installment sales. If you receive at least one payment for the sale of the S corporation's assets in future years, you can pay the capital gains tax over an extended period. Any undrawn profits or retained earnings will potentially increase the capital gains tax.

Not all profits will be taxed at the capital gains rate during the sale of an S corp. This only applies to capital gain income. You will be charged ordinary income tax rates on items such as inventory, accounts receivable, and property owned for a year or less.

You may experience double taxation via the built-in capital gains (BIG) tax if your company was ever solely a C corporation. Essentially, if you elected S corporation status after forming a C corporation, any property obtained before S corp status may be taxed twice.

Double taxation will be at the highest corporate rate at 21%. Then, shareholder earnings are taxed at an individual level of 20% for long-term capital gains and 3.8% for net investment income tax (NIIT). This tax will occur after the sale at the corporate tax level and again at the shareholder level when the payment for stock is made.

Shareholder Payments

During an S corp asset sale, the corporation liquidates and distributes sale proceeds to the S corp shareholders. For tax purposes, shareholder payments are generally made under employment consulting and noncompetition agreements to avoid double taxation.

Because an S corp is a pass-through entity, any gain by the company flows through and is paid by the individual shareholders on their tax returns. The payments will be taxed only once at the shareholder level. However, those payments will also be considered taxable at ordinary income tax rates for the shareholder taxpayers. 

Note that employment and consulting payments will also be subject to employment taxes.

Net Investment Income Tax (NIIT)

The Net Investment Income Tax (NIIT) is a 3.8% tax imposed on individuals, estates, and trusts with high levels of investment income. This tax must be paid when income exceeds the statutory threshold amounts during an S corp asset or stock sale.

According to the IRS, NIIT thresholds are $250,000 for individuals who are married and filing jointly, $125,000 for those who are married and filing separately, and $200,000 for single individuals.[5]

FAQs

Is the income of an S corporation taxed as capital gains to the owners?

Yes, S corporation income is taxed as capital gains to the owners on the shareholder’s personal tax returns.

How do you report the sale of an S corp?

You can report the sale of an S corp using IRS form 1120-S (U.S. Income Tax Return for an S Corporation) and Schedule K-1 (Partner's Share of Income, Deductions, Credits, etc.).

What does it mean to report a sale of an S corp?

To report the sale of an S corp, you must record the sale on the corresponding IRS forms and pay the required taxes.

Is the sale of a business taxed as income or capital gains?

The sale of a business is usually taxed as capital gains. This tax occurs when you sell an asset for more than its basis, or what you paid minus fees. The IRS requires payment of two capital gains — long-term and short-term. Long-term gains experience more favorable tax treatment, including lower tax rates.

What is the capital gains rate for S corporations?

S Corporations' long-term capital gains rate is 0%, 15%, or 20%, depending on taxpayer income. Short-term gains are taxed at the federal income tax rate. 

How is goodwill taxed when selling a business?

If you have owned your business for over a year, goodwill is treated as a long-term capital gain and taxed at 0%, 15%, or 20%, depending on your income level.

Is capital gain from the sale of a business subject to net investment income tax?

If the capital gain is excluded from gross income for regular income tax purposes, it will not be subject to net investment income tax (NIIT).

Bibliography

1. IRS. “Shareholder’s Instructions for Schedule K-1.” Accessed November 4, 2023.

2. IRS. “About Schedule D (Form 1040), Capital Gains and Losses.” Accessed November 4, 2023.

3. IRS. “Topic No. 705, Installment Sales.” Accessed November 6, 2023.

4. SBA.gov. “7 Tax Strategies to Consider When Selling a Business.” Accessed November 6, 2023.

5. IRS. “Questions and Answers on the Net Investment Income Tax.” Accessed November 4, 2023.