I generally don’t recommend structuring a business as an S corporation.  Unlike LLCs and partnerships, the S corporation rules (i) restrict the number and type of owner, (ii) provide no flexibility in allocating income and loss, (iii) do not allow a step up of the assets at death of the shareholder and (iv) unlike other pass-through entities, the sale of assets and liquidation are both taxable events. This creates a sticky wicket to navigate.

Straight Stock Sale Tax Treatment Unlikely with S Corporations

A business sale can be structured as either a stock sale or a sale of the assets.  Buyers like asset sales because they can pick and choose what they want, and they do not inherit the existing liabilities of the company.  Sellers like stock sales because there is only one taxable event, rather than two.  However, even if an S corporation shareholder is able to negotiate a stock sale, the tax code allows buyer and seller to elect to treat the sale as an asset sale by making a Section 338 election.  Buyers like to do this because it allows them to step up the basis of the assets.  In a simple sale for cash the 338 election often works fine.  Assuming the asset sale results in a taxable gain.  It is passed through to the seller and taxed, and the gain increases his basis in his stock, so the distribution of the sale proceeds, which is deemed a sale, results in no gain because the basis in the stock equals the cash distributed.

Earnouts and Contingent Payments Cause a Sticky Wicket

The problem is that most transactions are not straight stock for cash.  Typically, a portion of the payments are made over time, and, when we introduce the installment sale rules to the mix, we find a huge disparity in tax treatment.  It is possible to have a situation where the seller has a large gain in the year of sale, but not enough cash to pay the tax.  That is a bad situation in its own right, but it can be made downright intolerable later when it turns out the seller reported too much gain in the year of sale, and only has a capital loss in later years that he cannot use.  A lot of these problems can be mitigated by structuring all of the sale consideration as notes, but that introduces business risk to the seller that the notes do not get paid.

Plan Ahead

Given the sticky wicket discussed above, an S corporation shareholder contemplating the sale of his company needs to consult with counsel before he starts the sales process.