8 MIN READ
As a financial planner, you're not only responsible for helping others plan for their futures—you also need to plan for yours. At some point, this might involve selling or liquidating your S corp or sole proprietorship/single-member LLC. Or perhaps your plan involves growing by acquiring an existing practice, which has implications for both the buyer and the seller; understanding what each side is hoping to gain from the transaction will help close the deal.
Your decision to sell or liquidate may come from pursuit of your own retirement. Or you could choose to sell part of your business to allow one or more of your employees to share ownership with you. Unfortunately, life could also throw you a curve ball, whether it’s a family emergency, personal health, or an opportunity that’s too good to pass up, that forces you to make changes sooner than expected.
Or you might encounter interested buyers who make leaving the business lucrative for you. These interested buyers could be looking to expand their current business, or to jump-start their business with your client base and business reputation. Or maybe they want to take advantage of economies of scale, sell new services to your existing customers, or gain ownership in your company (in the case of an employee). Just as there are many reasons why you might sell your business, there are many reasons why someone might want to buy it.
Now let's take a closer look at what the seller is giving up and what the buyer might be getting.
Buyer and Seller Perspectives
At the most basic level, the buyer is looking to buy the future cash flow from servicing your clients. For the employee buying in, they want an ownership interest with a chance to share in the profits instead of just wage income.
Establishing a selling price is beyond the scope of this post, but keep in mind that the selling price is often a multiple of your annual cash flow. The buyer should also be wary of assuming known and unknown debts of the company. Both sides need to do due diligence to understand the transfer.
Selling an Interest to An Employee – Partial Sale
Let’s first look at selling an interest to an employee. The employee is already known to you, and by selling an interest to them, it makes them sticky to your business instead of taking some of your clients and starting a completing firm. This transfer is less jarring to your existing clients because they are already aware of your employee. The employee might be aware of the profitability of the firm, and that getting a share of that profitability will improve their income; consequently, they might do less due diligence than a stranger to your firm would need to do.
When you are a sole proprietor or single-member LLC growing this way, your entity now becomes a partnership or multimember LLC where you and who was once your employee are now partners or members of the LLC. If you were doing business as an S corporation, your employee becomes an additional shareholder. What happens on the books and records of the company for a sole proprietor/single-member LLC is different than that happens if you operate as an S corporation.
When your existing entity is a single-member LLC or sole proprietor, the business is not filing a separate tax return like it does when an S corp. There is no tracking of partner capital or the balance sheet outside of your accounting program. This transition will bring a change to the operating agreement as you and your new partner establish your relative rights to income as well as cash flows (they can be different!), who is responsible for debts, and rights in liquidation.
For the employee buying in, their capital account starts with their purchase price. The owner will determine the basis in the capital they are selling and report the sale on the owner’s tax return. A 754 election is frequently made if the entity is a single-member LLC that adjusts the basis in LLC assets to what the new employee owner just paid for them. Note the employee buying in will no longer receive wages because partners don’t take wages from the company—income can be paid by guaranteed payments. Also, the new owner employee will need to pay self-employment taxes where before they usually drew wages that had withholding taken out.
For an S corporation, the admission of a new shareholder can be obscure from a basis perspective. An S corporation sells stock, and the original issued stock remains listed in the equity section of the balance sheet even if the ownership of that stock transfers to another owner. Only when new shares are issued would the stock balance in the S corporation go up (but that would mean the corporation is issuing the stock to the new buyer, not that the existing shareholder is selling some of their issued shares). Whereas the new partnership owner sees their purchase price in the beginning capital account, the new S corp owner does not.
There is an election for S corporations similar to the 754 election for partnerships called a 338 election, but there are additional restrictions that make the 338 election much less frequent in practice. For example, the 754 election can be made if even a fraction of a percentage ownership is sold, but section 338 requires at least an 80% change in ownership. Also, the 754 election is made on the partnership return, but components of the 338 election need to be made on both the buyer’s and the seller’s returns. Also note that S corporation distributions on stock ownership must be in relation to the actual share ownership. If the share distributions are not pro rata on ownership, it is evidence that two classes of stock exist, and the S corporation election is blown.
Closing Up Shop – Full Sale
If you simply close your doors and end your business, there is no sale to report. You’ll need to let your clients know you are closing up shop, pay liabilities to the extent possible, and distribute remaining assets to the owner. Also remember to close your lease if you’re renting business office space. If the entity is either an LLC or S corporation, be sure to dissolve the entity at the state level and file final tax returns.
When you are selling 100% of your company, consider what you are selling. For an S corp or single-member LLC, the deal can be structured as either a sell of the company as a whole, or the assets of the company. A buyer who wants the whole company takes the name, stock ownership or LLC membership in its entirety, and is responsible for future tax returns. The deal may include taking over the business location, so work with your landlord to transfer the lease to the new business owner. This is the cleanest deal for the seller because the stock sold is a capital asset so the entire purchase price over basis is capital gain to the seller.
The seller should take any assets out of the company they don’t want to transfer, such as the business vehicle or sentimental assets. The buyer of the whole company also takes the liabilities whether known or unknown. It’s especially important for the buyer to be careful in this situation. A friend of mine purchased an existing business and the due diligence did not turn up unpaid past tax liabilities. Even though my friend was a new owner of the company and the tax liabilities were incurred long before ownership changed, because of the structure of the deal, the government expected them to pay the delinquent debts.
For this reason, many purchases are structured as a sell of business assets. A sole proprietor usually sells the business assets as there is no entity to transfer at the state level. The buyer and seller agree which assets the buyer is getting—usually a mix of equipment, furnishings, a covenant not to compete, and the rest of the purchase price is allocated to good will. The buyer will want to allocate the most they can to shorter-lived assets like equipment. The seller will want to allocate most of the purchase price to goodwill for capital gain treatment. There is room to negotiate so each party gets some advantages in the transaction. No liabilities transfer unless both buyer and seller agree. Note that liabilities assumed are included as proceeds of the sale from a tax perspective.
Under an asset acquisition, the foremost tax benefit to the buyer is the step-up in basis of the assets acquired. Should the buyer sell the acquired assets in the future, less gain will be recognized, and thus tax liability will be lower because the assets will have been revalued up to their FMV.
The next most important benefit to the buyer is that the buyer can usually expense through depreciation or amortization the entire purchase cost in their business. Equipment and furnishings have a tax life of 5 to 7 years, and the goodwill is amortizable over 15 years. The seller is then responsible for reporting the sale of assets, and then liquidating and dissolving the business. Don’t skip this step as some states like California have a minimum tax due each year until dissolved. Even when the entire company is purchased, there are situations for tax purposes where an election can be made so it can be treated as a purchase of assets.
One final thought on making the transfer a success: negotiate with the buyer to transition clients over to the new firm ownership. Not all situations will allow for it, but by helping transition clients to a new firm ,you improve the likelihood they will stay with the buyers, and the transfer will be less jarring to your clients. You have invested a lot of time helping your clients. Do one last act of service for them by helping them transition to new advisors (and helping the new advisors transition to them). Setting this up as a consulting arrangement with the buyer can help you make the transition to your next phase in life too!
Whatever your situation is right now, it’s never too early to look down the road for your exit. Consider the pros and cons of the entity type you currently operate as, and what entity type might be best when it comes time to sell. In the best-case scenario, you’ve developed your business into a desirable one that will sell for a premium.
About the Author
Michael Law, CPA, is a Senior Tax Manager for XY Tax Solutions, a wholly-owned subsidiary of XYPN offering an outsourced tax team for XYPN members. Michael has 22 years of experience including time spent as Vice President of Tax Operations at Goldman Sachs. Other hats he has worn throughout his career include Supervising Senior Accountant, Tax Manager, Audit Manager, and Tax Partner.
He's been published or quoted in Accounting Today, Small Biz Daily, Business News Daily, and more. Michael holds a Masters of Science in Taxation from Golden Gate University and a Bachelor of Science in Business Administration from California State University.