Selling a business is one of the most significant events in an entrepreneur’s life. Most of the transaction process will be driven by the market, a buyer’s goals, or industry dynamics outside of the seller’s control. There are, however, critical steps sellers can take well before a letter of intent (“LOI”) is signed to preserve value, avoid unpleasant and unnecessary surprises, and position both the company and its shareholders for optimal results.
If you are planning to sell your S corporation within the next two years, the following are five action items you must pursue now.
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Be wary of restructuring
There are many tax strategies that could be advantageous to business owners, but are not necessarily advisable within two years of a sale.
For example, one hot-button tax savings technique is for shareholders to sell stock in a C corporation that qualifies as small business stock (“QSBS”) pursuant to IRC Section 1202 to take advantage of the potential $15M (or more) gain exclusion. Converting from an S corporation to a C corporation will generally not result in QSBS.
Furthermore, in most mid-market transactions, buyers will require an acquisition to be structured as the sale of assets (i.e., your corporation sells its assets and you will still own your corporation’s stock after the transaction) rather than as a sale of stock (i.e., you sell your stock in the corporation and no longer own any stock after the transaction). If a transaction must be structured as the sale of assets, it is almost surely more tax efficient for the selling corporation to be taxed as an S corporation and not a C corporation.
Unless there is a compelling, tax-driven reason, maintaining S corporation status through closing is usually the prudent course. Regardless, consult your tax attorney before making any structural changes to your S corporation.
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Confirm your S corporation’s ownership
Sellers should confirm ownership and equity rights before entering into discussions with potential buyers. Verify the number of issued and outstanding shares, review option and restricted stock agreements, confirm that phantom equity or convertible instruments are properly documented, and confirm no informal ownership promises were made to employees or others.
Buyers will scrutinize ownership and equity rights during due diligence, and discrepancies can delay or derail a transaction. Clean cap tables build credibility and protect negotiating leverage.
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Conduct S election diligence
In California (and most community property states), many S elections are ineffective as filed, often because of technical errors on Form 2553, Election by a Small Business Corporation. These issues are usually fixable with a simple IRS filing, but if not corrected, the corporation you believed was an S corporation may actually be taxed as a C corporation.
Buyers will review this issue carefully, and sellers can lose credibility when something so fundamental was missed. Conduct an internal ‘S election audit’ to confirm the election was properly filed, identify any inadvertent terminations, and ensure shareholder agreements, stock classes, and debt instruments comply with Subchapter S requirements.
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Conduct multistate tax and nexus diligence
State-tax “nexus,” when an out-of-state business must file sales, franchise, or income tax returns, is one of the most common diligence issues in middle-market transactions. You no longer need physical presence in a state to create filing obligations. Remote employees, online sales, and ‘economic nexus’ laws now pull many S corporations (and their shareholders) into taxation in multiple jurisdictions.
If your business has potential exposure for unfiled and/or underreported state taxes, resolve it before buyers get involved. Once a buyer identifies exposure, they will likely demand you handle the requisite cleanup at your expense (which will generally be much more than if you resolved on your own without a buyer involved), and may also reduce the purchase price and/or require your funds be held in escrow post-closing.
Most states offer Voluntary Disclosure Agreement (VDA) programs to help taxpayers come into compliance. Addressing these issues early shows strong governance and reduces post-closing risk.
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Plan any pre-sale gift/estate planning or residency planning
For sellers considering estate or residency planning, it should start well before a sale.
Gift and estate planning, such as transferring a portion of ownership to a trust or family member at a discount, can substantially reduce income taxes and future estate taxes. Residency planning, such as terminating/abandoning residency in a high-tax state (e.g., California) in favor of a lower tax state (e.g., Florida) can reduce or eliminate state income tax. In both cases, strategies must be implemented well before a transaction, and in certain cases, before the LOI (or, better yet, before the buyer is identified).
These strategies require time, documentation, and clear intent. Engage your estate planning and tax advisors early to determine what is achievable within your timeline. Regardless, these pre-transaction strategies must be implemented early.
Conclusion
The sale of an S corporation demands more than just business savvy. It requires disciplined tax and legal preparation. Taking action early is key to preserving value and minimizing tax exposure when the sale finally occurs. Engaging outside counsel well in advance of a potential sale can help ensure you are not missing opportunities to maximize your exit.
