*DISCLAIMER: I am a mechanical engineer. (Do I really need to say anything else to emphatically point out that I am not a lawyer or accountant advising you on legal or tax matters?)
So here’s the plan:
Buy the assets of a business, create an LLC that files taxes as an S-corp, and sell the LLC.
First a little background. You have a few options when forming a business entity:
- Sole-proprietorship – single owner as disregarded (pass-thru) entity
- Partnership – multiple owners as disregarded entity
- Sub-S C-corporation – up to 75 shareholders as disregarded entity
- C-corporation – unlimited shareholders with corporate tax on profits and capital gains on distributions
- LLC – unlimited members
However when filing your taxes you have to choose one of the top 4 OR an LLC (for legal purposes) filing as one of the top 4 (for tax purposes). So not including all of the types of partnerships (Limited, Family Limited, Master Limited etc. etc. etc.) or Trusts you have about 8 options when forming your business entity. Of those 8 basic options, the LLC filing as a Sub-S seems to be the best for our buy, build, and sell purposes.
Reasons why you want an LLC filing as an S-corporation:
- An LLC is the simplest legal entity requiring the least amount of corporate formalities.
- An S-corp is a pass-thru (disregarded) entity so all distributions pass-thru to the owner on his personal tax return and are only taxed on state and federal income (and in several states such as Texas, Tennessee, Nevada, and Wyoming there are no state income taxes).
- You only pay tax on your Net Profit in your P&L – not on the actual cash distributions.
- With Amortization, Depreciation, Interest on the loan you used to buy the business, and a Section 179 of your equipment expenses, you can have quite a lot of cash distributions with no paper income.
Taxes you won’t have to pay with your LLC filing as an S-corp:
- FICA – you only pay that on your “reasonable” salary, not on your distributions
- Self-Employment Tax – this is only necessary with a sole-proprietorship or a partnership
- Corporate Tax – currently around 34% on the profits of a C-corp plus another 15% capital gains on your distributions (is there any reason a small closely held business would be a C-corp???)
The reason you buy only the assets of a business is your depreciation and amortization schedules start all over again and with the numerous business valuation methods you can always come up with some “goodwill” to amortize. Keep in mind, that amortization is your best friend. It’s a non-cash accounting expense that can save you thousands in taxes. For a more in-depth analysis of Amortization and Depreciation check out my Business Valuation 2 – EBITDA can eat my shorts blog.
The reason you sell the shares of the S-corp is that you can provide vendor financing to the new owner and only pay capital gains little-by-little every month as the payments come in. However if you sell the assets out of the S-corp, you have to pay the entire capital gains up-front EVEN if you’re carrying a note for the new owner. This obviously is the worst part about an S-corp. I believe the only way around paying all of the capital gains up-front on an asset sale would be a Like-Kind exchange. This could be very tough if you’re selling a business to buy another one because it would have to be an extremely similar business and you’d have to meet all the strict deadlines for the transfer (usually less than 90 days). And of course if you’re carrying a note then you may not have the cash to buy that other business. Is there a better way?
- If you’re never going to have any income (such as with a rental property or if you have a great accountant) you might as well file your LLC as a partnership or sole-proprietorship. Without income you won’t have to worry about taxes and when you go to sell, you can sell the assets, carry a note and still not have to worry about immediately paying for all of the capital gains. In other words it gives you a bit more flexibility when you go to sell.
- If you have multiple owners/shareholders and you don’t want the distributions to be evenly split along ownership percentage lines you can’t use an S-corp.
- If you’re going to buy, build, and sell very quickly (i.e. less than a year) you’re probably better off filing as an LLC sole-proprietor or partnership. I say this because if you can flip a business that quickly you’re probably able to grow it extremely rapidly and your biggest tax concern would be the capital gains on the sale. With the sole-proprietor or partnership you could be flexible and either sell the assets or LLC with vendor financing and not have to pay all of the capital gains up-front.
Unfortunately, I can’t claim that I learned all of this from a single book. As a matter of fact, it took about an hour with my accountant which will cost me about $55. Money well spent! 😉
To your success, Bryan