Holly founded ExitPromise.com as well as StartupPromise.com and so far has answered more than 3,000 questions asked by business owners about starting, growing and selling a business.
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Entrepreneurs may often be under the wrong impression that their business debt will disappear when the business is sold. In some cases, the debt is absorbed or is assumed by the buyer. But usually this is not the case.
Knowing what happens to business debt when selling a business is a critical part of the exit planning process and in determining which buyer is making the best offer.
The pandemic introduced PPP Loans, which may not be forgiven by the SBA, further complicate things. The SBA issued a Procedural Notice to address how to handle an outstanding PPP Loan when selling a business.
Furthermore, understanding how the debt on the company’s books ultimately affects the purchase price paid by a buyer or investors is important. And regardless of how the business is transferred, it’s important to understand how debt on the company’s books influences the price paid by the buyer or group of investors.
Stock vs. Asset Sale
While larger businesses and those sold in the public markets are typically sold under a Stock Purchase Agreement, such transactions can occur in the lower-middle and middle market. Stock sales are consummated with the transfer of the common and/or preferred shares of stock to a new owner. When this occurs, the buyer or investor is responsible for all debt and liabilities recorded on the books, as well as any undisclosed liabilities which may be present. Because of this, many small businesses are not sold under a ‘stock sale’ arrangement.
Asset sale arrangements between a business owner and a buyer involve the transfer of title to certain assets and in some cases certain liabilities. The combination of assets and liabilities transferred in an ‘asset sale’ is varied and subject to negotiation.
For example, in an asset sale a buyer may purchase the Inventory and one half of the Accounts Receivable while assuming all of the Trade Accounts Payable. The seller may retain one half of the Accounts Receivable and the Line of Credit. Any combination of Assets and Liabilities may be transferred to a buyer and/or retained by the seller in an asset sale transaction. A better term for an asset sale may be a non-stock sale.
As you can imagine, every buyer wants to acquire different assets and may be agreeable to assume certain forms of debt or liabilities, so comparing multiple offers in an apples-to-apples fashion can be challenging.
To further complicate the comparison process, each asset being transferred holds a different tax basis which affects the net amount of cash the seller receives after filing his federal and state tax returns. Don’t try this at home!
Enterprise Value
When public companies are compared in acquisitions, sophisticated Investors use a financial measurement called Enterprise Value to compare companies with different capital or debt structures.
Enterprise Value is a measurement of how much it takes to buy the entire company, not just the stock or equity. A company may sell its shares of common and preferred stock to investors for a sum of ‘X”, and at the same time assume the debt or liabilities equal to ‘Y’ and enjoy the cash on its balance sheet equal to ‘Z’.
Enterprise Value considers all three factors: Stock Price (X); plus the debt or liabilities on the books (Y); less the cash on the books (Z). EV = X + Y – Z.
Enterprise Value is a more accurate measurement of a company’s value because it includes the debt that the business must pay to its creditors and also accounts for the offsetting cash on its books.
Debt Counts No Matter What the Size or Kind of Business Sale
Business buyers, who understand capital structure and how a company’s debt negatively impacts its value, incorporate debt into the amount they offer to the seller. This is true whether the transaction is a stock or an asset sale.
If it is a stock sale, the buyer has added the amount of debt owed and subtracted the cash on the books to compute the company’s value.
If it is an asset sale, the debt is accounted for.
However, it is not a straightforward computation and the debt’s impact on the cash they ultimately receive from the sale is not always obvious to the seller.
When selling a business, the entrepreneur will be well-served if he seeks advisors who are able to provide apple-to-apple comparisons while accounting for debt and other liabilities. Although the computations needed to do so are not as simple as calculating the Enterprise Value of a public company, the principle is the same.
Hi. I sold my single owner LLC C Corp business but have not filed the tax return yet. It was an asset sale and the business had debt including, bank loans, vehicle loans and money owed to previous owners of businesses that I had purchased. The business had always made the payments on those loans and it was considered business expenses. At closing, all debts were paid in full and I received a check for the remaining money. My question is, with regard to capital gains, am I required to pay taxes on the full sale amount before those loans were paid off or on the remainder that I received? I have been told it is on the full sale amount but that doesn’t make sense to me. Thank you.
Hi Mark,
The answer to your question depends on what the tax basis was in the assets your business sold to the new owner.
And given what you described, it sounds to me as if you had an LLC (which you were the only owner-member) and you elected to file its taxes as if it were a C Corporation. If my interpretation is correct, then I must say it’s unusual. Most LLCs are not treated as a C Corp, albeit it is possible.
If this is correct, then when your business sells its assets the C Corporation reports the sale of the asset, according to how the asset purchase agreement defines the assets purchase price allocation. The difference between the amount each asset (or class of assets) is sold for less the asset’s tax basis is the taxable gain to the C Corporation.
The C Corporation would report each taxable gain (or loss) on its final tax return.
Once the C Corporation pays off any outstanding debts and then pays a dividend to you (its only member/shareholder), you’d be subject to taxes on the dividend income.
C Corporations, when selling its assets in a business sale, are subject to two levels of tax — the first at the corporate level and then another when a dividend is paid out to its owner.
I’ve made a big assumption here that indeed your LLC is being taxed as a C Corp. I highly recommend you seek the advice of your CPA and make certain the Asset Purchase Agreement and all of the associated schedules are carefully reviewed before you file your business and personal income taxes.
If you need assistance with such an advisor, we will be happy to introduce you to someone who can help you.
Hope this helps a bit…
I inherited a company that is an LLC. The founder (and my partner) had put up some of his own money (long term debt) prior to my involvement. We’re selling the company now in an asset purchase, and the founder wants to pay back his long term debt prior to paying out the Cap table (me and him as well as a couple of other investors). In this case should the long term debt (money the founder put in out of pocket) be paid back before splitting up to the cap table? Thank you
Hi Zach,
The answer to your question will likely be found in the loan agreement between the former owner/founder and the LLC when the loan was put in place. The terms of the loan agreement should state when the loan is due to be paid back.
Generally speaking, loans are paid back to lenders before capital investments are returned to investors.
Hopefully your sale will go smoothly for all parties involved. All the best Zach…
Hi Holly, I just stumbled across your webpage.
I am looking to do a share purchase of a business for 750K, the seller has 260K in loans for recent improvements. How does these loans typically impact the purchase price. I would also need a loan of 350K to finance it.
Hi Chris,
When buying a business which has debt on the books, it’s important to understand whether such a purchase (of the stock or the business assets) will mean the loan must be paid off.
The answer to this question may be found in the loan or line of credit agreement the business owner signed when they borrowed money.
If you’ve agreed to purchase the stock and the lender does not have any language in the loan/line agreements which either requires the business to pay off the loan/line or the business owner to seek the lender’s permission to sell the stock, you should be able to proceed with the acquisition. The loan would remain on the books after the sale and the lender should continue to receive its payments on the loan after the closing.
Your agreed to purchase price of $750,000 (or any amount) should take into consideration the debt it is assuming (if that is indeed what happens). If you pay $750,000 to the owner for the stock of the company and then have to also pay off a bank loan of $260,000, you’ve essentially paid $1,010,000 for the business. If that’s not your intention, you may want to consider an asset purchase instead of a stock purchase when buying this business.
We have advisors to assist you with financing a business acquisition if you need assistance. Here’s where you may request help.
Hope this clarifies things for you a bit. If not, let us know. We’ll give it another try…
Assuming the loan has to be repaid, can’t it be replaced by taking a fresh loan from the bank? Would you still be paying $1,010,000 for the business or just the initial $75,000?
Hi nidhi,
Please pardon our delayed response to your question…
We learned last week that our site host was not able to handle the size and level of activity of our visitors so we put things on hold, found a new host and made the move. It was a long week!
Yesterday, we were able to fully-restore the site and now are able to move forward with posting and Q&A.
Thank you for your patience!
Now, to answer your question…
Yes, the loan may be replaced with a loan from any lender to the new owners. Banks and other lenders will look to the financial strength and personal history of the new owner(s) in this scenario.
If a price of $750,000 is paid for the business stock and the new owners have to borrow $260,000 to provide cash or liquidity for the business operation post-closing, then the total enterprise value of the business and the amount paid for the business is essentially $1,010,000.
Hope this helps…
If I want to buy only the fixed and and some of the current assets (like inventory, supplies, and prepaid rent for instance) then why do I need to do business valuation to know what the business is worth of?
Thank you in advance!
Hi Heydar,
When you have a business valuation prepared, the value includes the assets associated with the business — fixed, current as well as intangible assets. It also includes value attributable to the cash or profit a business operation produces.
If you are simply buying certain assets in a business and not assuming the operating business as a going concern (which produces revenue from customers), then having a business valuation prepared may not be necessary. It really depends on what you are purchasing from the business owner.
All the best…
Hi,
A business that I work for got recently sold to new owners (who also happen to be employees). It was a Stock Purchase Agreement. Purchase Price was lets say X+Y Mil. The new owners thru the business took a loan for XMil. XMil was then paid to previous owner. XMil is sitting as a Long Term Liability on the books (correctly so). However, YMil which is still owed to the previous owner after 5 years is not on the business books as the new owners (not the business) are personally responsible to pay the previous owner.
Is this a standard practice for a sale?
thanks
Hi Dawn,
If the sale of the STOCK ( a Stock Purchase Agreement) was sold by the former business owner to a few employees, the TOTAL purchase price would have been paid directly from the employees to the former business owner.
In such a case, there should not be a loan on the books of the company. That said, the Company may have simultaneously recapitalized by borrowing money from a bank and then distributing the cash to the new owners to buy the stock.
Similarly, part of the stock sold by the former shareholder may have been sold back to the Company’s Treasury.
As you can see, there are many ways to accomplish the sale of stock and how the sale is structured determines how it’s recorded on the company’s books (or not!).
It’s not clear to me by the way you’ve asked the question where the problem or concern may be in your situation. If you’d like more clarity, feel free to explain further.
All the best…
Selling a S corp. but it has $300k bank debt. Selling price $250k. Is the money used to pay off bank first and then taxes?
Hi Larry,
Most banks will file a UCC-1 in your state of operation and/or business entity formation that secures its first lien position for any bank loans, lines of credit, commercial leases, etc.
So, typically when you sell the business, the buyer is going to be certain such debts are satisfied before the transaction closes.
Federal, state and local taxes may be liened as well. If so, these would be paid in the order in which the lien filings occurred.
If liens for the taxes you mentioned have not been filed yet and the bank loan is paid at closing, then payment of the taxes (personal, business or payroll) will be the responsibility of the seller to pay, regardless of the amount of money the business was sold for.
Hope this helps you a bit Larry…
What about a person who may owe the company money? When the transfer of ownership occurs, legally does the person still have liability? At what point is the person no longer obligated? Please let me know. Thanks!
Hi Martin,
If an individual or company owes a business money and the business is sold, the debt owed is still valid and collectible by either the company or the shareholder/owner who may have retained the receivable in the transaction.
Business sale transactions are either a stock/equity sale or an asset sale. If it is a stock/equity sale, the receivable would remain on the books of the company sold. If it is an asset sale, the receivable may be transferred to the new owner or it may be transferred to the former shareholders/owners. It would depend on how the asset sale was negotiated by the buyer and seller.
Hope this clarifies things for you a bit Martin…
Hello,
My partner and I went into business together and have formed a partnership LLC. I am a 19% stakeholder and don’t feed many personal expenses through the business. We are in agreement that we want to sell the business.
I want to understand what I need to do to protect myself when selling the business. The company owes m $58k. This NP is on the books. My question is should I start taking personal expenses to offset the loan the company owes me in case of any issues when selling if the buyer doesn’t want to assume any loans? Not sure how this works. I just don’t want to lose the money the company owes me.
Thanks
Hi Meeta,
You are wise to seek counsel before you attempt to sell your business.
The idea of taking personal expenses out of the business to offset the loan won’t hold up if you are audited. The IRS only allows a business owner to deduct expenses from income if the expenditures are ordinary and necessary expenses to operate your business.
The way in which your business sale is structured and of course the amount of money paid by the buyer will determine what happens to the loan you made to the company.
Like others asking similar questions, you may benefit from the services of an advisor with expertise in selling businesses and we’d be pleased to make an introduction for you. Here’s where you may send in your request for further assistance.
All the best Meeta…
Hi my friend want to sale his resturant bussiness , he got 70 k loan & 25 k tax .
If i buy that resturant include abn & bussiness name howbit effects me .
Do im liable for it or my friend ?
Hi Rajesh,
I am having a bit of trouble understanding your question.
It sounds to me that your friend owes $70,000 to someone or a bank and another $25,000 for taxes. Is this correct?
If so and you purchase the assets, including the business name, and do not purchase the stock, it may be possible for you to avoid liability for the loan and taxes.
This is a transaction that you should have assistance with to protect yourself and to avoid making a serious mistake.
If you need assistance, we’d be happy to introduce you to advisors who you may hire to help you. Here’s where you may enter your request.
Hope this sets you in a good direction Rajesh…
Sub S corporation has one shareholder with $5,000 stock basis, incorporated in 2017, and has $30,000 loss in 2017. Shareholder loaned corporation $25,000 to create debt basis to be able to use loss pass through to shareholder on personal income tax return. If shareholder sells 100% of stock to unrelated person now using the cut off method, can the corporation repay the loan to former shareholder over time tax free to former shareholder? The new shareholder would pay tax on any subsequent profit as a pass through on their personal tax return.
Hi Robert,
There are three parts to the scenario you’ve described.
First, the tax basis available to the S Corp shareholder in order to take the loss in 2017; and
second, the sale of your stock in the S Corp to a new owner; and
third, the tax consequences to you when the S Corp repays your loan (and interest).
You are correct as far as the tax basis needed to take the loss in 2017 on your personal tax return. This is the case only because of your available debt tax basis, which differs from your $5,000 stock tax basis.
Taking the $30,000 loss would mean your stock tax basis is zero and your debt tax basis is also zero.
If your stock sale to the new owner is a qualified sale or exchange and not considered a distribution, then all of the proceeds would be reported on your Schedule D as a Capital Gain because your tax basis in the stock is zero.
At this point, you’d still have a valid loan receivable from the S Corp and when it’s paid back to you, it is my opinion the $25,000 loan principle and interest would be taxable income when received. The loan principle received would be capital gain income if the loan to the corporation was evidenced by a formal written note. Otherwise, its repayment would be ordinary income. And the interest income received would be ordinary income to you.
You should review your specific scenario with your CPA Robert, as he or she would know exactly what your stock and debt tax basis is related to your S Corporation ownership.
All the best…