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 holly
I bougt a small business and the seller has debt on the business but didnt tell me enything what should i do know
Hi Cj,
Well, I am sorry to learn you are experiencing this problem with the acquisition of your business.
The purchase agreement you signed when you bought the business should have spelled out in detail whether your acquisition was a stock sale or an asset sale. If it were a stock sale, then generally speaking the buyer is responsible for all of the business debts. If on the other hand the acquisition was an asset sale, then the debts may or may not be the buyer’s responsibility. Here’s more on the subject to help you understand the differences between an asset vs. a stock sale when buying a business.
Hi Holly,
I’m in a similar situation except I’m the seller of Bar and the buyer is my manager of the business . She has basically made the business not viable for myself and is willing to buy the LLC. Besides all of the previous debt will she be responsible for any taxes owed that my come to light well after I’m gone? For instance there may be some back payroll taxes or state sales tax that were overlooked by her as manager. Can this be written into the sale agreement or is it already implied? I just want to walk away from this and never look back…
Thanks for your time!
Hi Donovan,
Firstly, I am sorry you’ve had this experience. It doesn’t sound like a good situation.
That said, your manager’s willingness to buy the business is in your favor.
When you sell a business entity, such as an LLC, generally speaking the buyer is responsible for all of its debts on the books and any unknown debts and liabilities too.
It’s very important for you to hire an Attorney who is skilled in drafting sales agreements for the transfer of businesses. That Attorney should also be familiar with the requirements associated with transferring liquor licenses.
Good luck with your sale Donovan!
Hi Holly,
I’m interested in buying a restaurant (turn key) from the owner. Unfortunately, he has a large amount of debt in loans, state taxes, and IRS. If I purchases the restaurant, form a new lease agreement on the building, and change to a new LLC name, COULD the debt from the old LLC come back on me as the new owner?
Thanks so much for your insight.
Hi Michael,
Well, firstly I recommend you to consider working with an experienced Attorney who handles business acquisitions on a regular basis. Having a good CPA to consult is a good idea too.
Before you meet with them, it’s worthy to learn more about the ways you may acquire a business.
When you buy a business, you may acquire the company’s stock or the company’s assets. When you buy the stock, you get everything associated with the business (good and possible the bad too). You simply change the stockholder’s name on the stock certificates. In this case, you’d be held responsible for all of the debts on the books and even those not recorded on the books.
If you buy the assets of the business, during the negotiations of the Asset Purchase Agreement (APA), the specific assets and liabilities should be identified and those liabilities which the buyer will not be assuming should be specified as well.
Taking care to get the Asset Purchase Agreement negotiated properly should prove to be very helpful to you in the long run.
Hey Holly, I am selling my portion of a photography business to my business partner. We have agreed on a buyout amount but we are hung up on another issue. Since we are paid in advance as an owner I have collected payments for shoots I will not participate in. The other owner thinks I owe that money back in cash or in work. Is he correct? I would think that since the buyout came out of no where and I was owner at the time that what has been paid is paid and should not be retroactively owed. Thank you for your time and help.
Hi Eric,
You are asking about a pre-paid deposit which should have been recorded when received from your customers on your company’s balance sheet as a current asset. When the job is complete, then the asset would be recorded as income. I realize you may not be an accountant 🙂 and you don’t really need an accounting lesson either! I only mention this because it’s important to understand that when you sell or buy a business, it’s either considered to be an asset sale or a stock sale. And the difference tells you whether a prepayment from a customer should be considered in your situation.
If it’s an asset sale and your partner is only purchasing part of the business, such as inventory, customer lists, accounts receivable, then the prepaid accounts should be negotiated.
On the other hand, if the sale is a stock sale, the entire business is being transferred by one owner buying the stock, partnership equity or member equity from the other partner, then the prepaid accounts are ‘baked into’ the sale.
It may be the case that you and your business partner haven’t decided whether the sale is an asset sale or a stock sale. If this is the case, then the prepayments may be up for negotiations.
An LLC owned 50/50 by two brothers trusts is dissolving. For ease of asking the question lets assume they have inventory on the books at cost of $100,000. They have a liability of $1,000,000. Assume the inventory is valued at $800,000. The lender has agreed to take the inventory as payment on the loan and forgive the rest of the loan. I would assume the debt is reduced by the value of the inventory leaving $200,000 in COD income but the accountant is saying the loan is reduced by 100,000 leaving 900,000 in COD income. Do you know how it should be recorded?
Good morning K,
It’s very unusual to have inventory on the books of a business which has a fair market value so much greater that its cost.
The answer to your question depends on whether the debt was a secured loan, non-recourse or recourse.
Given the size of the loan, the inventory’s unusually high fmv and the complexity surrounding the types of loan you may have with your lender, you should consult with a bankruptcy Attorney who is well-versed in taxation. I am sorry I am not able to assist you with this question.
Holly while I was a sole proprietor, I borrowed money from my parents to float my business. I repaid a portion of the loan. A year and a half later I converted the dba to an LLC with an S Corp election. I now want to pay another portion of the money I borrowed from my parents. Can I make this payment from the LLC?
Good morning Alley,
Well, good for you! And congratulations… you are doing well and I’d bet your parents are pleased.
Yes you may make the payments from your LLC. However, how the payments would be treated for tax purposes depends on how you capitalized your LLC when you took the assets and liabilities from your sole proprietorship and converted it to an LLC.
If you recorded the debt on the LLC’s books when you converted, then it is just a matter of reducing the liability account (debt) when you make the payments to your parents.
If not, then the payments you are making on the debt is a distribution from the business to you. This is the case because you’ve elected to be treated as an S Corporation for tax purposes.
You should discuss this with your Accountant or CPA to determine the best solution for you and if it is possible to amend your first tax return as an S Corp to make things right.
Hi. I wonder if you would be able to give us an answer to this – we do however live in South Africa so I’m not sure if things are the same throughout the world…. We wanting to buy a CC – closed corporate – from a lady who has a small business selling toys. Some people are saying if she had hidden dept we will be liable if we take over the CC. Others say not she personally would be liable. Any ideas if we would be or not? Thanks Jo
I released my partner from her half (50/50) of the LLC after she asked to leave and now I have an offer to buy my restaurant. In Pennsylvania, does she have any ability to claim compensation from the sale? If so, is there a time frame that she can file a claim? Thanks.
Good morning Kevin,
If you mean by saying you “released” your business partner that in fact you previously purchased your partner’s ownership rights as a member of your LLC, then she should have no rights to any amount of money received from the sale of the LLC.
In all cases, each state has its own statute of limitations laws which apply to claims made by parties.
Kevin, you should consult with your business Attorney about this matter before proceeding to sell your business to be certain all is in good order.
Good morning Jo,
I am sorry, I am not familiar with how debt is handled when selling a business in South Africa.
If there’s another advisor reading this post who may be able to help Jo out, please chime in!
Hi Holly,
Thank you for all the advice you share on your site. I am selling my restaurant (it is a single-member LLC in FL that files as an S-corp), as an asset sale to my brother. The sale price is $125K and the equipment is valued at “cost to replace” of $75K.
The cash at the time of the sale will be $0 as we will not have any left over after the final payroll and vendors are paid for the month. My question is how to structure the agreement/contract so that the tax on the sale that either the business or myself is liable for are accurate.
My brother is giving me $100K in cash at closing and I agreed to finance the remaining $25K for 3 years at 3%. The business currently has $100K in debts that need to be paid immediately at closing. This includes state unemployment taxes, sales tax, as well as business loans and past due vendor invoices. I am planning on paying all of these debts off immediately, so I will net $0 on the sale.
The remaining $25K that he is paying me over 3 years will go to pay off prior year 940/941 federal taxes that are not finalized yet but will need to be paid. I will again not benefit at all from these payments, and in fact will likely need to supplement with some of my own cash to ensure any federal balance in the business name is paid off down the road.
How should I structure the contract to ensure this $125K is not taxed as income since it is all going to pay off business debt? Should I list the business debts being paid in the contract or should I stipulate as a part of the sale which debts my brother will pay off and reduce the contract price by that much? Just trying to ensure I proceed wisely as I am already taking a loss to sell it.
Thank you!
Michelle
Good morning Michelle,
As you’ve described very well, the sale of your business to your brother is an ‘Asset Sale‘ which means your existing LLC (being treated for federal tax purposes as an S Corporation) will remain intact until you wind up its affairs. Given the structure of the payments being made to you for the assets of the LLC, the winding up (or closing of your LLC business entity) will not occur until all of the payments are made to it. In your case, that will be about 36 months from now.
Your agreement should spell out which assets are being sold to your brother and breakdown the amount being paid for each asset. If there are any liabilities to be transferred to your brother at the time of the sale, they should be spelled out in your agreement as well. The agreement should state that no liabilities are being assumed by your brother if indeed this is the case. If so, this would mean your LLC is retaining all liabilities.
By accepting payments over 36 months, you will have what is known as an Installment Sale for tax purposes. This is important as it will spread out the sale transaction over multiple years.
I am not able to tell you what the tax consequences will be for you because your S Corporation’s tax basis, sale price vs. tax basis for the assets being sold and several other factors determines the tax consequences. You should speak with your CPA about this matter.
You are asking great questions Michelle and I encourage you to reach out to your CPA to get a better understanding about your tax situation. He or she may be able to direct you to an Attorney who can help you with the asset purchase agreement as well.
Holly,
I have a full time job and a business set up in case I ever get laid off. In short, my “partner” has been running the business. I checked in periodically early on and things were running okay so I backed off. The last time I checked in, GRT had not been paid and EFTPS taxes had not been paid for 6 months. What is my exposure? Can I sell the business to him via written document/notarized and shift that tax obligation solely to him?
Hi Eric,
I am sorry for your troublesome situation…
What you are asking about is known as the Trust Fund Tax Assessment where the IRS (and State) can hold a business owner personally liable for unpaid employment taxes.
The business owner may be held responsible as well as the individual (employee, spouse, or other) who makes the decisions about paying (or not paying) such tax liabilities. Given what you’ve described, the government may choose to hold your business ‘partner’ personally responsible as well.
You should seek the counsel of a CPA or Attorney who is experienced handling these matters to represent you.
I hope all turns out well for you Eric…
Hello Holly, I have been scouring the internet looking for an answer to this question but can’t find a single thing about it. I had a C-corp which essentially went out of business and sat stagnant for several years. There was money owed to two contractors, both friends of mine, that was unable to be paid when the business closed and ran out of cash and dissolved. There was also a small loan from the company to me which I was planning on having my C-corp write off as a bad debt and then I pay the tax due on the forgiven amount. The two contractors agreed to simply forgive the debt since there was no way for my C-corp to pay them. So my question is: Would the C-corp pay taxes on the forgiven debt amounts as “income” since the contractors forgave the debts, even though the company is completely dissolved at the state level?
I’m now beginning to think that was supposed to be the case but before the C-corp files its final tax return here in the next couple months and there is no cash available, would that “tax due” from the “income” from the debt forgiveness become my personal responsibility as the 100% shareholder of the company?
We thought we had this all figured out when we dissolved the company but apparently not and now I’m thinking we should have filed bankruptcy or something. I just want to make sure I’m doing the right thing even if that means I have to take on the tax amount due from the company personally, and claim that forgiven loan to me as income since I cannot repay it at the moment.
It would obviously be a huge tax burden on myself but I’d rather owe tax, even if I can’t pay it, instead of simply not claiming it. I just have no idea even where to begin on this and was wondering if you had any insight. Thank you so much–your work has always been inspiring and I figured if anyone knew where to begin with this new entrepreneurial mess, it would be you! Thanks!
Hi Paul,
Well thank you for your kind words.
I don’t think I have all of the facts and circumstances related to your question and recommend exploring your situation with your CPA.
Here’s what you should be thinking about and prepared to cover with him/her:
1. When you have a business that is “completely dissolved at the state level”, the debts owed to creditors of the corporation are required to be notified of the dissolution as part of the dissolution process. It is not clear to me whether this occurred or not. Typically, the strategy is to file for dissolution and file the final federal tax return as soon as the dissolution is approved and it is feasible.
2. If the company balance sheet has liabilities (Accounts Payable), these amounts will need to be written off by the company during the dissolution process. This would involve charging (Debiting) the Accounts Payable Account. This will reduce the expenses (and create income). If this is done, the C Corporation may have prior Net Operating Loss Carryovers which would offset this income.
3. The small Note Receivable on the C Corp’s books owed by you if forgiven should be recorded as Cancellation of Debt Income to you if you had properly documented the money taken from the C Corp was truly a loan and not a dividend. Dividends from C corporations to shareholders are subject to dividend income tax.
4. Although you did not ask, it’s important to consider whether the C Corporation distributed any assets to its shareholders during the dissolution process. You will need your CPA’s input regarding the potential tax consequences on this as well.
All the best Paul…
My situation is not necessarily debt. I was a business partner of a contractor that needed an indemnity bond. The contractor (S corp) negotiated the bond but needed My wife and I to signed is as personal guarantors of which we we did and thus my current problem. There was a little over a year of great profit, however, the main partner was implicated with a previous business of his of bribing government officials! He spent time in jail and still has this business going but of course no profits – all losses. The minute we found out about his criminal issues we asked for and was granted a sale of my % back to the company and I no longer was partner. However, the Indemnity Bond allowed me not being partner but not removing my personal liability. And now even though that business is still ongoing there is debt to subcontractors of over 1 million dollars!! And the Indemnity company wants me to pay with my assets. I have spoken to advisors and lawyers and they say there is NO WAY out so I am going to have to pay.
My CPA cites Arrowsmith v. Commissioner from 1944 that this Million dollars is capped at 3000 a year as capital losses! Held: Under §§ 23(g) and 115(c) of the Internal Revenue Code, these losses should have been treated as “capital losses,” since they were paid because of liability imposed on the taxpayers as transferees of liquidation distribution assets.” Can this be possible? I was hoping to use as ordinary losses and go back a few years as much as possible then carry forward whatever left over! The indemnity company will pay the subcontractors directly and I will have to pay the indemnity company as I sell assets.
Hi Rick,
Oh my, I am sorry for your troubles.
It sounds to me that your S Corporation had a Payment Bond (as opposed to a Performance Bond) which you and and your spouse personally guaranteed. I am not an expert in these types of bonds. That said, if your advisors have not carefully examined whether the claim has been made in a timely and proper fashion, you should consider doing so. It sounds to me that this all happened a while ago so there may be some chance the claim was not filed timely. If not, or if the claim was not in proper form it may be beneficial to you and your spouse.
The case your CPA is quoting pertained to a C Corporation — in 1944, S Corporations did not exist. C Corporations and S Corporations are very different when it comes to the way in which stock tax basis is calculated and in turn how losses are deducted by shareholders. In an C Corporation, a loss from operations is non-deductible to its shareholders. Such losses in C Corporations are limited at the corporate level. Whereas in an S Corporation, if a shareholder has sufficient tax basis, they may deduct losses on their personal tax return (as you’d like to do). However, in your case you no longer own the stock of the S Corporation and are being forced to pay the debts incurred by the business.
That said, I would like to ask if you’ve explored buying the stock of the S Corporation back from the company. It appears your former business partner is out of the picture. If you are going to have to pay for all of the damages due to the personal guarantee, as the S Corporation shareholder with sufficient tax basis you may be able to deduct an ordinary loss. If you haven’t explored this, look into purchasing the stock under a Section 1244 transaction. The timing of the expenses which the S Corporation would be paying will impact whether this option is possible.
I am not familiar with any cases such as yours. However, I am sure you are not the first person in this situation and recommend asking other CPAs and Tax Attorneys for their thoughts. You’ve got a lot at stake and I wish you and your spouse all the best…
Thanks for your quick response! Yes the claim was filed on time and Non-Tax Attorney fought hard to explore all defensible options.
As far a buying back stock – The Payment Bond (you are correct) is all we are liable for. The company is still active and incurring more debt and fines on other projects that we are NOT liable for – so buying back would be worse!
I was thinking of starting a new construction company and just pay all the claims from here but of course this would have no income and probably IRS wont like that.
I will seek out a second opinion with another CPA and see if I get a better solution than waiting over 150 years at 3K a year cap!
You are welcome Rick.
Taking deductions for another business’s expenses/debts would not be legitimately deductible.
One more thought here…
You may want to seek advice about possibly making a business loan to the S Corporation — filing a UCC-1, preparing all of the documentation regarding the loan, charging interest and demanding payments. This may be considered a valid business loan to the S Corporation which if not paid back, would be deductible as a business bad debt. Business bad debts may be deducted as ordinary losses whereas non-business bad debts put you back to the $3,000 net capital loss annual limitation. Who knows? If the business is still operating and you lend cash to pay the bulk of its bills (because you are being forced), maybe the company will pay your loan back. Wouldn’t that be nice?!
This is not a strategy I would ‘try at home’! Please seek counsel so all of your facts and circumstances may be explored and fully understood.