The short version
Many owners would rather sell to the people who already run the business than to a stranger, and the people who run it are often the most natural buyers: they know the customers, the crews, and the numbers. What they rarely have is the money. So most sales to key employees are financed by the seller. The employees put down what they can, the owner takes a promissory note for the rest, and the business itself, now owned by the people paying the note, earns the money that pays it. That makes the owner a lender, for as long as a decade, to the people who bought the business (or to the company itself, if it buys the shares back), with the loan secured largely by a company the owner no longer controls. It also means the price is paid out of the company’s future profit after the buyers’ income tax, which is the number that decides whether the deal works.
In the worked example below, two managers buy an HVAC service company appraised at $3,000,000 with $300,000 down and a ten-year note for $2,700,000. The note takes about $404,000 of the company’s $650,000 of annual profit in its first year, and more each year after, even though the payment never changes. Spreading the gain over ten years keeps most of it in the 15% bracket, for about $138,600 less federal tax on the gain than if all of it landed in the year of the sale, and the note pays $834,078 of interest along the way. Whether that is worth still being owed $1,520,810 at the halfway point is the real decision, and it turns on how the note is written as much as on the price.
Why Key Employees Usually Buy on a Note
An outside buyer brings its own money, or a bank’s. A key employee usually brings savings, a home equity line, and a strong desire to own the place. Owners who see the sale coming years out sometimes help build that down payment, with bonuses or a phantom equity plan that pays cash as the company grows, as our article on key employee ownership explains. The gap between what the business is worth and what the buyers can put down has to be financed by someone, and there are three candidates.
A bank or an SBA-guaranteed lender. A lender may finance part of a sale to employees, especially a business with steady cash flow and hard assets. The owner gets more cash at closing, but the lender will want the buyers to have real money in the deal, may want the owner to stay on for a transition, and will usually require any note the owner also carries to sit behind its loan, sometimes with payments to the owner limited or suspended for years. SBA rules can require a seller note that counts toward the buyers’ down payment to receive no payments at all for the life of the SBA loan.
The company itself. The company can buy back the owner’s shares over time, paying for them out of its own profit, which is a redemption. The buyers end up owning the company because the owner’s shares are retired, not because they bought them.
The owner. The owner sells the shares to the employees and takes their note. This is the most common answer for a small or midsize company, because it is the one the buyers can actually reach.
The structures can be combined, and often are: some cash from the buyers, some from a lender, the rest on the owner’s note. Either way the economics are the same. The business has to earn the price, after tax, over the life of the debt.
Some owners sell in stages instead: a minority block first, more a few years later, and control last, with each block often paid for from the distributions on the shares already bought. That keeps the owner in control longer and gives the buyers a record as owners before anyone asks a lender to finance the rest. It also takes more cash than it appears to. In an S corporation every distribution is paid per share, so for an employee who owns 20% to receive $100,000 toward a note, the company has to distribute $500,000, and $400,000 of it goes to the owner, who owed tax on that profit anyway. (In a C corporation, those distributions are dividends, taxed a second time.) How much the company can distribute after reinvesting in itself is the real limit on how fast a staged sale can move.
An employee stock ownership plan is a different path, a retirement plan that buys shares on behalf of all eligible employees, with its own financing rules and tax deferral, as our article on selling to an ESOP explains. Bringing one employee in as a minority owner is a different path too, covered in that same key employee ownership article. This article is about selling the company to a few specific people. Whether they are ready to own it is the first question, and it gets the same honest look described there: track record answers it better than conversation does.
Two Ways to Structure the Purchase
When the owner finances the sale, the employees can buy the shares directly or the company can buy them back. The tax result depends heavily on what kind of company it is.
A cross-purchase. The employees buy the owner’s shares and sign the note personally. The price is their basis in the shares, which matters when they sell someday. They pay the note with money the company pays them, as salary, bonus, or distributions, after their own income tax.
A redemption. The company buys the owner’s shares for its own note. When the company retires all of the owner’s shares, the owner’s ownership ends completely, and the redemption is treated as a sale of the shares, with capital gain, under Section 302(b)(3) of the tax code. Keeping the note does not spoil that result, so long as it is real debt rather than a disguised continuing stake in the company, such as payments that rise and fall with the company’s profit. In an S corporation, a redemption note also needs to stay clear of the one class of stock rule; a note that meets the tax code’s straight debt rules (Section 1361(c)(5)) is protected. The installment method can apply to a redemption note, as an IRS private letter ruling has confirmed for one taxpayer (PLR 201405005), though such a ruling binds only the taxpayer who asked for it. The employees need their own shares no later than the redemption, bought from the owner beforehand or issued by the company as part of the same plan, so that someone still owns the company.
All of that works cleanly when the buyers are not the owner’s relatives. If a buyer is the owner’s spouse, child, grandchild, or parent, the owner is treated as owning that buyer’s shares, and a complete termination then requires waiving family attribution. The waiver bars any role in the company other than creditor for ten years (no job, board seat, or consulting arrangement) and limits how the note can be written (Section 302(c)(2) and Treas. Reg. 1.302-4(d)).
In a C corporation, the choice matters a great deal. The company pays a redemption out of profit taxed once, at the corporate rate of 21%. In a cross-purchase, the employees would need dividends or wages to pay the note, which means profit taxed twice, or taxed at their personal rates plus payroll tax. A redemption is usually far cheaper. Interest differs too. The company’s interest on its own redemption note is deductible (the general bar on deducting the cost of buying back stock, in Section 162(k), leaves interest alone), subject to the business interest limit for larger companies. Employees who borrow to buy C corporation stock have investment interest, deductible only as an itemized deduction and only up to their net investment income. The qualified small business stock rules deserve a check on both sides. An owner whose shares qualify may exclude much of the gain. On the employees’ side, shares bought from the owner never qualify, because the exclusion requires stock acquired from the company itself, and shares the company issues to them within a year before or after it buys back more than 5% of its stock’s value generally do not qualify either, as our article on the QSBS exclusion explains.
In an S corporation, the two structures come out much closer than most owners expect. The company’s profit is taxed to whoever owns the shares, whether it pays a redemption note or distributes cash to employees who pay a cross-purchase note, and once the owner is fully out, the employees are taxed on all of it either way. Interest is deductible in both cases, at the company level for a redemption note and on the employees’ own returns for a cross-purchase note, as described below. The real differences are legal and practical: who owes the money, what the owner can take back if it is not paid, whether the employees sign personal guarantees, and how the employees’ basis builds over time.
Setting the Price
The price is set the same way as in any sale: an independent appraisal of what is actually changing hands, as our article on how a business is valued for sale explains. That appraisal measures fair market value, the price a hypothetical buyer with no special synergies would pay, which can sit below what a competitor or other strategic buyer would offer. Many owners accept less than the best outside offer from the people who run the business, for certainty, speed, continuity, or loyalty, and that is a legitimate choice with a real price. For tax, the line is fair market value, not the best outside offer. In a sale of the whole company, that is control value. In a staged sale, where employees buy blocks over several years, each early block is usually a minority interest, worth less per share because its owner cannot control the company or sell the interest easily, and the block that finally moves control may be worth more per share than the ones before it. An owner who sells in stages should expect to be paid less per share for the early blocks, and a staged plan should say in writing how each later block will be priced.
The price has to be real for the employees’ sake as well as the owner’s, because a sale below value to someone who works for the company is partly pay, taxed to the employee as compensation. The same regulations also recast the owner’s side, in a way that surprises people. Under Treas. Reg. 1.83-6(d), when an owner’s shares go to an employee of the company below value, or with vesting tied to staying employed, the owner is treated as contributing the shares to the company, and the company as transferring them to the employee. The employee’s payment becomes a distribution from the company to the owner, tested under the redemption rules, and a partial sale can fail that test. In a C corporation, that can turn part of the price into a dividend. In an S corporation that was never a C corporation, the result is often close to a sale, though the timing of the owner’s gain can change. Vesting can still have a place on shares an employee pays for; it is worth settling with the company’s CPA before it is added, because it changes the owner’s tax, not just the employee’s.
Formula prices deserve a careful look, because they appear in many buy-sell agreements and staged sales. The regulations give a formula special weight when the shares carry a permanent restriction: any holder, now or later, can sell them only at the formula price (a nonlapse restriction, in the regulations’ term). The formula price is then treated as the shares’ value for Section 83 unless the IRS proves otherwise, and a price based on book value, a reasonable multiple of earnings, or a reasonable combination of the two will ordinarily be accepted (Treas. Reg. 1.83-5(a)). An employee who buys at that price generally has no compensation income, even if an appraiser would have said the shares were worth more. A restriction requiring resale at fair market value, or one that ends on some future event, does not qualify.
Three separate sets of rules judge a formula price, and passing one does not mean passing the others. For Section 83, the question is the nonlapse restriction. For an S corporation, an ordinary buy-sell price generally does not threaten the one class of stock rule, as our article on the S corporation one class of stock rule explains. For estate and gift tax, Section 2703 can set a formula price aside when the owner’s estate is valued, a test our article on buy-sell agreements after Connelly covers. Its regulations treat that test as met when more than half the value bound by the agreement is owned by people outside the owner’s family who are bound by the same terms (Treas. Reg. 25.2703-1(b)(3)), which a sale to unrelated employees can reach.
Writing the Note Like a Lender Would
The note is the deal. The price says what the business is worth; the note decides whether the owner collects it. A lender writing a loan to two managers to buy a company would want to know who is liable, what it can take back, what it can see, and what happens when something goes wrong, and an owner who is the lender should want the same.
The interest rate. The note has to charge at least the applicable federal rate the IRS publishes each month, or part of every payment is recharacterized as interest, under Sections 1274 and 483. The rate depends on the note’s term: the short-term rate for three years or less, the mid-term rate for more than three and up to nine, and the long-term rate beyond nine. For a note that repays principal along the way, the term for this test is its weighted average maturity rather than its final due date (Treas. Reg. 1.1274-4(c)(1)), so a ten-year note with level payments, which returns its principal in a little under six years on average, is measured against the mid-term rate. For a sale, the minimum is the lowest rate in effect during the three calendar months ending with the first month there is a binding written contract that substantially sets out the terms on which the sale closes, or, if lower, the three months ending with the month of the sale. The mid-term rate for October 2026 is 4.61%, but a contract first signed in October 2026 whose terms carry through to closing could use August’s 4.35%. The minimum is a floor, not a recommendation. The rate is a negotiated term, and it is not free to either side: each extra point pays the seller for years of lending risk, but as ordinary income rather than capital gain, while the buyers deduct it. The rate and the price are worth modeling together.
The term and the payments. Most notes in sales to employees run five to ten years, with level payments that pay off the balance. A shorter note pays less interest and gets the owner paid sooner, but each payment is larger, and the worked example below shows how quickly a short term can outrun the company’s profit. A note with interest-only years and a balloon at the end keeps early payments low and concentrates the risk in a single payment the buyers may need to refinance.
Personal liability, and why it matters for tax. A note the employees are personally liable on is worth more to the owner than one secured only by the shares. It also matters for the employees’ own taxes. Under Treas. Reg. 1.83-3(a)(2), when an employee buys stock with a note secured by the stock and has no personal liability for all or a substantial part of it, the purchase may be treated as an option rather than a purchase, which defers the transfer for tax purposes and can turn later growth into wages. The regulation weighs the type of property, how much of the risk of a decline in value has really passed to the buyer, and how likely it is that the price will actually be paid. A full-recourse note that is being paid on schedule speaks to the last two, though the regulation does not make any single feature a safe harbor.
Security. The usual security is a pledge of the shares the employees buy, held by the owner or an escrow agent until the note is paid, sometimes released in steps as the balance falls. Some owners also take a security interest in company assets or personal guarantees from the buyers. In Texas and the other community property states, the shares and the debt can belong to the buyers’ marital estates, so the buyers’ spouses are usually asked to sign, and the owner’s spouse, who generally has a community interest in the shares being sold, usually signs the sale documents as well.
What the owner can see and control while the note is outstanding. Financial statements on a regular schedule; limits on raises, new debt, and distributions beyond the buyers’ tax distributions and note payments; and approval rights over major decisions such as selling the company, taking on large debt, or changing its business until most of the balance is paid. In a staged sale, the owner can keep voting control until the final block is paid for.
Insurance. Life insurance and disability coverage on each buyer, owned or assigned so that a death or disability pays down the note rather than leaving it to a buyer’s estate or to a company that just lost a key person.
Default and acceleration. What counts as a default (missed payments, a buyer leaving the company, a broken covenant), how long the buyers have to cure it, and what happens next: the full balance due, the pledged shares returned, or both. These provisions are the owner’s protection, and they are easiest to agree on before anyone is behind.
Where a bank is involved. If a lender finances part of the price, the owner’s note will be subordinated, meaning the bank is paid first and the owner’s rights to collect are limited by an intercreditor agreement. That makes the owner’s note riskier than the same note standing alone, and its terms deserve a fresh look.
Consents from outside the deal. A change of ownership can need someone else’s approval: a franchisor or manufacturer, a state licensing board, a lender whose loan covenants restrict a change of control, a landlord, or a major customer whose contract has a change-of-control clause. Licenses and certifications held by the owner personally do not pass with the shares, so the buyers may need their own before the owner steps away.
How the Owner Is Taxed
A seller-financed sale of stock is an installment sale under Section 453. The owner reports gain as principal arrives: each dollar of principal is part return of basis and part gain, in the same proportion as the total gain bears to the price (the gross profit percentage). Interest is ordinary income in the year it is received. Our article on installment sales and earnouts covers the machinery in detail, including the interest charge on very large notes, the rule that taxes a loan secured by the note as a payment, and when electing out to report the whole gain at once can come out ahead. Two points matter most in a sale to employees.
The 3.8% tax. For an owner who materially participates in the business, gain on the sale of S corporation stock is generally excluded from the 3.8% net investment income tax to the extent it reflects the company’s business assets, under Section 1411(c)(4). A long-time owner who sells early in a year generally still qualifies for that year, because material participation in any five of the prior ten years counts. That exclusion is measured in the year of the sale and generally carries through to the later payments on the note. Gain on C corporation stock gets no such exclusion. The interest on the note is investment income either way, subject to the 3.8% tax once the owner’s modified adjusted gross income is above $250,000 for joint filers.
Death with a note outstanding. An installment note gets no new basis at death; the remaining gain is taxed to whoever inherits the note as the payments arrive (Section 691). One point is specific to sales to employees. If the owner’s will forgives the note, or leaves it to the buyers, the estate is treated as disposing of the note, which pulls the remaining gain onto the estate’s return at once, measured at no less than the note’s face if the buyers are related. A note expected to run past the owner’s life expectancy belongs in the estate plan from the start.
How the Buyers Are Taxed
The employees pay no tax to buy shares at appraised value. Their price is their basis. What they pay the note with is the question.
Principal is paid with after-tax dollars. Nothing the employees pay toward principal is deductible. In an S corporation, they owe tax on their share of the company’s profit whether or not it is distributed, and the note is paid from what remains. Each dollar of principal takes more than a dollar of profit, by an amount that depends on their tax rate.
Interest can be deductible, and how depends on the company. Interest on money borrowed to buy S corporation stock is allocated among the company’s assets under IRS Notice 89-35. The part allocated to assets used in the business is business interest. For an employee who works in the business, it is deducted on Schedule E against the company’s income, as nonpassive interest. Any part allocated to investment assets the company holds is investment interest. For C corporation stock, the interest is investment interest, deductible only as an itemized deduction and only up to the employee’s net investment income, with any excess carried forward.
The first year. A buyer who acquires shares partway through the year is taxed only on the profit allocated to the days the shares were owned, unless the company, with the consent of the owner and the buyers, elects under Section 1377(a)(2) to close the books on the day the owner’s interest ends; in a redemption, everyone who was a shareholder during the year must consent. Once an employee owns more than 2% on any day of the year, the fringe benefit rules for owners apply to that employee for the entire year, and above 5%, the company’s retirement plan testing treats the employee as an owner; the article on key employee ownership walks through both.
A Worked Example: Two Managers Buy an HVAC Company
A heating and air conditioning service company outside Houston has been an S corporation since it was formed. Its founder is 62, married, and files jointly; he and his wife have $40,000 a year of other income before the standard deduction, none of it investment income. His service manager and his operations manager want to buy the business, half each, and both already hold the state licenses the work requires. An appraiser values the whole company at $3,000,000. The founder’s basis in his shares is $250,000. They sign the purchase agreement in October 2026 and close at the start of January, so the founder’s last year of company profit is 2026. Every share changes hands at closing, so the founder is out of ownership entirely and the managers own the company 50/50.
The managers put down $300,000, $150,000 each from their own savings. The founder takes a ten-year note for $2,700,000, with level annual payments starting a year after closing, at 5.22%, a rate he and the managers negotiated. The legal minimum for this note, a mid-term rate under the weighted average rule above, would have been 4.35%. The annual payment is $353,408. Over ten years the managers pay $3,534,078, of which $834,078 is interest.
The company earns $650,000 a year of taxable profit after paying market salaries to both managers and to whoever now does the founder’s old job. The example holds that number steady, uses 2026 federal tax figures in every year, and leaves out state tax, which Texas does not levy on individuals.
Can the business carry the note? Each manager files jointly and, with salary and a share of the profit, is in the 24% bracket, and the 20% qualified business income deduction lowers the tax on each added dollar of the company’s profit to 19.2%. The note interest is deductible business interest and saves the same 19.2%. So each dollar of interest takes one dollar of profit, and each dollar of principal takes about $1.24 of profit, because 19.2 cents of every profit dollar goes to tax first. In year one the payment is $140,940 of interest and $212,468 of principal, which takes $403,895 of the company’s profit, about 62% of it. The managers owe $97,740 of tax on their shares of the profit, and after that tax and the payment, $198,853 is left for the business and the people running it.
The burden rises over time even though the payment does not. As the balance falls, more of each payment is principal, which is paid with after-tax dollars, and less is deductible interest. By year ten the payment is $17,533 of interest and $335,875 of principal, and it takes $433,220 of profit, about 67%.
The margin for a bad year is narrower than it looks. If profit fell 25% in the first year, to $487,500, the note would still be covered, with $83,605 of profit left over (before the tax on it) for equipment, trucks, and a slow season. If profit fell more than about 38%, the note could not be paid from that year’s earnings at all. A shorter note makes this sharper. On a seven-year note at the same 5.22%, the payment rises to $470,341, total interest falls to $592,384, and the note takes $548,614 of profit in year one, about 84%, and $576,560 in its last year, about 89%. Seven years saves $241,694 of interest and leaves almost no room for anything to go wrong.
What the founder keeps. The gross profit percentage is 91.67%: the $2,750,000 gain divided by the $3,000,000 price. The down payment brings $275,000 of gain in the year of the sale, and each year after, 91.67% of the principal received is gain. Taxed this way, the $2,750,000 gain costs about $367,400 of federal income tax over eleven tax years. Most of it is taxed at 15%, and about $300,000 of it at 0%: part of the sale year’s gain, and a growing share in the later years, as the shrinking interest leaves more room below the top of the 0% bracket. The January closing helps: the founder’s last full year of company profit lands in 2026, so the sale year carries little income besides the gain on the down payment. If the whole gain had landed in the year of the sale, most of it would have been taxed at 20%, for about $506,000, so spreading it saves about $138,600. The $834,078 of interest adds about $109,000 of income tax at ordinary rates over the ten years, and, because the founder’s income stays above $250,000 in every year of the note, about $30,900 of the 3.8% tax. The example assumes all of the gain reflects business assets, so none of it is subject to the 3.8% tax.
The comparison assumes the note is paid in full. A buyer with a bank loan who paid $3,000,000 at closing would leave the founder with more tax in the first year and no exposure to the company afterward; the founder would also have earned something on that cash once it was invested. With the note, the founder still has $1,520,810 owed to him by the company’s new owners after five years of payments. Whether the tax saving and the interest are worth that exposure depends on the founder’s other assets, how much of his retirement the note is meant to fund, and how much he trusts the business to keep performing without him. That is a planning question before it is a tax one.
Money That Is Not the Price
Sales to employees often include payments to the owner outside the purchase price: a salary for staying on through a transition, a consulting fee, a payment for agreeing not to compete, or rent on a building the owner keeps. Together with the price and the interest, that makes five ways money reaches the owner, each taxed differently, and the buyers and the owner usually want opposite things.
Salary or consulting fees after closing. Ordinary income to the owner, plus payroll tax on wages or self-employment tax on consulting fees, and deductible to the company when paid, if the amount is reasonable for work the owner actually does. Moving a dollar from the price into a consulting fee changes the tax on both sides: the owner gives up capital gain rates and takes on payroll tax, while the buyers get a deduction now instead of basis they recover only when they sell.
A covenant not to compete. Ordinary income to the owner. For the buyers, or for the company in a redemption, it is amortized over 15 years under Section 197, however quickly it is paid, because a covenant made in connection with buying a business, including through a stock purchase or redemption, is a Section 197 intangible. The deduction arrives slowly, so a covenant is a poor place to put money for tax reasons. It belongs in the deal for what it actually protects.
Rent on property the owner keeps. Many owners keep the building, in a separate company, and lease it to the business at a market rent. That lowers the price the employees have to finance and gives the owner an income stream secured by real estate rather than by the company’s stock. The rent is deductible to the company and taxable to the owner. While the owner owns the business and materially participates in it, a special rule for renting property to one’s own business generally keeps the rent out of the 3.8% tax. Once the owner no longer has a stake in the business, that rule stops applying, and the rent is generally subject to the 3.8% tax above the income threshold.
Five ways money reaches the selling owner, and how each is taxed
The price
Down payment and note principal
Seller: capital gain, taxed as principal arrives. Buyers: their basis in the shares in a cross-purchase; never deductible.
Interest on the note
Paid every year
Seller: ordinary income, plus the 3.8% tax above the threshold. Buyers: deductible business interest for S corporation stock when they work in the business.
Salary or consulting fees
After closing
Seller: ordinary income plus payroll or self-employment tax. Company: deductible when paid, if reasonable for real work.
A covenant not to compete
Paid for a promise
Seller: ordinary income. Buyers or company: amortized over 15 years, however fast it is paid.
Rent on property the owner keeps
Paid by the company
Seller: rental income; once he no longer owns the business, generally subject to the 3.8% tax above the threshold. Company: deductible at a market rent.
The IRS can look past labels. An allocation the parties agree to in writing generally binds them, but a consulting agreement for an owner who does no consulting, or a covenant with no real competitive threat behind it, invites the IRS to treat the payment as part of the price, or the price as something else. These payments are worth negotiating as explicit numbers, at what the services, the covenant, and the property are actually worth.
When a Buyer Leaves, Dies, or Stops Paying
A note that runs ten years will outlast something: a buyer’s health, a buyer’s interest in the job, a partnership between two buyers, or a good economy. The documents should say what happens in each case before it does.
A buyer leaves or is terminated. The buy-sell agreement among the new owners should give the company or the remaining buyer the right to buy the departing owner’s shares, at a stated price or formula, and say how that purchase interacts with the departing buyer’s share of the note. Often the departing buyer’s shares are bought back with a credit against what that buyer still owes the seller.
A buyer dies or becomes disabled. Insurance on each buyer is what keeps the note from depending on a grieving family or a company that just lost one of its two owners.
The buyers stop paying. If the owner takes back the pledged shares, that is a taxable event, not a return to where things started. The owner’s gain or loss is measured by the shares’ value at that point against the owner’s remaining basis in the note, with the same character as the original gain, and the shares take that value as their new basis (IRS Publication 537). The special relief for repossessions in Section 1038 applies only to real property. The buyers have their own tax consequences on giving the shares back, and any unpaid debt that is forgiven can be income to them. A default is also usually a sign the company is worth less than when it was sold, which is the deeper reason the security and covenants above matter.
How We Think About It
We lean toward treating the seller note as a real loan, written the way a careful lender would write it: a meaningful down payment from the buyers’ own money, a note the buyers are personally liable on, and the purchased shares pledged back as security. Until it is paid, that means regular financial reporting, limits on raises, new debt, and distributions beyond the buyers’ tax distributions and note payments, life and disability coverage on each buyer, and approval rights over major decisions until most of the balance is paid. We also lean toward testing the seller’s own plan against a note that is paid late, renegotiated, or never paid in full. The business that pays the note is the same business the seller just sold, so it is worth knowing in advance how much of the seller’s next chapter rests on it.
We lean toward deciding whether the business can carry the note before agreeing on the down payment, the term, and the structure. The price starts from an appraisal of fair market value. An owner may choose to take less than the best outside offer from the people who run the business, but a price below fair market value to an employee is partly pay. If the business cannot carry a note at that price with room for a bad year, the levers are a larger down payment (built over several years with bonuses, when the sale is far enough out), a lender, a staged sale, or a different buyer. That test, the company’s profit after the buyers’ income tax against each year’s payment, is modeled alongside the seller’s own multi-year tax projection, so the payment schedule is set by both sides’ numbers rather than by a convention about how long these notes usually run.
We lean toward pricing salary, consulting, a covenant not to compete, and rent at what they are actually worth, and negotiating them as explicit numbers, because moving a dollar from the price into any of them changes the tax on both sides of the table. Throughout, the choices are made alongside the seller’s CPA and attorney, who draft the documents and file the returns, with the buyers advised by their own, since the two sides of this sale are negotiating with each other. And the readiness of the buyers comes first, as it does for any key employee ownership.
Common Questions
Can I sell my business to employees who don’t have the money to buy it?
Yes, and most sales to key employees work that way. The employees put down what they can from their own savings, a lender may finance part of the price, and the owner takes a promissory note for the rest, paid over five to ten years out of the company’s profit. Alternatively, the company can buy back the owner’s shares over time, which is often cheaper for a C corporation. The question that decides whether it works is whether the business can earn the payments, after the buyers’ income tax, with room for a bad year.
Is it better for the company to buy back my shares or for the employees to buy them?
It depends mostly on how the company is taxed. In a C corporation, a buyback (a redemption) is usually much cheaper, because the company pays the note from profit taxed once at 21%, while employees buying the shares themselves would need dividends taxed a second time or wages subject to payroll tax. In an S corporation the tax comes out much closer, because the profit is taxed to the owners either way, and the choice turns on who owes the money, what the seller can take back after a default, and whether the buyers sign personal guarantees. A buyback of all of the seller’s shares is generally taxed as a sale, as long as none of the buyers is a close relative of the seller.
Can employees deduct the interest on a note used to buy company stock?
For S corporation stock, generally yes. The interest is allocated among the company’s assets, and the part allocated to assets used in the business is business interest that an employee who works there deducts on Schedule E against the company’s income. For C corporation stock, the interest is investment interest, deductible only as an itemized deduction and only up to the employee’s net investment income. The principal is never deductible, which is why the price is effectively paid with after-tax dollars.
What happens if the employees stop paying the note?
Whatever the documents say, which is why they say it in advance. Typically the owner can declare the whole balance due and take back the pledged shares, and can also pursue the buyers personally if they signed a recourse note or guarantees. Taking the shares back is a taxable event for the owner, measured by the shares’ value at that point against the owner’s remaining basis in the note, and it often comes when the company is worth less than when it was sold. Insurance on each buyer, regular financial reporting, and limits on distributions and new debt while the note is outstanding are what make a default less likely.