A founder I worked with last year ran an S-corp that he was selling to a strategic buyer for a number with a comma in the middle that he had spent fifteen years getting to. The deal was a stock purchase. Closing was scheduled for mid-October. The LOI he had signed in July said all the things LOIs say — purchase price, exclusivity period, customary closing conditions, working-capital adjustment to be agreed. There was no reference to taxes. There was no reference to a closing distribution. There was no reference to anything specific about the S-corp structure other than a parenthetical that the target was a Subchapter S corporation.
In late September, his accountant ran the numbers on what his year-to-date pass-through income would look like through the closing date. The answer was that his K-1 for the short year ending at closing was going to show roughly $1.8 million of taxable income that the corporation had earned but had not distributed. He would owe federal and state tax on that income — call it $700,000 — on April 15 of the following year. The cash sitting in the corporation that would normally fund that distribution was now going to belong to the buyer at closing, because the corporation was the asset being sold. He asked me, sitting in his kitchen on a Tuesday night, where the $700,000 was supposed to come from.
The answer was that, under the LOI he had signed, it was supposed to come out of his pocket. He had not negotiated a pre-closing tax distribution. He had not negotiated a special carve-out from the cash-free, debt-free mechanic. He had not negotiated a working-capital target that excluded the tax payable on his pre-closing income. The LOI was silent. The buyer’s draft purchase agreement was, predictably, also silent — and the buyer’s CFO took the position that any distribution by the corporation between signing and closing would reduce the cash being delivered at closing dollar-for-dollar, and would either reduce the purchase price or trip the working-capital target. By the time we surfaced the issue, the buyer had every incentive to treat it as a renegotiation rather than an oversight.
This is the most common preventable disaster in S-corp founder sales, and it is preventable at the LOI stage with one paragraph.
Why this happens — the structural mismatch
An S-corp is a pass-through entity for federal income tax purposes. The corporation does not pay tax on its income. The shareholders pay tax on their pro-rata share of the corporation’s income, distributed or not, as it is earned. The corporation typically makes “tax distributions” during the year to give the shareholders the cash they need to pay the tax on the income the corporation has generated — but those distributions are a discretionary timing decision by the board, not a statutory requirement.
The way IRC § 1366 works in the M&A context is that the shareholders’ pro-rata share of S-corp income runs through the closing date. If the corporation has earned $1.8 million of taxable income during the short year ending at closing, the selling shareholders owe tax on that $1.8 million whether or not the cash to pay it has been distributed before the deal closed. After closing, the cash is gone — it belongs to the buyer. The shareholders are stuck with the tax bill but no longer have access to the entity that generated the income.
In a normal year, this would not be a problem. The corporation would make a tax distribution in February or March to cover the shareholders’ April liability, and the cycle would repeat. In a sale year, the cycle breaks. The closing happens before the shareholder ever sees the tax distribution that would have funded the bill. If the LOI and the purchase agreement do not specifically reserve a pre-closing tax distribution, the buyer takes the cash that would have funded the distribution and the shareholders carry the tax liability personally.
What the LOI should say
The cleanest fix is a single paragraph in the LOI that does three things. It permits — and ideally requires — the corporation to make a pre-closing tax distribution to the selling shareholders sufficient to cover the shareholders’ federal and state income tax liability on the corporation’s income through the closing date. It excludes the tax distribution from the cash-free, debt-free calculation, so the distribution does not reduce the purchase price. And it excludes the tax payable corresponding to the distributed amount from the working-capital target, so the distribution does not get clawed back through the post-closing true-up.
The number that should be specified — or at least bounded — is the assumed tax rate. The market default is something close to the highest combined federal-and-state rate the shareholders are actually subject to, often expressed as a fixed percentage (forty percent, forty-five percent, sometimes higher in California or New York) applied to the corporation’s pre-closing taxable income. Some agreements compute the actual tax liability with reference to each shareholder’s actual marginal rate, which is more precise but creates a post-closing reconciliation. The fixed-percentage approach is administratively cleaner and is what I usually push for unless one of the shareholders has an unusual tax profile that the formula will systematically misprice.
The mechanic that I prefer for the actual distribution is a two-step approach. First, an estimated tax distribution made shortly before closing, based on the corporation’s good-faith estimate of pre-closing income through the closing date. Second, a post-closing true-up made within a defined window — usually thirty days after the corporation’s tax return is filed — that trues up the estimated distribution to the actual liability, with the buyer required to allow the corporation to make the true-up distribution from corporation cash. Without the post-closing true-up provision, the buyer ends up with the position that the estimated distribution is the cap, and any shortfall belongs to the shareholders personally. That position is unfair and is also negotiable away if the founder catches it early.
Where the working-capital target hides the same problem
The working-capital target is the second place this problem surfaces. I wrote earlier about the working-capital target number and the post-closing true-up — that piece focused on the question of which line items go into the target and why “normalized” working capital is so contested. The S-corp pass-through context adds a specific item to that fight: the accrued tax liability of the shareholders for pre-closing pass-through income.
If the working-capital target is computed using a balance sheet that includes “accrued income tax” as a current liability — which is unusual but not unheard of, particularly in deals where the buyer’s accountants are applying C-corp accounting conventions to an S-corp target — the target absorbs the cost of the pre-closing tax bill. The cash that funds the closing distribution gets booked out of working capital. The accrued liability gets booked into working capital. The target adjusts. The founder pays twice — once when the distribution is reduced and a second time when the working-capital adjustment claws back the difference.
The drafting fix is to put a specific exclusion in the working-capital target definition. The target excludes any “Seller Tax Amount” — defined as the corporation’s accrued pass-through tax liability allocable to the selling shareholders for the period ending at closing — and the cash distributed to the shareholders to fund the Seller Tax Amount is not netted against the cash component of the purchase price. Both exclusions need to be in the definitions section, not just in the price-adjustment paragraph. Buyers’ counsel will sometimes agree to one but not the other, on the theory that one fix is enough; it usually is not.
The 338(h)(10) overlay
If the deal is structured with a Section 338(h)(10) election — which is common when the buyer wants stepped-up tax basis on the target’s assets — the tax distribution problem gets larger, not smaller. The 338(h)(10) election treats the stock sale as a deemed asset sale for federal income tax purposes, which means the corporation is treated as having sold its assets and liquidated. The deemed asset sale generates ordinary income on the recapture of depreciation and amortization, which flows through to the selling shareholders as additional pre-closing K-1 income on top of the operating income they already have.
That recapture amount can be very large. In a target with a lot of intangible asset value being stepped up, the 338(h)(10) gross-up that I have written about elsewhere is the cash payment from the buyer that compensates the shareholders for the additional tax. The pre-closing tax distribution is something different — it is the corporation’s distribution of cash to fund the shareholders’ personal tax liability on the deemed asset sale. The two interact: the gross-up generally covers the incremental tax on the deemed sale at the agreed rate, but the distribution still has to happen to actually deliver the cash to the shareholders’ bank accounts so they can write the IRS check.
Founders selling S-corps with 338(h)(10) elections need both provisions in the LOI: the gross-up and the pre-closing tax distribution covenant. Buyers’ counsel will sometimes argue that the gross-up subsumes the distribution issue. It does not. The gross-up sets the dollar amount the buyer owes. The distribution sets the mechanism by which the cash gets out of the corporation to the shareholders before closing. They are different paragraphs and the deal needs both.
The fix is cheap if it happens at the LOI
The negotiation cost of a tax-distribution paragraph in the LOI is fifteen minutes of lawyer time and zero dollars of purchase-price concession. The buyer is generally indifferent to the existence of a pre-closing tax distribution, because the distribution amount is the shareholders’ money anyway under the pass-through regime — the buyer’s only legitimate concern is that the distribution mechanic does not become a vehicle for stripping value out of the target beyond what the shareholders actually owe to the tax authorities. A tightly-drafted distribution covenant addresses that concern. A silent LOI does not address it, and the founder eats the tax.
The negotiation cost of fixing this in late September, three weeks before closing, with the buyer’s CFO digging in on the cash position and the buyer’s counsel taking the position that the parties’ intent was clearly to deliver the cash to the buyer, is a multiple of that. I have seen this fight resolved with seven-figure purchase-price reductions. I have seen it resolved with the seller writing a personal check to the IRS funded by post-closing earnout payments. I have seen it resolved with the seller selling stock in the buyer at distressed prices to raise the cash. None of those outcomes were necessary. The LOI paragraph would have prevented all of them. The standard form merger agreement that most founders see for the first time at signing does not have a tax-distribution covenant unless the founder’s counsel put one in. The default is silence, and silence in an S-corp sale is the worst possible setting.
If you are a founder running an S-corp through a sale process and your LOI does not yet have a pre-closing tax distribution covenant, fix it before signing. If the LOI is already signed and the covenant is missing, fix it in the first draft of the purchase agreement, before the buyer’s counsel has had time to think about why the silence might benefit the buyer. Sell-side M&A representation for pass-through targets is largely the work of catching tax-structural traps like this one before they become permanent.
If you are a founder selling an S-corp and trying to figure out whether your LOI or purchase agreement protects the cash you need to pay your last K-1 tax bill, feel free to reach out to my firm manager, Magda, at Magda@montague.law, or fill out our contact form. Mention you read this post.
