Conversion to S-corp might provide way out of "double-tax" hit

"The taxpayer – that's someone who works for the federal government but doesn't have to take the civil service examination."  -- Ronald Reagan

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When an incorporated business sells, the transaction can be structured as a purchase and sale of assets or stock. In most small private business acquisitions, the buyer’s attorney and accountant recommend an asset purchase for two reasons: 1) the buyer avoids inheriting the seller’s contingent liabilities (as with a stock sale); and 2) the buyer gets a “step up” in tax basis with which to shelter future income. There has to be a very compelling set of circumstances for a buyer to agree to purchase stock, and one of those circumstances is usually a price discount.

An asset sale presents a major tax problem for the seller of a C-corporation because a double tax occurs. C-corps pay tax at the entity level – up to 35 percent federal, plus state taxes. C-corp shareholders pay tax again at the individual level when proceeds are distributed to them. S-corps, partnerships and LLCs, on the other hand, are pass-through entities – where the only tax is at the individual level.

According to IRS statistics, there were 1.86 million C-corps in the U.S. in 2007, the latest year for which I found this data on its website. C-corps represented 5.8 percent of all businesses that year. The number of C-corps declined every year since 1998, while all other entity types grew in number. In our work selling private companies, most of our clients sell to retire, and their corporations were often set up many years ago, so we see a higher percentage of C-corps – too many from my perspective, because of the double tax problem most of them face when they sell.

C-corp owners with high values and low tax bases have a large double-tax truck barreling at them in their lane. Can they change lanes before colliding head-on?

Convert to an S corporation

If you own a C-corp and your expected holding period is 10 years or more, you should seriously investigate converting to an S-corp. Although S-corps generally aren't subject to tax, those that sell within 10 years after converting from a C-corp will be taxed on any “built-in gains” that the C-corp had at the time of conversion. If the fair market value of your business has declined temporarily, now is an excellent time to convert to an S-corp to avoid built-in gains. There are other potential tax issues that will affect your decision. If you haven’t already, I recommend that you call your tax adviser tomorrow to analyze the potential tax effect of converting to an S-corp given your particular circumstances and exit plans.

Allocate some of the purchase price to personal assets

When an asset sale is reported for tax purposes, the selling price is allocated among the various assets sold (cash, AR, inventory, equipment, goodwill, etc.) One way to lessen, though probably not escape, the double tax is to allocate some of the sale price to individual versus corporate assets.

Personal goodwill is such an asset. In a small company, the business may be highly dependent on one or more of the shareholders, often because that person has unique know-how behind the product or service or personal relationships with clients that bring in sales. Without these individuals, the business may have little value. It can be argued that the business sale is partly an individual selling his or her personal goodwill, which represents a potential tax savings.

Let’s say you own a C-corp with a combined federal and state income tax rate of 40 percent, and let’s assume your individual capital gains tax rate (federal and state combined) is 20 percent. For every $1 of selling price that can be allocated to personal goodwill, you save 32 cents in taxes, because the $1 allocated to personal goodwill won’t be taxed at the C-corp level.

This example does not apply to every C-corp owner, and other allocation strategies may apply. You should expect any attempt to allocate the purchase price outside the corporation to be scrutinized by the IRS, and you should be sure that your business broker, transaction attorney and tax adviser are familiar with the case law and have experience negotiating, documenting and reporting this type of transaction.

Since the S-corp is the better entity choice for tax purposes at the time of a sale, given the probability of an asset sale, shouldn’t every privately held corporation elect to be taxed as an S-corp? Not necessarily. C-corps have unique tax attributes that are beyond the scope of this article (and well beyond my limited tax expertise). I only see the tax problems owners face when they sell, and my goal is to help them maximize their proceeds.

If you are a tax professional, I encourage you to educate your C-corp clients on this impending tax problem and help them change course if the truck is headed their way. If you are a C-corp owner, ask your tax professional if this is still the best entity choice for your circumstances and plans. Exit right, retire well.

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Al Statz is president of Exit Strategies Group Inc., a business brokerage, mergers, acquisitions and valuation firm serving closely-held businesses in Northern California. He can be reached confidentially at 707-778-2040 or alstatz@exitstrategiesgroup.com.