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
[caption id="attachment_15728" align="alignleft" width="88" caption="Al Statz"][/caption]
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.