Usually, no other factors carry the weight of the tax issue or significantly differentiate the C from the S Corporation. Limited liability is attainable in both the C and S Corporation forms. Voting rights need not differ. An S Corporation conducts business, on a day-to-day basis, exactly as a regular corporation. The only difference between the C and S Corporation is the filing of a one-page IRS form (Form 2553) electing treatment as an S Corporation.
There are, however, some limitations on the type of shareholders permitted an S Corporation. For example, S Corporation stock may not be owned by another corporation or by a nonresident alien, and some trusts may not be S shareholders.
THE IDEAL SITUATION
The taxable income consequences of S Corporation flow through to the owners of the S Corporation like a partnership. Thus, when an appreciated corporate asset, like good will, is sold, the capital gain is taxed directly to the owner of the S Corporation.
Often, it makes sense for a business to be a regular corporation during its formative years in order to take advantage of the lower income tax brackets, which in turn lead to the faster accumulation of capital within the company. When the business is sold, however, the S Corporation form is almost always more beneficial because it can avoid the double tax consequences of an asset sale.
Seemingly, the best strategy is to operate as a C Corporation until just before the company is sold and then quickly convert to an S Corporation. This strategy worked well for many years. Too well, noticed the IRS, in depriving it of tax revenue.
So the IRS changed the rules. Today, if a regular corporation converts to S status, a ten-year “built-in gain rule” is applied to maximize the tax revenue to the IRS. The built-in gain rule is the IRS’s weapon in its attempt to prevent avoidance of the two-tier C Corporation tax.
Every owner of a C Corporation who harbors a desire to sell his business would do well to understand the basic operation of this rule. Careful attention to its structure will allow you to design and plan to avoid its most onerous features. This rule imposes a corporate level tax on the built-in gain existing on the conversion date to S status on assets owned by the former C Corporation. The built-in gain on those assets is taxed if those specific assets are sold during the ten years following the conversion. Any assets carried over from C status may be subject to the built-in gains tax. These assets include furniture, equipment, land, securities, as well as the goodwill of the business.
Unrecognized income items, such as accounts receivable in a cash basis corporation and inventory accounting procedures, create current tax recognition when S status is elected. These income items, if applicable to your company, must be carefully scrutinized by your tax professional for adverse tax consequences. The corporate level tax is imposed on the unrealized appreciation (the built-in gain) then in existence on the conversion date and which is realized when the asset is sold.
It bears repeating that the S Corporation incurs built-in gain tax only upon the disposition of an asset. If an asset is sold, for example, there is no built-in gain tax if that asset was acquired after the conversion date or to the extent the gain is attributable to post-conversion appreciation.
What does all this mean?
If you are considering conversion to S status, it is critical to use an experienced and competent tax professional. Proper planning, done up front and by a professional, can substantially limit the impact of the built-in gain tax. For example, owners can minimize the net unrealized built-in gain by having the assets of the company appraised by a competent appraiser.
A sale during the ten year built-in gain period will not result in a double tax if you can establish that the appreciation in the asset occurred after the conversion date; hence the importance of an early conversion, competent tax advice, and an appraisal or valuation that can withstand the scrutiny of your friends at the Internal Revenue Service.
Perhaps the best advice is for C Corporation owners to meet with a tax advisor to discuss the ins and outs of converting to an S Corporation. With that in mind, examine the following sale options for an S Corporation and a C Corporation.
SALE OPTIONS FOR THE S CORPORATION
If you wish to sell a business organized as an S Corporation, you can choose one of three options.
Option 1. Sell assets. Sell assets and pay a single tax (at the individual level) on the gain from the sale.
Option 2. Sell stock. Sell stock and pay a capital gains tax on the difference between the sale price and the basis in your stock. Note that the basis of your stock is likely to be increased by earnings retained in the S Corporation during previous years. For example, a client recently sold his S Corporation for $3 million. Over the years, he had retained approximately $1 million in earnings in the corporation. At the time of the sale, the buyer agreed to pay this client $2 million and allowed him to take $1 million in cash and other securities that had been kept at the corporate level. Thus, this client paid a gain on the $2 million paid by the buyer and was able to remove $1 million of cash from the business at the time of the sale with no tax liability since the taxes had been paid in previous years when the income was retained.
Take a moment to contrast that result with a C Corporation in which the distribution of the $1 million from the company to the owner would have been taxed once again (as would the net proceeds on the $2 million sale of assets). It bears repeating that with an S Corporation an owner has an increased basis due to income retained in the corporation during previous years. This upward basis adjustment in the owner’s stock interest and consequent return of the basis without tax consequence is not allowed with C Corporations.
Option 3. Merger. In a merger, the owner exchanges his stock for the stock of the acquiring company. Structured properly, this is a tax-free merger with you, the owner, receiving stock in the new entity which can then be sold at a future date. A capital gains tax will be paid at the future date. The tax is based on the difference between the then current sale price, and your basis in the stock of your company immediately prior to the merger.
When an S Corporation is involved in a merger, the normal scenario is to have the S Corporation owner remove cash and other liquid assets from his business equivalent to his basis immediately prior to the sale. This results in a tax-free distribution of cash from the business to the owner. A merger is then based upon the value of the S Corporation after the cash distribution has been made to the owner.
Note that in all of the possible S Corporation sale scenarios (asset sale, stock sale, or merger), there is but a single tax on the unrealized gain the owner receives as a result of the sale.
SALE OPTIONS FOR THE C CORPORATION
Remember, the double tax consequences of an asset sale by a C Corporation are typically disastrous, often 40 percent (or more) of the available sale proceeds. The prudent owner must examine all alternatives before the sale occurs.
Option 1. Sell stock.
The sale of stock results in a capital gain to the owner on the difference between the sale price and the owner’s basis in the stock (usually very low or nonexistent in most closely held businesses). This is one of the most advisable options as a single capital gains tax is imposed on the gain.
Option 2. Sell to CRT.
With proper planning, an owner can avoid all tax consequences at the time of sale.
Briefly, the steps are:
- create a charitable remainder trust (CRT);
- transfer the stock to the CRT;
- have the CRT enter into an agreement and sell the stock to a third party. (If this is of interest to you, we have a White Paper on the use of Charitable Remainder Trusts in Exit Planning.)
Option 3. Merge with the buyer’s company.
Again, there is no tax due at the time of the merger. Eventually, capital gains tax will be paid when the owner of the C Corporation sells the stock acquired in the merger.
Option 4. Don’t sell the business.
Hold onto the stock until your death. Continue to receive income for your ongoing efforts connected with the business. Your heirs will receive a stepped-up basis in your stock to the extent of the fair market value of the business at the date of your death. This approach is not recommended for owners who wish to spend money (however diminished by taxes) before their deaths.
Option 5. Convert to an S Corporation.
This conversion will be subject to the built-in gain rules previously discussed. Although the built-in gain rule is a ten-year rule, much can be achieved by converting to an S Corporation a few years before the sale.
Recall how the built-in gain rules operate. The double tax is not imposed on appreciation on assets after the conversion date. This fact, combined with a certified valuation of assets (especially goodwill) at the time of conversion that is conservatively low, allows much of the gain on a third party sale to be taxed but once. Again, the key is allowing as much time as possible to pass between the date of conversion and the date of sale. Much of the adverse tax consequence of a C Corporation sale can often be eliminated if the S Corporation form is elected even a few years before the sale is consummated.
Option 6. Form other flow-through entities now.
These flow-through entities (usually in the form of a Limited Liability Company or partnership) acquire equipment, real property, or other assets (such as intellectual property rights, patents, copyrights, etc.) that your business uses to operate. When the business and the assets are sold, there will be a single tax on the gain recognized by the flow-through entity, and a double tax will be paid to the extent the gain is recognized at the C corporate level.
Option 7. Negotiate to minimize impact of an asset sale.
Several techniques can be used to minimize the double tax impact of an asset sale. These generally take the form of a direct transfer of dollars from the buyer to you, with a corresponding reduction in the money paid by the buyer to your corporation. The most common techniques are: a covenant not to compete, consulting agreement, employment agreement or licensing or royalty agreement directly with you. The double tax bite is avoided at the cost, however, in the case of employee-based compensation, of having to continue working and being subject to FICA taxes on some portion of the money you receive. At best, these techniques are a partial offset, not a complete solution, to the double taxation consequences of selling assets within the C Corporation.
TRANSFERRING A BUSINESS TO FAMILY MEMBERS OR KEY EMPLOYEES
This Paper has highlighted several advantages available to entities other than regular C Corporations when selling a business to an outside third party. But do the same advantages apply when transferring a business to children or key employees?
The answer, very simply, is that the advantages of an S Corporation are even greater when you transfer your business to a child or key employee; and that “greater advantage” is due primarily to the distinguishing factor between a sale to an outside third party and an insider (your business-active child or key employee). That distinguishing factor is money, or more precisely in the case of your insider, the lack of money. An outside third party comes to the closing table with cash. Your child, or your key employee, comes to the closing table with the promise to pay you cash at a future date.
When you sell to an insider, the sole source of your buy-out money is the future income stream of the business. Given this overarching consideration it is imperative that the business’s future income be transferred to you with the least tax loss possible. An asset or stock sale involving a C Corporation causes the business’s income stream to be reduced twice by taxation: once when the corporation sells its assets (or buys back your stock with nondeductible payments) and once when you sell your stock. Of course, having paid careful attention to the earlier part of this Paper, you are already acutely aware of the double tax upon a sale of a C Corporation’s assets.
But, why when selling stock to your child (or employee) do we need to be concerned with two levels of tax? After all, you will only be taxed on the gain attributable to your stock sale. Remember, the seller in a related party sale must also be concerned with the tax consequences to the buyer—because all of the money is coming from the business.
Remember, the buyer is taxed once when receiving income from the business (as compensation). She uses part of that compensation to pay you for your stock. The income stream of the business then is taxed twice: once when the buyer receives (compensation) and again when you receive the net monies from her for the purchase of your stock.
The solution to avoiding the double tax bite (whether asset or stock sale) involved in a sale to a related party, is to value your ownership interest as low as your valuation expert can properly defend and for you to directly receive the future income stream of the business—so that it is taxed only once.
As a family business owner, you begin the transfer process by selling some stock at a low value over time to minimize double tax consequences to the extent value is attributable to stock ownership. You continue to own a significant amount of S Corporation stock from which you receive dividends that are taxed but once. After you have received sufficient income from the business to reach your financial security goals, you then transfer, by gift or sale, the remaining stock to your related party.
This is but one of several techniques you can use when you are selling or transferring ownership in an S Corporation to your child or key employee. In all such situations, operating your company as an S Corporation facilitates the transfer of the business at the lower total tax cost to you and to the business.