The business structure of your company has a huge impact on the taxation of your firm’s profits. A C-corporation (C-corp) structure, for example, has several drawbacks that generate a higher tax on company profits over time. If your business was formed as a C-corp, you can convert to another form of ownership and reduce your tax liability. These tax issues become especially acute when it comes time to sell a company.
If you (or your client) operate as C-corps, use these tips to start a conversation about a C-corp conversion.
The Double Whammy of Double Taxation
Three of the most common business structures are C-corps, S corporations (S-corps), and partnerships, and the C-corp is the one entity of the three that subjects the business owner to two levels of taxation. Assume, for example, that MountainAir Sporting Goods makes clothing for the hiking and outdoor sports market, and this C corp generates $1,000,000 in profit for the year. MountainAir’s C-corp files a tax return and pays a 25% corporate tax rate on the $1,000,000 in profits, or $250,000. Bob, an investor, receives a dividend from MountainAir’s after-tax profits totaling $100,000. The $100,000 dividend is considered income to Bob, and Bob pays personal income taxes on the amount. The C-corp structure results in two layers of taxation.
Taxes When Selling the Company
This same double taxation issue rears its ugly head when it’s time to sell the company.
Most small businesses, when sold, are structured as an “asset sale” which means that the buyer purchases specific company assets and takes on specific liabilities. The seller actually retains the corporate “shell,” and that shell is paid proceeds in exchange for the assets sold. Conversely, in a “stock sale,” the purchaser actually buys the corporate entity. Essentially the seller exchanges their stock in the business for financial consideration.
Buyers prefer the asset sale approach for a number of reasons. One of the largest and most common reasons is that the buyer avoids taking on contingent liabilities related to buying the entire entity. If, for example, MountainAir was audited and back sales taxes were assessed after the asset sale, the buyer is not liable for the taxes since the purchaser did not buy the entire business.
When a C-corp’s assets are sold, first, the corporation pays tax on the sales proceeds. The difference between the sales proceeds and the adjusted basis in the asset is taxed to the seller as ordinary income. Say, for example, that MountainAir sells the assets and liabilities of the hiking division for $3 million, and that the adjusted basis on the balance sheet is zero (a common scenario), MountainAir’s pays corporate income tax on the $3 million gain.
We’re not done yet. When those proceeds are distributed to shareholders, shareholder then pays tax again at ordinary income rates. Bottom line: an asset sale for a C corp is rarely tenable as the blended tax rate can often exceed 60% of the sales price.
What to do? Well, the first thing you need to consider is engaging a valuation firm to establish value at the time of conversion. Without this crucial step, your goals of tax simplification fall by the wayside.
To avoid the higher taxes imposed on a C-corp, many companies convert to another business structure. The idea here is to convert the C-corp into a pass-through entity, which allows the company’s profit and losses to flow through to the personal tax returns of the owners or partners.
A C corp, for example, can convert into a Limited Liability Company (LLC), which can elect to be taxed as a partnership, and the profits and losses of the partnership flow through to the personal tax returns of each partner. In some cases, the C corp can elect to be taxed as an S corp, but the entity must have less than 100 shareholders and only one class of stock. An S corp is also a pass-through entity.
When an LLC or an S corp receives assets from a C-corp, the company acquiring the assets must calculate the built-in gains on the assets received, which is the (fair market value) less (adjusted basis). If the assets are sold during the recognition period, the LLC or S corp pays the highest corporate tax rate on the built-in gains (BIG).
Assume that MountainAir’s fair market value is $10 million and that the adjusted basis on the balance sheet is $8.5 million. Instead of a sale, the entire C-corp is converted into an S-corp. The new MountainAir S-corp has a built-in gain of $1.5 million. If any MountainAir assets are sold, the built in gain on those assets must be recognized. Historically there was a 10-year recognition period for built-in gains. The period has changed over recent years to as low as five years (consult your tax professional on current issues).
When doing a conversion, the BIG issue makes it important to establish value at the time of the conversion. A qualified valuation (or appraisal) is the way to do that. Using a third-party valuation firm, like Quantive, helps forgo any questions later as to the value at the time of conversion. Tip: if a valuation is completed for another purpose (shareholder buy-sell, exit planning), it’s a great opportunity to also engage a valuation for a conversion to realize cost savings.
Start the Clock to Avoid the Tax
Fortunately, there’s a way to avoid the built-in gains tax: not selling the assets until after the recognition period has ended. The tax law on the length of the recognition period has changed several times in recent years, and the current time period is five years. So, here’s a great reason to convert a C-corp sooner rather than later, because the sooner you convert, the sooner that five-year recognition period will end. By starting the clock ticking, you can avoid the built in gains tax and profit from selling the assets.
A Complex Process, but Worth It
Understanding a C-corp conversion can be difficult, but the tax advantages of making the change can be substantial. Use these tips to decide if a C-corp conversion makes sense and reduce your tax liability.