Tax Consequences of Selling a C-Corporation
Much to my surprise, when business owners discuss with me the value they would like to achieve in the sale of their business, they refer to a pre-tax number rather than an after tax number. I presume the assumption is that the tax consequence in a transaction cannot be controlled, but that is not the case. In fact, structuring a deal appropriately can have significant implications on the amount that a business owner puts in their pocket after paying Uncle Sam. The goal of this article is to focus on one common issue that costs business owners severely – taxation of a C-Corporation in the sale of a business.
In order to explore the tax consequences, allow me to provide some brief backdrop. When a buyer purchases a company, there are two ways to go about the transaction – an asset purchase or a stock purchase. In an asset purchase, if XYZ Manufacturing Inc. doing business as XYZ Manufacturing went to market and I purchased the company, I would set up my own business entity – Randy Katz, Inc. I would then absorb all of the assets of XYZ Manufacturing Inc. into my own corporation. That includes, but is not limited to, machinery, fictitious business name, website, customer list, vendors, employees, operating manuals/procedures, etc. The actual entity, XYZ Manufacturing Inc. would still belong to the original business owner who would likely dissolve that corporate entity after receiving the proceeds of the sale. In a stock purchase, I would purchase the actual entity, XYZ Manufacturing Inc., and since the existing entity continues to own all of the assets, the business would continue to operate as usual. The taxation mechanism of an asset sale and a stock sale are different.
Let’s first explore the way an S-Corporation, LLC or sole proprietor are taxed in an asset sale. Keep in mind that S-Corporations and LLCs are flow through entities, so along with sole props are only taxed once at the individual level. As part of the deal structuring, the total purchase price is split up into different buckets that make up the business; this is a process known as the allocation of purchase price. This could include, but is not limited to: inventory, accounts receivable, furniture, fixtures & equipment, goodwill, covenant not to compete, leasehold interest, and leasehold improvements. Each piece of the bucket is taxed a specific way - some are taxed at ordinary income tax rates and others at capital gains tax rates. Ultimately, the tax consequence to the seller will be some blended rate somewhere between the two.
Now let’s compare this to the sale of a C-Corporation in an asset sale. Since this is our double taxed entity, the value received is reported as earnings to the corporation first. In 2015, the top corporate tax rate was 39%. After the tax is paid, the cash is on the balance sheet of the corporation and still needs to be paid out to the shareholders. To do this, the shareholders needs to pay themselves a dividend, of which the top dividend tax rate in 2014 was 20%. It’s easy to see how a business owner could end up with less than 50% of their proceeds following an asset sale of a C-Corporation.
The taxation in a stock sale for an S-Corporation and C-Corporation are much simpler and is similar to the sale of a publicly traded company. If the stock is held for less than 12 months, it is taxed at short term capital gains rates, and if it is held for more than a year, it is taxed at long term capital gains tax rates.
On the surface, this seems like an easy solution if you own a C-Corporation….sell the stock. The problem is that buyers do not want to purchase your company stock. There are two main reasons for this:
1) No step up in tax basis: When a buyer purchases your assets, the value of your assets get stepped up to the value agreed upon in the allocation of purchase price. The buyer then gets to re-depreciate the assets, thus receiving tax deductions and a lower income tax bill. When a buyer purchases stock, since the entity is a going concern, the buyer assumes the depreciated and amortized basis of your assets which may very well be depreciated to zero or close to it. This creates a higher income tax consequence to the Buyer over the coming years.
2) Purchase of unknown liabilities: When an acquirer sets up their own business entity as they would in an asset sale, that newly born entity does not have any history, therefore its liabilities are clean. However, when purchasing stock, an acquirer will not only pick up the debt that can be seen on the balance sheet, but liabilities that may not even be known by the buyer or seller. This could include a former employees bringing a lawsuit for sexual harassment, wrongful termination, worker’s comp claims, customer claims for faulty product, vendor claims for outstanding accounts payable etc.
To make things challenging, this is not an issue that can be fixed overnight. In fact, it currently takes 5 years from the time an owner elects for subchapter S status to get the full tax benefits of being an S-Corporation in a sale. This 5-year time frame is known as the recognition period and is subject to built-in gains tax.
The point of the article isn’t to say that there aren’t reasons to be a C-Corporation. Perhaps you have more than 100 shareholders or multiple classes of shareholder, neither of which are allowed in an S-Corporation. Or perhaps you are saving enough in taxes through income shifting that any downside in the future will be more than offset with tax savings today. However, in most instances, I see C-Corporations solely because a business has been around for 25-30 years when they were en-vogue and the owner never thought to change the structure.
Give your CPA a call and discuss with them your thoughts regarding a sale of the business and find out if you are structured appropriately. It could be the most profitable business call you make all year.