Nestled amid the excitement and long hours involved with launching a new company are decisions that could have huge tax consequences at the back end.
It’s never too early to start thinking about succession planning. In fact, some aspects of succession tax planning should begin a full decade before your planned exit, while some decisions, like what type of entity to use, must be made upon the initial formation of the business.
“If you’re operating as a C corporation and are interested in exiting your business, it may be beneficial to first convert your firm to an S corporation,” says Bruce Coblentz, partner, Armanino McKenna LLP in San Ramon. “The catch is that you probably should do this at least 10 years prior to the sale of the business.”
Smart Business spoke with Coblentz about the tax implications of exit strategies.
What is the most important aspect of a business sale?
One of the most important aspects is the current entity status of your company. Namely, whether it is a C corporation or a ‘pass-through entity,' such as a partnership, limited liability company or S corporation.
Many businesses operate as C corporations for a number of reasons. In the past, the array of choices available today did not exist. Also, some businesses are required to operate as C corporations. There exists the possibility of double taxation while operating as a C corporation. Taxes are first paid at the corporation level and again at the shareholder level when dividends or liquidation proceeds are received from the company.
Taxable income of pass-through entities, on the other hand, is generally taxed only on the individual owner’s share of income from the business and not at the entity level.
Will some companies benefit at exit by changing their type of corporation?
For C corporations, a similar double-tax issue potentially arises upon the sale of the business. The C corporation pays tax on the gain on the sale of the assets, then the shareholders pay additional tax when they receive cash upon the liquidation of the corporation.
In contrast, pass-through entities typically only have a single level of tax at the owner level upon the sale of the business. This is obviously more desirable, so you’ll have to consider converting your firm or company to an S corp. Be aware that the IRS has already thought of this, and there are significant potential tax consequences in doing so within a 10-year window, called the recognition period for the Built-In-Gains (BIG) tax.
Alternatively, a stock sale by the C corporation shareholders will avoid these negative tax consequences, and the gain on sale will be taxed at preferential capital gains tax rates. Unfortunately, most buyers are unwilling to purchase the stock of a company because of the potential liabilities involved. There are also typically greater tax benefits to the buyer in an asset purchase.
What tax rates will be encountered at the time of sale?
C corporations do not enjoy the preferential 15 percent capital gains rate, but are taxed on all income at the regular corporation tax rates. With the C corporation, you may have substantial retained earnings represented by the assets of the business, such as cash, accounts receivable, inventory, property, plant and equipment. Once those retained earnings have been converted to cash by selling the assets and paying the corporate-level tax, the owners need to get the after-tax cash out to the owners to enjoy the benefits of the sale. Such a liquidity event will qualify the owners for capital gains tax rates. Alternatively, the corporation could pay out dividends to owners.
Until 2010, the tax rate on dividends is the same as the capital gains tax rate. Pass-through entities and individual owners, however, typically do enjoy the 15 percent preferential rate. In an asset sale, if your pass-through entity has tangible assets, such as equipment, vehicles, office equipment and/or furniture, the gain on sale of these assets is taxed at higher ordinary rates (maximum 35 percent federal tax rate for individuals).
Intangible assets, which include goodwill (the value of a company in excess of its tangible net worth), customer lists, trademarks and intellectual property, and stock in subsidiaries, are generally taxed at the lower capital gains rates of 15 percent. Real property sales may be taxed partially at the lower capital gains rates of 15 and 25 percent, and for much older real estate, partially at ordinary income rates.
With tax implications in mind, what financing options are available for buyers?
In a cash sale, the buyer secures third-party financing upfront to pay the purchase price in full. For an installment sale, the buyer puts some cash into the deal and finances the balance with a loan from the seller. In a stock-for-stock swap, the seller receives stock of the buyer in exchange for the stock of the company being sold.
No matter what type of entity is in place, a well-drafted buy-sell agreement, LLC operating agreement or partnership agreement is strongly recommended.
BRUCE COBLENTZ, CPA, is a partner, Tax Department, at San Ramon-headquartered Armanino McKenna LLP, the largest California-based accounting and consulting firm. Reach him at (925) 790-2600 or email@example.com.