C-corp or S-corp? Your Business Structure Can Cost You (A Lot)
C-corporation or S-corporation? The
alphabet soup of legal entities -
it’s enough to make a business
owner’s head swim. If the sale of your business is even a
remote possibility - whether now
or the distant future, you MUST advise him or her on this information
in this article. That is,
if you want to save your client 35
percent or more of the sale proceeds.
The C-corporation is the classic for-profit legal entity in the
U.S. It is unique in that it is taxed as an entity in itself, separate
and distinct from its shareholder, and it may have its ownership
interests (shares) trade on public exchanges. Tax advisors and accountants
often recommend the C-corporation structure because of allowances,
particularly the lower legal and tax liabilities. Shareholders enjoy
significant protection from personal liability from company obligations,
and ownership interests can be easily be transferred. Moreover, at
lower annual income levels, income tax rates are lower for C-corporations
than for individuals. Dividends however, are the only means for distributing
company profits to non-employee shareholders and are subject to double
taxation. Double taxation means that company distributions (dividends)
are paid out of the corporation in after-tax dollars (i.e., dividends
are not a deductible expense of the business), and then, the shareholder
who receives the dividend will owe taxes on the amount receive as
the IRS requires that such receipts be included as taxable ordinary
income to the shareholder.
When a C-corporation is sold, the sales proceeds are injected into
the business, taxed at corporate level, and then when removed by
the seller--as dividends are taxed at ordinary income rate. Conceivably,
after a business sale, a seller could retain a mere 40 percent of
sales price (i.e., based on up to a 30 percent corporate taxation
rate, followed by a 30 percent ordinary income taxation rate)!
You can protect your proceeds by converting your C-corporation into
an S-corporation. An S-corporation has similarities to its C-corporation
cousin, such as ease of ownership transfer and the shielding of shareholders
form the liabilities of the company. Benefits such as life and health
insurance and housing cost reimbursements are treated as tax-deductible
expenses in a C-corporation and are considered taxable compensation
for shareholders who own more than a 2 percent share in the S-corporation.
When an S-corporation is sold, the sale proceeds in the corporation
are treated as income that flows (immune from corporate tax liability)
through the business, directly to the shareholders who, at that point
are subject to ordinary income or capital gains tax. Conceivably,
after a business sale, a seller may retain up to 65 percent of sales
price (i.e., assuming 35 percent ordinary income taxation rates,
depending upon his or her state of residence and sales price allocation)!
So, would you rather retain up to 65 percent (depending upon your
state of residence) versus 40 percent of proceeds upon the sale of
your business? You can convert a C-corporation to an S-corporation,
but be forewarned that the IRS has established a 10-year recapture
period if the business is sold during this window. For example, consider
a C-corporation that is valued by a certified business appraiser
at $2 million upon conversion to an S-corporation. If this company
is sold within the 10 year recapture period for $8 million, then
$2 million of the sale proceeds will be treated as if a C-corporation
had been sold (i.e., subject to double taxation), while the remaining
$6 million of the sale proceeds will be treated as if an S-corporation
had been sold (i.e., subject to ordinary income taxation). You may
be advised to sell stock (subject to capital gains tax) if the business
is a C-corporation, but realize that a prudent buyer will discount
the price offered by the present value of what was lost in the savings
through this structure.
Some business owners think they will never sell their company and
disregard this important financial information, however unanticipated
circumstances may necessitate a sale, such as health requirements,
family situations, and/or retirement. Consider the restructuring
of your business to an S-corporation, and if your business is currently
an S-corporation - congratulations! You will keep more of the spoils
from your business sale.
Discuss this information with your tax professional for additional
advice that is best for your specific situation.
Mark Gould, C.B.I., C.B.O.A., President of Gould Business Group and Vercor Principal, provides middle market companies (annual revenues of $2 to $50 million) with a systematic approach to mergers and acquisitions. Mark also has extensive experience in business ownership including industries such as medical distribution, printing, manufacturing, professional services, and food related businesses.
Copyright © 2003
by Mark Gould
All rights reserved