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 protected].