One of the most important decisions a business owner makes is to choose the type of entity that is best for their business (“C” corporation, “S” corporation, limited liability company, partnership). While it may have some drawbacks, it is not uncommon for business owners to elect to do business as a C corporation due to lower corporate tax rates and the feeling that a C corporation makes your business seem more substantial. However, there are disadvantages to the C corporation that should be considered before choosing the type of entity for your business. What follows is a brief examination of the tax differences in the sale of a C corporation and the sale of an S Corporation.
The majority of business sales are done as asset sales, meaning that the assets of the business such as hard assets (furniture, fixtures, equipment), good will, books of business and other tangible and intangible assets are sold to a purchaser. In a stock sale, the business is sold through the sale of the corporation’s stock from one or more shareholders to the shareholders that are purchasing the business. Other than the fact that when a buyer purchases the stock of a business he or she also assumes the liabilities to the corporation, a buyer in a stock sale is not allowed to take a step-up in basis of the assets when the stock is acquired.
In an asset sale, a business operating as a C corporation must first pay corporate income tax on the sale of those assets, and the remainder is then distributed to the shareholders of the corporation who pay capital gains tax on the sale proceeds. The same asset sale in an originally elected S corporation would only result in a tax at the shareholder level; there is no tax at the corporate level in an S corporation. In addition, the other drawback to the C corporation (other than the “double taxation”) is that the structure of most asset sales requires the seller to pay the corporate-level tax immediately, meaning the seller must have adequate reserves in order to pay the corporate level taxes at the time of sale.
Unfortunately, simply converting from a C corporation to an S corporation does not necessarily allow the seller to avoid the “double taxation” set forth above. A newly elected S corporation must wait 10 years (currently 7 years for C corporations sold in 2009 and 2010 pursuant to the 2009 Economic Stimulus Package) to avoid having to pay built-in gains at the corporate level tax on the sale of its assets. However, after the S election is made, all future growth from the date of the S election is excluded from the corporate-level tax if a sale takes place before 10 (or 7 if the sale takes place in 2009 or 2010) years elapse.
*This article is for general information purposes only and is not meant to constitute specific legal advice. A trusted attorney and accountant should be contacted to discuss the information contained in this article.