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Selling A Business: The C Corp To S Corp Dilemma?

Selling a business set up as a C corporation can have some very painful tax consequences.

The following is not legal or tax advice. Consult with your CPA and/or attorney before taking any action


Is your business a C Corporation?

If yes, PLEASE READ THIS!


Do you want to pay 50% or more in taxes when you sell your business?

I didn’t think so. If you want to avoid that potential calamity? Read on.

But first, let’s talk a minute about the characteristics of a C corp. A C corp is a legal entity in which a business is operated. An S Corp and LLC are also entities used frequently to operate a business.

The primary difference from a tax perspective is the C Corp profits are subject to “Double Taxation”. Meaning the corporate entity is taxed and then the shareholders are taxed when what’s left is taken out of the C corp by the shareholders.

S Corps and LLCs are often set-up as “pass-through” entities meaning there is only taxation at the shareholder or member level (we’ll use shareholder and member interchangeably but there are some differences). There are circumstances where LLCs are taxed as C Corps. Check with your CPA when you establish your LLC to make certain it’s set-up correctly.

The issue is when the buyer does not want to buy the stock in your company but instead buy the assets (equipment, customer lists, inventory, goodwill, etc). The buyer wants to buy the assets to get the tax-deductibility of depreciation and amortization associated with the assets. If the buyer buys the stock in your company they lose deductibility. Since an asset purchase gives the buyer more tax protection the buyer can usually pay a seller more in an asset purchase than in a stock purchase.

Double taxation can be painful

Many business owners have been advised by their accountants over the years to switch from a C corp to an S corp but the business owners have ignored this advice too often. Timing the conversion can have an effect on the impact felt by the C to S conversion. If it comes time to sell your C Corp almost all buyers prefer an asset sale as opposed to buying the stock of your C corp. Therein lies the value trap caused by the double taxation at the C corp level.

Why is important to advisors like us (Mergers & Acquisition advisors and business brokers) who sell businesses for business owners? Because the same “double taxation” on your profits could be a problem upon the sale of the business. How would you feel if you spent decades building a business and then when you sell it you get the privilege of paying 50% or more in taxes on the selling price?

How Long does it take to get the S Corp tax treatment after you convert?

There is a look back period in the tax law that is designed so that you can’t just convert your C Corp to an S corp at the time of sale and reap the lower tax windfall. The IRS is way too smart for that trick.

The tax code “look back” period has varied in recent years from 10 years to 5 years to 7 years to the current 5 years. Who knows what it might be in the future?


Here are the pitfalls and options: 1) If you don’t plan to sell your business for at least 5 years consider converting from C to S now

2) If you do plan to sell your business in the next 5 years, seriously consider converting from a C to S now

Yes, the advice is the same. Why? Because the lookback window starts when you make the conversion and the sooner the clock starts, the sooner you are out from under the C Corp tax burden if/when you sell your business. Obviously, check with your CPA to determine any “look-back” issues with rules or time.

Selling a business is more about how much you end up with, not how much you sold it for

What are the steps to convert?

An important first step recommended by most CPAs is to get a Business Valuation done for the C Corp. This valuation captures and locks in the potential C Corp tax burden. Then the value gained above that valuation will not be subject to C Corp taxes in the future. That 10 year or 5 year or 7 year window or whatever other look back period the IRS decides to impose on you.

At the very least talk to your CPA now about converting from your C Corp to an S Corp, I promise, you’ll be glad you did. This tax burden has negatively impacted many business owners because they didn’t act before the issue arose.

In order to convert a C corporation to an S corporation, the business entity must meet the five conditions below.

  1. The business must have been created in the United States — both legally and effectively. A business entity that was not legally incorporated in the US is not eligible for electing S corporation status.

  2. A C corp seeking to elect S status cannot have more than 100 shareholders. If shares are spread – in part or in whole – across a network of immediate family members, they are considered to be one shareholder.

  3. Each and every shareholder absolutely must be one of the following: an estate, a business entity classified as an S corp, a resident alien, or a full-on United States citizen. Further, a handful of types of trusts can also be considered eligible.

  4. If a business can obtain consent in writing from each and every shareholder to flip-flop the status of a C corp to an S corp, the C corporation business entity can be considered eligible to elect the status of an S corporation.

  5. Lastly, the business entity in question can only have one type of stock up for grabs – this means an entity can’t have both preferred and common shares, for example.

Here’s how to elect S Corp status:

First, the owner of a business must file Internal Revenue Code Form 2553 — titled the Election by Small Business Corporation. All shareholders and the chief executive officer or president — whoever signs the tax returns once they’re completed — must sign the aforementioned form.

Finally, simply deliver the completed form to an IRS office.

Remember, the preceding information is no substitute for talking to your CPA or attorney about your particular situation and whether changing your type of business corporation is right for you. But in certain situations, converting your company’s tax status from a C corp to an S corp can save you a lot of money!

 

Mr. Elliott is Managing Director of Sunbelt Texas Business Sales & Acquisitions with more than 20 years experience in mergers, acquisitions and business broker. Mr. Elliott purchased Sunbelt Houston in 1996 and has managed the sale of over 500 companies from very small businesses to companies with revenue of more than $30,000,000. Mr. Elliot has provided Business Broker and merger and acquisition adviser services to privately held business in Houston, Austin, San Antonio and throughout Texas.


Over a 20 year career, he has handled a wide range of industries including manufacturing, distribution, medical, machining, construction, and contractors. Mr. Elliott has completed transactions with Private Equity Groups, strategic buyers and a wide range of regional companies executed plans to grow through acquisitions.

Mr. Elliott has been recognized as a “Thought Leader” by Sunbelt Business Brokers Global Network. Mr. Elliott is frequently interviewed in various media and is considered an expert in the field of buying and selling privately held businesses.

Mr. Elliott has received the professional designations of Certified Business Intermediary (CBI) and Master Merger & Acquisitions Intermediary (MMAI).

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