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.
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 advise 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 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 look back 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.
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.