Episode 6 Transcript: Structuring Your Business for a Tax-Efficient Sale

BRETT: Welcome to The Charleston Entrepreneur Podcast.

BRETT: Here my radical idea is that personal finance should be…personal.

BRETT: Ultimately, the human element in each of us is what makes up personal finance. We are all business owners doing the best we can to make the right decisions about our personal lives with the information we have.

BRETT: In this podcast it is my goal to give you everything I have to make you successful. I want you to live your most fulfilled life, and I know you can.

BRETT: My theme over the last few episodes has been about how someday, every one of us business owners will exit our business. And that’s going to be either by choice or against our will.

BRETT: And unfortunately far too many business owners take a reactive approach to this event. They don’t begin the process until something or someone has forced them too.

BRETT: So my goal in today’s podcast is to motivate you to undertake some kind of planning today, specifically, how you structure your business entity, so that you don’t double the taxes you will owe upon the sale of your business.

BRETT: As we all are well aware, each of our businesses are conducted, for income tax purposes, as either a regular corporation (a C-corp) or as some type of flow-through tax entity (like an S-corp).

BRETT: And if you were to ask a CPA which business entity he or she suggests, that CPA will typically answer, “A C corporation – at least in the early, capital-forming years of the business.”

BRETT: However, ask any Investment Banker or other transaction advisor which entity they prefer and you will likely hear, “An S corporation, LLC, or perhaps a partnership or sole proprietorship. Anything, anything, but a C corporation!

BRETT: And they’d both be right. The best entity for tax purposes during a business’ startup and operational years is often a C corporation.

BRETT: However the C corporation is the worst entity…because it causes the most tax problems…when it comes time to sell the business.

BRETT: And of course not shockingly, the best tax entity at the time of a sale – an S corporation – is often a poor choice for tax purposes during the company’s operational and growth years.

BRETT: Now, if you’re like me, the entity decision I made when I founded our business, has never changed nor has it ever even crossed my mind.

BRETT: There’s usually not too much thought given to minimize tax when we first started our business, because there was so little income to begin with!

BRETT: However, consequences – both harmful and beneficial – arising from our choice of business entity, do enter the picture drastically when we decide to exit from our business.

BRETT: Alright, alright, get on with it Brett. I hear you. So why? What is it that you mean by this?

BRETT: Let’s say you decided to take advantage of the lower tax rates of a C corporation during your business’ startup and growth years.
BRETT: Should or when you sell it, you’ll discover that selling its assets results in a tax on all of the gain, at the company level.

BRETT: Now this large amount of income cannot be transferred from the company to you the owner: It stays in the company and is taxed accordingly.

BRETT: This…can more than double the taxes that you must eventually pay because you still don’t have the proceeds…the company does!

BRETT: So when the proceeds are distributed to you, a second tax is paid.

BRETT: On the other hand, selling the assets of an S corporation usually results in a single tax levied only at the individual level. So shouldn’t every business elect to be treated as an S corporation?

BRETT: If you remember in our last episode, episode 5, I talked about a prospect in 2015 who came to us, and she wanted to sell her business, and her company had already been valued at $4 million.

BRETT: In her mind, and she wasn’t unrealistic, she anticipated a 20% capital-gains tax, netting her over $3 million.

BRETT: Then, when she met with a CPA and a deal Attorney, they brought up some key things we all have to consider about our business.

BRETT: First, since most of us here in Charleston are service businesses, there aren’t many hard assets to our business. And as service companies, most of any purchase price to our business would be paid for using “goodwill” (which means an asset without any basis).

BRETT: Second, this prospect was a organized as a C corporation. Her CPA and Attorney told her this would be a major stumbling block, because any buyer would want to buy assets rather than its stock. As a C corporation, she could expect her total tax bill alone, to be closer to $2 million.

BRETT: So you can imagine this change in her expectations did not sit very well.

BRETT: It wasn’t anyone’s fault, but it still took a lot of time for her trusted advisors to explain this to her.

BRETT: As a C corporation, there is a tax imposed at the corporate level on the sale of her assets. When he company receives the $4 million, it is taxed on the difference between that $4 million and its basis in the assets being sold.

BRETT: At most, her basis in the assets was $1 million, so the tax will be levied on the gain of $3 million.

BRETT: Once you calculate the corporations effective tax rate for both Federal and State, the company would pay over $1 million in taxes.

BRETT: Then, when she received the $3 million from the company, there will be a second tax – a capital gains tax – on that gain.

BRETT: That 20% capital gains tax equals about $500,000 since she had such little basis in her stock (a situation most business owners face).

BRETT: So at the end of the day, the end to her was not going to be $3 million. It was a little over $2 million – well short of her goal.

BRETT: Now, let’s flip this scenario. If she were an S corporation, most of the $3 million (again the $4 million sale price minus $1 million basis) would be taxed once…at capital gains rates.

BRETT: Her takeaway as an S corporation would have been a little over $3 million, as opposed to $2 million in a C corporation.

BRETT: Obviously she failed to choose the entity that would perform best (from a tax standpoint) when she sold her business.

BRETT: Had she been formed as a S corporation, the double tax would have been avoided, because an S corporation is a “flow-through tax entity” with no separate tax at the corporate level.

BRETT: So, what’s the difference between a C corporation and an S corporation? Given a $4 million sale price, the difference is another $1 million or so in the owner’s pocket instead of the IRS’s.

BRETT: An ideal situation sounds like it would be to form as a C corporation in your formative years in order to take advantage of the lower income tax brackets, which in turn would lead to faster accumulation of capital in your company.

BRETT: Then, just before you’re ready to sell, convert to an S corporation.

BRETT: Unfortunately, the IRS figured that one out, they saw the tax revenue they were losing out on. You can’t do it.

BRETT: Today, if a regular C corporation converts to S status, a 10-year “built-in gains rule” is applied to maximize the tax revenue to the IRS. This is the IRS’s weapon to prevent any lost tax to them.

BRETT: So if you own a C corporation and desire to sell one day, you’d do well to understand the basic operation of this rule. My best advice is for C corporation owners to meet with a tax advisor to discuss the ins and outs of converting to an S corporation.

BRETT: If you are an S corporation, you can choose one of three options to sell your business.

BRETT: A first option; Sell Your Assets. You can sell assets and pay a single tax (at the individual level) on the gains from the sale.

BRETT: A second option; Sell Stock. If you don’t have any assets to sell, you can sell stock and pay a capital-gains tax on the difference between the sale price and the basis in your stock.

BRETT: And the third option; Merger. In a merger, the owner exchanges his or her stock for the stock of the acquiring company. Structured properly, this is a tax-free merger, with the owner (say you) receiving stock in the new entity, which then can be sold at a future date.

BRETT: A capital gains tax will be paid at the future date. The tax, is based on the difference between the then current sale price and your basis in the stock of your company…immediately prior to the merger.

BRETT: The key takeaway for you today about selling as an S corporation, there is only a single tax on the unrealized gain you receive as a result.

BRETT: So how do you sell a C corporation?

BRETT: C corporations you can of course sell and it obviously happens all the time. And although maybe as not as tax efficient as selling an S corporation, a C corporation does have many options.

BRETT: First; Like the S corp, you can Sell Stock. The sale of the stock results in a capital gain to the owner on the difference between the sale price and the owner’s basis in the stock (which is usually very low or nonexistent in most closely held businesses). And this is one of the most advisable options for a C corporation, as a single capital-gains tax is imposed on the gain.

BRETT: A Second option; Sell to a Charitable Remainder Trust. With proper planning, an owner can avoid all tax consequences at the time of sale.

BRETT: Briefly, the steps to do this are: 1.) Create a Charitable Remainder Trust. 2.) Transfer the stock to the Charitable Remainder Trust. 3.) Have the Charitable Remainder Trust enter into an agreement and sell the stock to a third party.

BRETT: A Third option; Don’t Sell the Business. Here you would hold on to the stock until your death. You’d continue to receive income for you ongoing efforts connected with the business. Your heirs will receive a stepped-up basis in you stock to the extent of the fair market value of the business at the date of your death.

BRETT: This approach however is not recommended for owners who wish to spend their money (however much its been diminished by taxes) before their deaths.

BRETT: Option Five; we touched on this a little earlier, Convert to an S corporation. This conversion will be subject to the built-in gains rule I talked about, but you still could achieve greater take home from a sale, even if you have less than 10 years to play with.

BRETT: Option Six; Form other flow-through entities now. These flow-through entities are usually in the form of an LLC or partnership, and can acquire equipment, real property, or other assets that your business uses to operate.

BRETT: When the business and assets are sold, there will be a single tax on the gain recognized.

BRETT: And last, Option Seven; Negotiate to minimize the impact of an asset sale. There are several techniques that can be used to minimize the double-tax impact of an asset sale. These generally take the form of a direct transfer of dollars from the buyer to you the owner, with a corresponding reduction in the money paid by the buyer for your corporation.

BRETT: The most common techniques like this are; a covenant not to compete, a consulting agreement, an employment agreement, or a licensing or royalty agreement directly with you.

BRETT: At best however, all of these seven techniques are a partial offset, not a complete solution, to the double-taxation consequences of selling assets of a C corporation.

BRETT: I want to change gears here for a minute. Everything I’ve spoken to so far has been if an S or C corporation were sold to a third party. But what if you wanted to transfer your business to children or key employees? Do the same advantages of an S corporation apply?

BRETT: The answer, very simply, is that the advantages of an S corporation are even greater when you transfer your business to a child or key employee, and those greater advantages are due primarily to the distinguishing factor between a sale to an outside third party and an insider (your business-active child or key employee).

BRETT: That distinguishing factor is money (or in many cases to an insider a lack-of-money). An outside third party comes to the closing table with cash. Your child or key employee most likely comes to the closing table with a promise to pay you cash at a future date.

BRETT: So when you sell your business to an insider, the sole source of your buyout money comes from the future income stream of the business.

BRETT: Given this, it is imperative that the business’ future income be transferred to you with the smallest tax loss possible.

BRETT: So as a family-business owner, you do this by selling some stock at a low value over time to minimize double-tax consequences to the extent value is attributable to stock ownership.

BRETT: You continue to own a significant amount of S corporation stock, from which you receive dividends that are taxed only once. After you have received sufficient income from the business to reach your financial security goals, you then transfer by gift or sale, the remaining stock to your child or key employee.

BRETT: This actually is only one of several techniques you can use when you are selling or transferring ownership in an S corporation to your child or key employee. But I want your takeaway to be that in any situation, operating your company as an S corporation facilitates the transfer of the business at the lower total tax cost to you and the business.

BRETT: Wrapping up, I want to emphasize, as I mentioned earlier, the entity choice that best suits doing business may not be the best entity for selling the business. Keep that in mind if you remember nothing else from this episode!

BRETT: Thanks for tuning in today everybody. As always, visit our website oakcapitaladvisor.com for more information, and request a Free Retirement Assessment to get started on your retirement planning journey. And check out the show notes for more resources that can help you succeed. Until next time.

BRETT: Have a great day!

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