The C-to-S Conversion for Impatient Owners

Submitted by John Brown on Sun, 01/08/2017 - 6:00pm
Image of Impatient Business Owner Looking at Watch

Brent James had just been offered $10 million cash for his company. He was ecstatic, until he met with his Exit Planning Advisor and learned that he had two big problems.

First, the buyer wanted to buy only assets, not Brent’s C corporation stock. The Advisor explained that the double tax (first on the corporation and second on Brent’s dividend) meant that Brent would end up with about $4.5 million after all taxes rather than the $7.5 million he expected.

Second, the possible solution—convert the company to an S corporation, wait five years until the built-in gains (BIG) recognition period lapsed, and then sell the assets—eliminated the double tax but created a new problem: Brent would have to wait five years to exit rather than exit by his 65th birthday, which was 3 years, 2 months, and 11 days from the date he first met with his Advisor. Brent was not willing to budge on his exit date.

In this article, we will explore the benefits of converting to an S corporation without completely eliminating the BIG tax. However, before doing so, let’s review the reasons why meeting with owners of C corporations well in advance of any expected departure date or ownership transfer is so important.

  • In the event of a third-party sale, it is likely that buyers will want to purchase only assets, resulting in double-tax consequences for sellers.
  • Owners who tell you that they do not intend to sell within five years often overlook the fact that situations can cause sales to occur sooner than they expect. Such situations may include a top-dollar offer from a strategic buyer that is just too good to pass up or a decline in health.
  • There may be tax advantages associated with a C-to-S conversion, even if a sale doesn’t occur for many years, because any accumulated earnings at an S corporation level are taxed at the owner’s personal income-tax rate. There is no corporate tax. These taxed-only-once accumulated earnings can eventually be distributed to owners without further tax consequences. Contrast that with the taxes on those earnings accumulated in a C corporation: A corporate tax (basically comparable to the top rate for individuals) is levied at that time. A second tax is levied when those already-taxed-once assets are distributed to the owner. Owners can avoid that double tax by converting to an S corporation today.
  • Organizations that are S corporations facilitate transfers of ownership to insiders (e.g., key employees or children). We’ll discuss the reasons for that in future articles.

Better Late Than Never

Which advantages can Brent’s Advisor cite in converting to an S corporation, even though he will exit during the five-year BIG recognition period?

Post-election goodwill is not subject to the BIG tax. We can see the benefit to Brent if we look at what happens if Brent decides not to convert his company to an S corporation.

Let’s assume that three years after meeting with his Advisor, Brent sells the assets of his C corporation to a buyer for $15 million cash. For simplicity, let’s further assume that the entire purchase price is attributed to the goodwill of the corporation. In that case, Brent’s tax consequences are as follows:

  • A 40% corporate tax (35% federal and 5% state) of $6 million on the $15 million gain on the sale of corporate assets.
  • An individual tax of $2.5 million on the $9 million Brent received as a dividend. After deducting his $1,000 basis in the stock, he pays a 28.8% tax (20% federal, 5% state, 3.8% net-investment income tax).

Thus, the net to Brent is approximately $6.5 million.

Fortunately, instead of remaining a C corporation, Brent listened to his Advisor and converted to an S corporation. Then, 3 years, 2 months, and 11 days after he made that election, he sold the assets of the business for $15 million. After making the S corporation election, the following occurred:

  • First, $10 million of BIGs were taxed at the corporate level (35% federal plus 5% state). The total tax was $4 million.
  • The remaining $6 million was then taxed a second time when Brent received the distribution. The $6 million was reduced by a 28.8% tax (20% federal, 5% state, and 3.8% net-investment income tax), or a bit less than 30%. Brent netted $4.3 million.
  • The post-conversion gains of $5 million ($15 million purchase price less the $10 million value at date of S conversion) were taxed once at the shareholder level. Brent paid a capital-gains tax on $5 million less a 25% tax (20% federal plus 5% state). The net to Brent was $3.75 million1.

In the end, Brent netted a total of more than $8 million after taxes ($4.3 million from this sale subject to the BIG tax and $3.75 million taxed a once because it is post-conversion gain). The difference to Brent was almost $1.5 million in additional net proceeds.

Bring in the Valuation Cavalry

It is essential to use an experienced, credentialed business appraiser to establish the value of each asset subject to the BIG tax as of the conversion date. Should the IRS ever question asset values at the date of conversion, this valuation will be invaluable. Additionally, a valuation provides the opportunity to document a conservative but correct value on assets, particularly goodwill. The lower the value of goodwill at the time of conversion, the lower the asset value subject to the BIG tax. Since goodwill is often the predominant component of value in a closely held service business, it’s vital to accurately but conservatively value it.

As long as we are discussing the topic of valuing goodwill, what if we could shift much of it from the corporation to the owner so that the goodwill becomes personal and not corporate goodwill? What effect might that have on the BIG tax? How do we establish “personal goodwill?”

In next week’s article, we’ll discuss these strategies designed to minimize the BIG tax.

Please contact us if you have any questions on the benefits of converting to an S corporation without completely eliminating the BIG tax.

I have you have additional questions about C-to-S conversions please contact us today!

1. It is worth noting that most owners of S corporations retain some earnings in their corporations. These once-taxed, accumulated earnings can subsequently be distributed to owners without tax, increasing the net proceeds of a sale. Many S corporations accumulate substantial earnings that run into the millions of dollars. To simplify our illustration, we’ve ignored those likely and additional tax savings.