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The Double-Tax Problem Affects Your Clients

Submitted by John Brown on Sun, 12/25/2016 - 8:00pm
Business Graphs and Charts

With over 1 million C corporations still active, advisors engaged in Exit Planning will inevitably encounter their owners. If the thoughts of these owners run along the same lines as owners of other types of companies, then about half of them presumably would like to exit their businesses within the next five years. However, C corporation owners face a huge problem that will likely prevent them from exiting their businesses on their terms if they choose to sell their companies to third parties. This problem is the double tax. At the very least, this problem will reduce the proceeds they can expect from a sale by 50% or more.

Double-Tax Shock

Brent James, the owner of Construction Services of Kansas (CSK), was jovial as he strode into his new advisor’s office. After exchanging preliminaries, Brent jumped in, saying, “A private equity group (PEG) just offered $10 million for my company! Before I sign this letter of intent (LOI), my accountant urged me to meet with you. I’m not really sure why: I’m pretty happy with what I think are pretty straightforward terms. It took us about five months to agree to $10 million—almost all of it in cash—and I don’t have to stick around after the sale. My wife, Mary, and I are sure that we can live comfortably on the $7.5 million we’ll walk away with after paying taxes.”

Brent’s new (and soon-to-be most important) advisor chose his words carefully: “Brent, I’ll need a little time to review this LOI, but may I ask you a few questions about your company and the assets you’re selling?” Brent nodded. “I assume,” ventured the advisor, “that since yours is a service-based company, your biggest asset is likely goodwill.”

“You’re absolutely right,” Brent answered. “And that’s what we’re selling: assets. CSK has some office assets and equipment (furniture, computers, and the like), but that’s about it. Everything else is all about the advice we provide to urban real estate developers regarding zoning laws, community interaction, and other issues that affect their ability to build what they want, where they want it. I guess you’d call that goodwill. So yes, this buyer wants CSK’s goodwill.”

“Let me make sure I understand this,” said the advisor. “This buyer is purchasing the assets of CSK and not the stock, correct?”

“That’s what I said,” responded Brent, in a tone that indicated some impatience and concern about this advisor’s level of expertise.

The advisor continued: “Can I assume that CSK is an S corporation?”

After a slight pause, Brent replied, “Well, no. We’ve always been a C corporation. Is there a problem?”

Brent’s new advisor continued: “Brent let me illustrate, in general terms, what the tax situation is for you if you move forward with an asset sale.

“First, because CSK is a C corporation, it is its own taxpayer. Consequently, when CSK sells its assets to the PEG, CSK will pay a tax on that gain. If we assume—just for discussion purposes—that all of CSK’s assets consist of goodwill, you’re looking at a federal corporate tax of 35% in addition to our state tax of 5% . So, when CSK receives the $10 million, it will pay a tax of 40%, or $4 million. That’s one tax.

“When you receive the $6 million from CSK, you will pay a second tax on that amount. The IRS will consider that $6 million a dividend and will tax you 20%. Then, our state will collect its 5% from you.”

Brent’s eyes widened as the advisor continued.

“In addition there’s a 3.8% tax called the ‘Net Investment Income Tax.’ In sum, you’ll pay almost 30% of the $6 million in taxes. At the end of the day, you won’t end up with $7.5 million. You’ll end up with a little over $4 million. And you’ll still have to cover sale expenses.”

Brent stared blankly in stunned silence. After collecting his thoughts, Brent asked, “Are you telling me that, simply because my company is a C corporation, my taxes on this sale will be $3 million more than I’d pay if CSK were an S corporation?”

“That’s right.”

“Then let’s do something about it! I’ll pay my fair share, but how do we fix things so I just pay a capital-gains tax on the amount of the gain?”

The advisor explained to Brent that had CSK been an S corporation for at least five years before the sale of any assets, he would have paid one tax—a capital-gains tax. That tax (20% federal and 5% state) would be small compared to the taxes he faced as the owner of a C corporation selling assets, which totaled more than 55%.

“But how do we fix this problem now?” Brent asked.

One Double-Tax Problem: Four Articles and Possible Responses

For owners of C corporations, the double-tax problem is the dominant impediment to a successful exit. As an Exit Planning Advisor, you must be prepared to address it as soon as possible, because the best solutions to the double-tax problem generally take the most time.

In each of the next four articles, we will discuss the following possible solutions to Brent’s question:

  • Option 1: Convert to S corporation status as soon as possible and do one of two things:
    1. Wait to sell until the built-in gains-tax period lapses.
    2. Sell within the five-year waiting period but take actions to minimize the double tax.
  • Option 2: Negotiate a stock sale by providing liability protections for the buyer and reducing the sale price.
  • Option 3: Sell corporate assets but act to reduce the tax consequences pre- and post-sale.
  • Option 4: Sell to an inside party or keep the business until the owner’s death.

No Tax Expertise Needed or Wanted!

Our purpose in describing each of these options is not to make you a tax expert. We doubt, unless you are already one, that you want to become one. However, we do intend to accomplish the following:

  • Familiarize you with the risks and threats your clients face.
  • Describe the options available to your clients to minimize or avoid the double tax.
  • Persuade you to recruit the necessary tax and legal experts from your advisor network to serve on your clients’ Advisor Teams. These advisors supply the expertise you’ll need to design and implement the best possible solutions for individual owners.

As an Exit Planning Advisor, you can help your clients make wise decisions regarding the sale of their businesses if you are equipped to discuss these issues with them. Once owners understand the double-tax problem and the possible solutions, they will be ready and even eager to listen to the experts on your team.

If you’d like more information on how to avoid double-tax problems, please contact us today.