BY SCOTT WAXLER
Managing Partner, LockeBridge, LLC
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BY SCOTT WAXLER
During the first or second meeting with a perspective Seller we are invariably asked what the proceeds from the sale of their business will be after taxes and transaction expenses (LockeBridge specializes in selling businesses and real estate with valuations between $5M – $100M). A relatively high percentage of our perspective clients are incorporated as “C” Corporations. Most of these businesses were incorporated 20 – 30 years ago when LLC’s did not exist or were not popular (LLCs’ came into existence in 1977) and subchapter S corporations had other disadvantages at that time. For most of these companies current “C” corporation benefits, such as the right to have foreign shareholders or the ability to carry large amounts of revenue from one year to the next without negative tax implications, are not relevant or substantial.
When it comes time to sell the business, most small company “C” corporations will pay the “Tax Man” dearly.
That’s because “C” Corporations and their shareholders are subject to a double tax. Both the corporation and the shareholders are taxed. Upon the sale of assets this two tiered tax is levied on the increased value of the property when the property is sold or the corporation is liquidated. By contrast, LLC owners (called members) and Subchapter S Corporations avoid this double taxation because the business’s tax liabilities are passed through to the owners; the LLC or S Corporation itself does not pay a tax on its income.
While many tax advisors believe that a “C” Corporation Shareholder can sell stock and not incur corporate level tax on the transaction, in reality most businesses will not acquire the stock of a small corporation.
Corporate Purchasers seek to acquire the assets of the corporation because of two primary reasons:
- The Purchaser of the corporate assets (as opposed to stock) receives a new, stepped up, basis in the assets of the corporation equal to the purchase price. This stepped up basis can be very valuable when offsetting future gains.
- The liabilities of the corporation will stay with the current entity and not transfer to the Purchaser.
Issue #1 can often be overcome by adjusting the purchase price to reflect this benefit to the buyer however, issue #2 is often a showstopper impeding the sale of corporate stock. For example, imagine that the Seller is a $20 million manufacturer of snow skis which is valued at $10 million and the Acquirer has revenues of $200 million. Although a well structured stock transaction may result in total tax savings of 50% over a sale of assets, in this example these savings may only be on the order of $2 million. After considering the economic loss of the stepped up basis and some split of the tax savings between Purchaser and Seller, chances are that the Purchaser will only realize a minimal amount of net savings on the stock transaction. Let’s use a net savings of five hundred thousand dollars for this example:
It is Critical to Know Exactly Why Your Business is a “C” Corporation
The major issue for the Purchaser to consider will be:
Is it worth a savings of five hundred thousand dollars to expose their $200 million business to all the potential liabilities of the target acquisition?
Imagine that the ski manufacturer made a defective binding a year prior to the acquisition? Subsequent to the acquisition the binding failed and the skier fell and seriously injured himself. The Purchaser will be liable for the damages!
Product and environmental liabilities are two of the most concerning issues to potential Purchasers of corporate stock.
While a strong intermediary may be able to overcome such liability issues and subsequently structure a sale of corporate stock that will work for both parties, corporations should review the current pros and cons of the “C” corporation status and consider converting to an LLC or S corporation well in advance of the sale of the business. If converting to an S corporation is not possible, don’t lose sleep yet. It may be possible to structure a transaction that will allocate the purchase price so not to be exposed to double taxation. For example, professional service businesses may be able to allocate a substantial portion of the price to personal goodwill, which bypasses the corporate level tax. Additionally, retainers and non-compete agreements may be negotiated which will also bypass the corporate tax.
It is critically important to hire a strong transaction team (accountant, attorney and intermediary) that has substantial negotiation and structuring experience. When it comes to selling a “C” corporation the transaction can become much more complex and the team’s structuring tactics even more crucial. An effective deal structure will maximize the amount the Seller will have to show for a lifetime of sweat equity. Note: A strong intermediary will advise you on required skill se of the team members and coordinate the team member’s activities.
Conversion from a Subchapter S to a “C” corporation is not a problem from a tax perspective. However, going from a “C” corporation to an S can be a taxable event if the value of the corporation has appreciated since its formation. Note that generally, you cannot convert a corporation to an LLC. You will need to dissolve your corporation. Once having done this, generally one may form a new LLC using the same name.
When an existing “C” corporation converts to an S corporation, only the post-conversion appreciation in the corporation’s assets will qualify for single level tax treatment, unless the corporation’s assets are sold more than 10 years after the date of conversion. This 10-year “look back” period prevents a “C” corporation with appreciated assets (and subject to double taxation on the sale of those assets and subsequent distribution of proceeds to its shareholders) from converting to an S corporation in order to achieve a single level of taxation.
If your company is a “C” corporation seriously consider a conversion that will lower the taxable impact on your business. If you plan to sell the business prior to ten years from the time of conversion then hire a strong team that will be able to assist in structuring a tax efficient transaction.