Spence Desenberg + Lee, PLLC

Business owners frequently plan to fund their retirement with the proceeds from a sale of their business.  However, they frequently fail to take the steps necessary to maximize the after-tax proceeds from the sale.  One such step relates to closely-held corporations and involves making an “S election” for tax purposes.

Often, a small business will operate as a regular corporation (a “C corporation”).  Typically, the C corporation pays tax on its profits as they are earned, and the shareholder pays tax on the earnings when they are distributed by the business.  These two levels of tax can raise the overall tax rate to nearly 50%!  However, a closely-held corporation will often qualify to be treated as an “S corporation” for tax purposes.  With a proper “S election,” only the shareholder will pay tax on the earnings, thereby eliminating an entire level of tax.

During the life of the business, the owner of a C Corporation may minimize taxes by paying himself (or herself) a salary.  “Reasonable” salaries are tax deductible, reducing the corporation’s tax obligation.  Depending on the situation, only a small portion (if any) of the profits from the business will be subject to tax at both the corporate level and the shareholder level.

On the sale of a business, however, it is much harder to avoid the two levels of tax.  The shareholder cannot justify paying a salary to himself or herself if there is no longer an operating business to manage.

Another disadvantage for a C corporation is that it pays tax on capital gains at the same rate as for any other type of income.  In contrast, a non-corporate taxpayer (i.e. the individual shareholder) will pay tax on capital gains at a reduced tax rate.  This may further increase the S election benefit.

Generally, a qualifying C corporation may elect to become an S election before it sells its assets.  However, a recently-converted S corporation must pay a corporate-level tax if it sells appreciated assets within five years of making the S election.  The corporate-level tax is based on the gain (i.e. fair value in excess of tax basis) existing on the date of the election.  Five years after the S election, the corporate-level tax is not imposed.  [Note: this corporate-level tax only applies to an S corporation that was previously a C corporation.  In other words, a corporation electing “S” status on formation will avoid this punitive corporate level tax.]

The potential S election benefits can be seen in the following example:

Assume a C corporation sells its assets for $6 million and distributes the sales proceeds to the owner.  The C corporation has a $1 million tax basis in the assets, and the shareholder has a $100,000 basis in his or her stock.  The corporation will have $200,000 of depreciation recapture, which is taxed at ordinary income tax rates.  The calculation below assumes the shareholder is taxed at the rates for a married person filing a joint return.

A.       After-tax Proceeds for the C Corporation Shareholder

1.       Tax at Corporate Level
Proceeds                                              $   6 million
Basis in Assets                                       <1 million>
Gain                                                      $   5 million
Tax on Gain (34%)                               $1.7 million
Net Corporate Proceeds                      $4.3 million
($6 million – $1.7 million)

2.       Tax at Shareholder Level
Proceeds                                              $4.3 million
Basis in Stock                                      <0.1 million>
Gain                                                      $4.2 million
Tax on Gain                                             <999,600>
Net Shareholder Proceeds                   $3,200,400
($4.3 million – $999,600)

B.       After-tax Proceeds for S Corporation Shareholder

1.       Tax at Corporate Level
Proceeds                                               $ 6 million
Asset Basis                                           < 1 million>
Gain                                                       $ 5 million
Tax on Gain                                                   0       
Net Corporate Proceeds                        $ 6 million

2.       Tax at Shareholder Level
Proceeds                                               $   6 million
Basis in Stock                                     <$0.1 million>
Gain                                                      $ 5.9 million
Gain Treated as Ordinary Income        $    200,000
Gain Treated as Capital Gain               $ 5,700,000
Tax on Ordinary Income                       $      42,986
Tax on Capital Gain                              $ 1,356,600
Total Tax                                               $ 1,399,586
Net Proceeds                                        $ 4,600,414
A shareholder in the above example could save over $1.4 million, approximately 23% of the sale proceeds, by making an S election at least five years before selling the business.

An obvious question is whether the shareholder could lower the tax burden by selling the company (i.e. the corporate shares) rather than having the business sell its assets. The answer is yes – one level tax would be avoided.  The problem, however, is that most buyers of closely-held businesses are simply unwilling to buy corporate stock.  They are afraid of assuming the corporation’s liabilities.  As a result, buyers typically are only willing to buy assets.  By making an S election sufficiently in advance, the shareholder of a closely-held corporation can have the corporation sell assets and still maximize the after-tax proceeds from a sale.

An S election may greatly reduce taxes as can various other planning techniques associated with selling a business.