Tips for Business Succession Planning
The number of S corporations and partnerships in the United States has been increasing since the 1980s. According to Tax Foundation, in 2014, there were 1.7 million C corporations and 7.4 million partnerships and S corporations. For many of these business owners, selling a closely held business, such as an S corporation, can represent the culmination of a successful career. However, as with so many financial transactions, selling a business can be complex. Following are four important considerations to keep in mind as you strive to execute a successful sale that is mutually beneficial for both you and your buyer.
Consideration #1 – What are you selling?
Before doing anything else, take time to carefully evaluate what you are selling. Are you selling the assets of your business or the stock? Understand that shareholders typically want a business sale that is structured to take advantage of long-term capital gains rates, which are substantially lower than ordinary income rates. (For now, anyway. Potential legislative changes will necessitate another article, as well as another cup of coffee.)
On the other hand, the buyer will likely seek a step-up in basis of the business assets in order to restart depreciation after the deal closes. This can create a direct conflict with the seller, but it is still possible for the buyer and seller to work together to achieve a mutually beneficial result.
There are three basic options for the transaction:
- Sell the assets through a straight asset sale – A straight asset sale involves the direct sale of corporate assets. This type of transactions often works to the buyer’s benefit more than the seller’s. A direct asset sale can be more challenging when the business’ assets are so numerous that it would be too difficult or costly to transfer them separately.
- Sell the stock with a Section 338(h)(10) or section 336(e) election – A deemed asset sale under Section 338(h)(10)/336(e) involves selling a company stock by joint agreement among all shareholders and the buyer. Note that in this type of transaction, the “buyer” must be a corporation under Section 338(h)(10). For legal purposes, this stock sale is treated the same as an asset sale.Be aware that this type of transaction may trigger unfavorable tax consequences for the seller, including depreciation recapture. On the other hand, the buyer gets a step-up basis and can then depreciate the assets. To overcome these sticking points, the buyer can compensate the seller for the added tax costs. Or, the seller may be able to increase the sale price of the entity and articulate the value of the stepped-up basis to the buyer.
- F reorganization – F reorganization is a method available when a buyer wants to achieve a step-up in basis but a section 338(h)(10) or 336(e) sale is not viable. Instead, the seller creates a new S corporation, transfers shares to the new corporation and converts it to a single member LLC. The buyer then purchases an LLC interest, which is treated as an asset purchase, giving rise to a stepped-up basis while the seller only recognizes gain on the portion it sold. This method is highly technical and requires advanced planning.
Consideration #2 – Avoiding the BIG (built-in-gains) tax
Built-in-gains tax can apply if the business was formerly a C corporation and converted to an S corporation. In this situation, an asset sale could trigger double taxation at the highest corporate rate (to the extent of the recognized gain). Corporate earnings are taxed at 21 percent. Then, earnings distributed to shareholders are taxed as qualified dividends at the individual level up to 23.8 percent (20 percent long-term capital gains + 3.8 percent net investment income tax). And, depending on what state you’re in, there could be yet another layer of taxation. Ouch!
There are two simple ways to avoid or minimize the BIG tax:
- Don’t sell any corporate asset