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 assets with built-in gains for five years after an S election is made.
- If you must sell an asset, try to offset the gain by using an NOL (net operating loss) carryforward from when the business was a C corporation.
Consideration #3 – Phantom income
What happens if an owner sells his or her shares mid-year? The IRS says that, by default, you must allocate an entire years’ worth of business income to each shareholder, regardless of when a share sale occurs. For example, let’s say I am a 50 percent owner and sell my shares on September 1, 2020. My business generated $500,000 in income from January 1 through September 1, 2020. Then, the business earned an additional $1.5 million in income from September through December, for a total $2 million in income for 2020. You may think I would only need to report $250,000 in income for my 50 percent share from January to September when I had ownership in the business, but that is incorrect. Instead, because I owned shares for 244 days out of the year, which equals 67 percent of the year, the IRS calculation uses that number times total annual income to determine how much I owe. So, $2 million in 2020 total income times 67 percent times my 50 percent ownership share equals $670,000 in reportable income. ($2,000,000 X .67 X .50 = $670,000) That could easily mean the difference of $167,099 in taxes due. And to make things more painful, assume that as an owner I typically receive a cash distribution to help. However, given that I’m no longer a shareholder, the business is not obligated to distribute cash to me. That stings! The “closing of the books” method is a potential workaround. Under this rule, the shareholders may choose to close the books as of the date of the share sale, therefore avoiding any “phantom” income for the seller. However, this method requires the consent of each shareholder. It’s wise to consult with an advisor to determine what method best meets the needs of your business and shareholders.
Consideration #4 – One class of stock
An S corporation must follow specific rules. One of those rules states that an S corporation must not have more than one class of stock. The Treasury defines one-class stock as having identical rights to distribution and liquidation proceeds. This ensures that all corporate items of income, deduction, loss or credit flow to shareholders. For example, suppose ABC Corporation was a C corporation with two classes of stock (A and B) that elected to become an S corporation. Initially, the only difference was that B shares held no voting rights. Does the Treasury care? No. Does this affect the S corporation election? Again no. Voting rights don’t affect an S corporation election. But what if, prior to becoming an S corporation, ABC amended its articles to say that A and B shares were entitled to equal shares in liquidation only up to a certain amount? Now we’ve got a problem. The amendment affects the rights to distributions and liquidation proceeds. What could happen? The buyer could walk away from the deal. If the error is discovered after the closing and it financially impacted the buyer, the buyer could seek redress from the seller. The buyer could also lose the step-up in basis for the business assets. To be blunt, it would be a mess. The economics of the deal would change dramatically, to the potential harm of both the buyer and seller.
The Bottom Line
Running a business requires hard work and careful, calculated decision making. Selling a business requires the same skill set. Good planning is the string that helps us navigate the IRC labyrinth and avoid the dreaded tax monster. As with any complex financial transaction, it’s wise to consult with a qualified advisor who can help guide you through the process and avoid any potential pitfalls.
At Creative Planning, our teams have extensive experience guiding clients through complex business transitions. Contact us to learn more about how we can help with your business succession planning.
- S Corporation Transactions, Planning, Opportunities and Obstacles – Green Hasson Janks 2019/12/11
- Using F Reorganization Strategically in Mergers & Acquisitions Transactions – Bennett Thrasher 2020/7/10
- Selling Your S Corporation: A Focus on Alternative Tax Structures – CFO Journal. Wall Street Journal 2016/3/30
- Tax Planning for S Corporations: Mergers and Acquisitions Involving S Corporations (Part 1) – Dean Mead Attorneys at Law. Published in The Practical Tax Lawyer, Winter 2016 issue.
- Built-In Gains Tax is a BIG Bad Wolf – Boyum Barenscheer CPAs, Chris Wittich 2018/1/19
- Liquidating an S corporation that is not subject to the BIG tax – AICPA, Linda Markwood, CPA 2019/12/1
- C Corporation to S Corporation: Why the Hype? – Delap CPAs, David Delmore, CPA 2017/3/2
- Allocating Income Using The “Closing of The Books” Method – Pickrel, Schaeffer & Ebeling Law, Jeff Senney
- S Corporation Shareholders Considering a Sale: Avoid this Potential Tax Trap – The Kane Firm, Andrew Ziolo, CPA 2017/2/8
- Selling S Corporation Stock – Are You Sure? – Farrell Fritz Attorneys, Lou Vlahos 2019/9/9