Tax Implications of Selling Your C Corporation
When it comes to preparing your business for sale, there are several aspects of your company you begin to evaluate to ensure you’re minimizing tax liabilities and maximizing the transaction proceeds. A common area often overlooked by many business owners is assessing whether your current corporate structure is the right fit for a business sale. For businesses structured as a C corporation (C corp), the tax implications associated with a sale are steep, so it is worth considering what they are and how to avoid this potential liability.
Asset Versus Stock Sale
As a C corp, an asset sale is subject to double taxation—first on corporate taxable income due to the gain on sale of assets, which is at ordinary corporate rates and again on shareholder dividends or liquidating distributions, which can cause a tax rate of almost 50 percent. A buyer will almost always favor an asset sale, because they are able to step-up the tax basis in the assets to the purchase price, which then reduces the future taxes, due to being depreciated at the new stepped-up value. In many cases, this helps the buyer with the cash flow to make the acquisition. Legally, an asset sale is preferred as well – it is easier to define what liabilities are included or excluded from the sale.
To avoid double taxation, sellers often want a stock sale so that they are taxed primarily at capital gains rates. The buyer does not get a step-up in basis of the assets, but instead takes over the current basis, which generates more taxable income each year for them after closing. The buyer will typically price these differences in tax treatment in their offer. However, these tax implications can be avoidable if you plan ahead to mitigate liabilities.
Mitigating Tax Liabilities
If you are currently operating as a C corp, consider these factors if selling your business:
Switch to a Pass-Through Entity
Consider changing your structure to a pass-through entity, such as an S corporation (S corp), a limited liability company or partnership before positioning your business for sale. The most obvious benefit of this switch is avoiding double taxation in an asset sale, as outlined above. There are also more subtle advantages of changing to a pass-through entity depending on your specific business needs and timing of the transaction.For example, switching from a C corp to an S corp may be the most common solution, but there is a five-year transition period to consider. If your business is sold within five years of making the entity switch, a portion your business is subject to being taxed as a C corp. However, if a company is increasing in value, this is still an important option to consider. Other forms of restructuring typically have current tax consequences, but depending on business sale timeline, these still can be effective strategies to consider. Consider this simple example to see the potential tax impact of switching your entity prior to selling on the goodwill portion of a purchase:
This is a tax savings of more than $1.5 million on $5 million of purchase price allocated to goodwill. As the value increases, the savings grow.
One of the most important ways to increase value when selling a C corp is to properly designate your assets. Under the right conditions, one of the few assets that can be removed from taxation in the C corp during a sale is personal goodwill. If much of your business’ success can be plausibly attributed to non-business assets like names and reputations of the owner or operator, this savings can be substantial.
Explore the Small Business Stock Gains Exclusion (Section 1202)
An additional way to minimize taxes if selling your C corp as a stock sale is if it qualifies under the Internal Revenue Service’s Section 1202. This may help close the gap between a buyer’s and seller’s tax positions by looking at each parties net proceeds.If you hold C corp stock and have held that stock for at least five years, a portion of the gain on its sale may be excluded under this tax code provision. The exclusion is 50 percent or more, depending upon the date upon which the shares were issued. Certain stock sales would qualify for 100 percent exclusion.The total amount of excluded gain may be limited to $10 million; however, there are also exceptions to this ceiling that may also apply.To qualify for the exclusion, the stock must be classified as Qualified Small Business Stock (QSBS). Primary requirements for QSBS include:
- Stock must be original issuance stock (i.e., you must have received the stock via a direct issuance from the company)
- The corporation must be involved in an active trade or business
- Carrying value of the corporation’s assets at the time of the QSBS issuance must not have been greater than $50 million
Count on Your Trusted Advisors
Seek counsel from your trusted business advisors before agreeing on any deal structure or signing an agreement. A trusted advisory team will help facilitate the process, outline tax strategies and determine a deal structure that best meets your needs. Doeren Mayhew’s M&A advisors will also evaluate the business and tax situations before engaging in a transaction to determine a likely tax structure for a sale, and the tax effect on proceeds and net after-tax proceeds received. The earlier you get your advisory team involved, typically the more the overall tax situation can be improved.
For more information on how minimize tax liabilities when selling your business, contact our investment banking team today.