Tax Planning for Business Buyers and Sellers
LIMITED LIABILITY COMPANIES, S CORPORATIONS, AND C CORPORATIONS:
WHAT’S THE DIFFERENCE?
By: Bart A. Basi & Marcus S. Renwick
In the past, choosing a business entity under which to operate was easy. Either you operated as a sole proprietorship, a partnership, or you incorporated as a C Corporation. There were clear advantages and disadvantages to each one.
Today the choice is not so simple. Business people have an alphabet soup of business types to choose from. Though many of the new forms offer limited liability and single layer taxation, the tax and legal differences are not nearly as clear as they used to be in the past. This article will discuss three types of business entities and point out some very subtle and not widely known differences between the chosen entities. All three entities are excellent for any small business person to operate a business.
When deciding which entity to operate under, the business owner must take into consideration legal liability, tax circumstances while operating and dissolution, the person’s goals, and the size of the operation among other factors. Tax circumstances are of utmost importance when choosing an entity. However, ease of transferability, legal protection, and other factors are affected under each entity type. The advantages of having a Limited Liability Company (LLC), S Corporation, and C Corporation are discussed below.
In an LLC, there are no restrictions on ownership. An S Corporation, on the other hand, does have restrictions on ownership. To hold an S Corporation status, one must be a resident and citizen of this country. No more than 100 people are allowed to own stock. If the ownership requirements are violated, the company losses its S Corporation status and it can not attain S Corporation status for a number of years.
With an LLC, these restrictions do not exist and its status is not jeopardized. While most LLCs will maintain membership of well under 100 members, the option or ability to expand the number of investors rapidly does exist. Many immigrants just starting business can benefit from this form of business as well without suffering from double taxation.
There are fewer formalities in maintaining an LLC. This is a major convenience and aides in limiting liability. The types of businesses identified here are all subject to being disregarded as an entity if the owner does not obey formalities. This is what is known as “veil piercing” and it happens when company owners do not observe formalities in paperwork, meetings, and otherwise use the business as an “alter ego”.
While the owner of the business can not use the company as an alter ego to defraud people out of money, the LLC does not require the formalities that corporations do. Hence the LLC can be a better insulator against liability if maintenance of meetings and documents is going to be an issue.
Shares of an LLC are easier to put into a trust than an S Corporation. To put shares of an S corporation into a trust, special trusts must be used. It can be somewhat complicated and LLCs tend to work very well instead of S corporations if you want to transfer ownership through a trust.
No unemployment taxes are due on income, unlike both the C Corporation and S Corporation. While this is not a huge tax savings, it is a significant savings. If your business is going to make less than 10,000 dollars per year, LLC’s may be the way to go. If you’re an at home business, this is particularly important.
During operation of an LLC, profits are taxed only at the shareholder level as opposed to C Corporations, which are taxed twice. However, profits from the operation of the business “flow through” to the income statement of the owner. This does not mean distributions are taxed immediately; the income of the LLC is taxed to the owner within the current quarterly period. This can be a significant disadvantage if the LLC does not pay out much in distributions. Owners can find themselves facing large tax bills with out the cash to cover it if regular distributions are not made.
When winding up the affairs of the entity and dissolving, profits are taxed once. Nearly all, if not all businesses will eventually close their doors. Both the LLC and the S corporation offer the owners the chance to close the doors and be taxed only once on the sale of the assets. This is in contrast to C Corporations, which can be hit very hard with taxes upon dissolution of the corporation.
LLCs are becoming more popular. This is because most business owners want a limit on liability, single layer taxation, want to limit the formalities and still enjoy the protections. Few attorneys know the advantages of the LLC, but with time, it will be more known.
Profit is not subject to self employment taxes. The self employment tax is 15.3% for those who are self employed and encompasses both Medicare and social security taxes. Normally when a person is employed by an employer, their employer pays half of the tax subjecting the employee to only paying half of the full tax. When one is self employed, they must pay the full tax by themselves. Under the use of a Subchapter S Corporation, salary (not profit) is subject to self employment tax. However, if the salary is insufficient, the IRS can reclassify the profits as a salary subjecting them to self employment taxes.
This is in contrast to LLCs. While operating under an LLC, both salary and profits are subject to self employment taxes. For people with incomes below the social security threshold amount, this can result in a significant amount of money being put into Self Employment taxes. Of course this can be good or bad depending on your retirement planning needs and expectations.
Since S Corporations are flow through entities, losses can be deducted. This also holds true for the LLC. However, this is in contrast to C Corporations in which shareholders cannot deduct losses. If an S Corporation is experiencing losses, it can deduct the losses and the owner will recognize the loss on his or her income statement leading to a lower tax liability. However, there is a limit. You cannot deduct amounts that exceed your investment and loans to the company.
During operation of an S corporation, profits are taxed only at the shareholder level as opposed to C Corporations, which are taxed twice. Just like with the LLC, the profit, not the distributions are taxed. This can be good or bad depending on the situation.
When winding up the affairs of the entity and dissolving the business, profits are taxed once. This is in contrast to C Corporations, which can be hit very hard with taxes upon dissolution of the corporation. As stated above, all businesses close their doors and their assets are sold at one point or another. With an S corporation this transfer is only taxed at the shareholder level.
Of less importance, the franchise fee and start up filing fees that S Corporations pay are substantially less than that of LLCs. Generally S Corporations will pay in the area of $25 per year in fees and LLCs can pay $300 - $500 per year.
Even though C Corporations are taxed once at the corporate level and then at the shareholder level, certain tax advantages can come into play due to new tax legislation.
Profits from a C Corporation to a shareholder are what is known as dividends, and not distributions. Dividends from C Corporations enjoy a special rate of tax at 15%. This means that money received from a C Corporation, no mater if it is $1 or $1 million, every dollar is taxed at 15% and it is not subject to ordinary income tax rates.
At the corporate level, C corporations enjoy lower tax rates than most people do at nearly any income level. If your income is low enough, you may be able to use this to your tax advantage. Generally if the corporations’ income is below $75,000, it can be to the advantage of the corporate holder to use a C Corporation.
Fringe benefits are nontaxable to shareholders of C Corporations. This is in contrast to LLCs and S Corporations where the owners are taxed on the value of the benefits. The fringe benefits are fully deductible at the corporate level, in a C Corporation.
There are no ownership restrictions when owning a C Corporation. Unlike the S Corporation, there are no ownership restrictions for a C Corporation. Nearly any person in the entire world, United States citizen or not, can own the stock. There is also no restriction on the number of shareholders. This works out well for publicly traded companies such as GE, Ford, and GM. Had there been a restriction on ownership in these situations, they would have lost their status long ago.
Shareholders do not pay self employment taxes on C Corporation dividends. When dividends are distributed, they get taxed at the federal 15% rate and the state tax rates. Medicare and Social Security taxes are not paid on dividends. However, the IRS is fast to reclassify dividends as salary subjecting them to self employment taxes if the salaries are not reasonable.
Shareholders of C Corporations do not immediately recognize income. If you plan on starting a company and not distributing profits, C Corporations are good for this. Otherwise, the shareholder would have a lot of income on their income statement and no dividends or cash to pay the tax bill with. Having a C Corporation allows the business person to accumulate a large amount of profits, reinvest them, etc. and not have to pay taxes at a personal level.
There is no one “be all, do all” separate entity for the business man or woman. Each entity has subtle differences which can make a substantial difference to the business owner. When deciding which entity type to go with, consider tax and legal aspects to the full extent necessary. The Center is well adept to providing, setting up and maintaining entities such as those discussed above. Call The Center for these and all of your other financial, legal, and tax planning needs.
CONDITIONS FAVORABLE: Consider Selling Your Business Now
by Bart A. Basi and Marcus S. Renwick
The tax rates are at low levels, interest rates have started to increase and the economy is on the upswing.
The time is ripe to sell your business. In the past couple of decades business owners wanting to sell their business faced high interest rates, high taxes, and at times, tough economic conditions. Today, three major factors exist to provide you with a substantial value for your business.
The three factors are the tax rules, interest rates and the economic environment. The current favorable tax structure allows you to sell your business for a lower price and carry away the same amount of money you would have, had you sold in another year at a lower price. Interest rates provide a similar relief. When interest rates are down, buyers can afford to finance more. Last, but not least, the economy is in an upswing. When the economy is in an upswing, business values rise concurrently. When all three factors are together, they provide for an optimal environment to sell a business.
Tax Consequences Of A Business Sale
The first major factor in selling a business is the tax rules. The tax consequences of a business sale are as important as the selling price itself. When selling a business, it is important to know there are two types of sales. One type of sale is known as a stock sale. In a stock sale, stock is sold and the result is a low tax rate. The gain in this scenario is taxed only once to the shareholders in both the sale of C Corporations and all other incorporated entities.
The other type of sale is known as an asset sale. In an asset sale, the assets of a company are sold. As such, the sellers must pay what is known as “recapture” to the extent depreciation has been taken. Recapture is taxed at ordinary tax rates. Beyond that, capital gains taxes are assessed for the difference. If a C Corporation is selling its assets, it is taxed not only at the corporate level at ordinary tax rates, but also at the shareholder level as capital gains.
Though not a sale, but yet a business transformation, mergers and acquisitions are another way to change ownership of your business. In a merger or acquisition, one business is taken into another business or combined into another business. The result is a tax-free transformation of the business for the seller. Though there are tax ramifications, it is possible for both the buyer and seller to get tax-free benefits.
The importance of taxes is even more important to sales involving small businesses. Often the owners of small businesses are not considered wealthy. When tax consequences on a business sale are large, the effect is felt disproportionately. A $300,000 tax burden will be felt more in a $1 million sale (where the owner walks away with $700,000 and cannot retire) as opposed to a $3 million tax burden where the owner walks away with $7 million and is able to retire. The current tax and financial conditions combined together make for a more optimistic selling environment. Therefore, it is more likely a seller will get a higher price for a business. The following explains why conditions are favorable to sell a business at the present time.
Low Capital Gains Rates
The capital gains rates are currently 5% and 15%. Historically, the capital gains rates have been as high as 20%. This means that capital gains will be taxed at 5% if the combined Adjusted Gross Income of the selling taxpayer (including capital gains) is at or below the two lowest tax brackets. The amount of capital gains at or over the 25% bracket will be taxed at 15%. These new rates produce much more favorable tax consequences than in past years.
For example, if a company is sold and capital gains are determined to be $1 million, in this tax year, the seller of the company would pay $150,000 in capital gains taxes as opposed to $200,000 in a past year. The result is a tax savings of $50,000 just given the fact that the sale happened this year as opposed to a past year.
Capital gains can be recorded in installment sales (ie., over a period of years). In an installment sale, gain is recognized when money comes through the door. This means the capital gains can be reported over time. However, a capital gain is dependent on the rate of tax in the year for capital gains. If it fluctuates, capital gains could go up. That is why it is important to consider selling a business now. The capital gains rates will more than likely not go up in the next few years and you will be able to use the lower rates effectively in an installment sale.
Low Ordinary Tax Rates
Ordinary tax rates are also some of the lowest they have been in recent times. Since ordinary taxes usually result in business sales of assets, sellers are at an advantage this year to sell their companies as opposed to waiting for a future year when ordinary tax rates go up.
For example, the top ordinary tax rate has been around 40%; now the top tax rate is 35%. Given a taxpayer has $100,000 in ordinary gains, the taxpayer will pay $5,000 less in taxes for selling this year as opposed to a higher tax year. Remember, taxes can go just so low before Congress has to raise them or increase our debt.
Low Interest Rates
The low interest rates of today are a bit of an anomaly in today’s market. Generally, buyers finance the amount of principal they can with the prevalent interest rate. This can best be seen in the housing market. Before the interest rates went down, housing prices were still generally low. An average American might have been able to afford $1,000 per month with his or her income. This would have financed roughly a $125,000 house. Since the interest rates went down, that same monthly payment can finance approximately a $200,000 house.
The same is generally true for business sales. When a buyer can finance more, sellers will get more for their business. The best results can be obtained by selling now before interest rates go back up.
A Thriving Economy
An important consideration in valuing a business for a buyer is attitude. If a buyer is optimistic, he or she will pay a higher value for the business. Though we have endured a few hard years, leading and current economic conditions indicate the economy is in an upswing, making for a better sellers’ market. The result will be a substantial premium on a business sold today as opposed to a business sold maybe even two years ago.
Special Consideration For C Corporation Asset Sales
The taxes at the C Corporation level are slightly less than they have been in the past. Additionally, it is a long-standing fact that corporations do not benefit from the low capital gains rates from which individuals benefit. Even though this might make a sale of a C Corporation seem bleak as far as tax consequences are concerned, such is not the case. In the recent past, the concept of “Personal Goodwill” has been developed. Personal Goodwill results when the owner of a business develops good will outside of the company. This type of good will is taxed only at the shareholder level and not at the corporate level. The result is favorable tax treatment at personal capital gains rates. However, since this concept is new, it may change. Therefore, C Corporations still face high taxes to operate their business, but may face low taxes to sell their business. C Corporation owners are advised to take advantage of this concept before it is changed or modified.
Subchapter S Corporations are taxed at the personal level. Thus, with the personal rates decreasing and capital gains rates of 15% applying, now is the time to consider selling your Subchapter S Corporation as well.
Future Tax Changes
Now that President Bush has been reelected, there will be changes. During his first term, the Administration and Congress changed the tax code five times in four years favoring taxpayers, both businesses and individuals alike. Being that he is a president who wants to alter the tax code, it is inevitable the tax code will be changed during the next few years. Many of the current tax changes expire during the next four years. The president has or has promised to extend these low tax rates through 2007. Then what happens is up to Congress!
However, President Bush is determined not to leave the White House without cutting the nation’s deficit. To do this, he will have to either cut spending, raise taxes or both. This leaves the future of tax rates uncertain for the remainder of his term. The president is straddling the possibility of changing the entire tax structure. This possibility has been expressed in many major newspaper articles. Being that this uncertainty exists in the tax laws, it is advisable to begin your business succession plan now and not wait.
From a tax, financial and economic perspective, now is a great time to sell your business if you are thinking about retiring. The tax rates are at low levels, interest rates have started to increase and the economy is on the upswing. Anyone planning to sell a business should do so now as long as taxes, finances and the economy are factors in the decision process. <<
Dr. Bart A. Basi is an expert on closely held enterprises. He is an attorney, a Certified Public Accountant, and president of the Center for Financial, Legal & Tax Planning Inc., Marion, Ill. He is a member of the American Bar Association’s Tax Committees on Closely-Held Businesses and Business Planning. He can be reached at: firstname.lastname@example.org. Marcus Renwick is an attorney and the director of research and publications at the Center for Financial, Legal & Tax Planning.