Legal Watch: Going from C to S

Feb. 6, 2014
If you ever plan to sell, make sure you avoid this major tax headache

If you own an electronic security company and intend to exit from the business at some point, do yourself a favor right now and make absolutely sure your company is not a C corporation. If it is, nearly half your purchase price likely will go to the federal government in the form of taxes.

I have been involved in a handful of acquisitions recently in which the seller was a C corporation. In some of the deals, the tax man took a significant bite — and in one instance, the selling shareholders ultimately decided they could not sell, given how little they would receive on an after-tax basis. In other deals, the sellers and their professionals spent a great deal of time and money trying to structure the deal to avoid the taxes.

If you are a C corporation, the sooner you take steps to limit your tax liability — by converting to an S corporation if you can — the more likely you are to save taxes on exit.

What is a C Corporation?

Corporations are creations of state law, and creating a corporation (called “incorporation”) is done solely at the state level (corporations are people, too, you know). Once incorporated, the shareholders must decide how the corporation is to be taxed for federal income tax purposes.

The default corporate tax provisions arise under sub-chapter C of the Internal Revenue Code (called the IRC). There are certain tax advantages for corporations under sub-chapter C, but they are few and far between, and they rarely provide any benefit to the types of entities most often found in the security industry.

A corporation has a limited time following incorporation in which to avoid the default tax treatment under sub-chapter C by filing a written election with the IRS (form 2253) under Sub-chapter S of the IRC.

If the company files it timely, the IRS will treat the corporation as a “disregarded entity” for tax purposes. This means that the corporation pays no federal income taxes; rather, the corporation’s taxable income is reported on each of the shareholder’s individual income tax returns and the shareholder pays taxes on their share of the income at the individual level. Failure to file the election timely means the corporation is a C corporation, and C corporations are subject to two levels of taxation — at the corporate level and at the individual level.

The Impact

The differences in tax treatment can be extraordinary, especially in the context of an asset sale. Here’s a simple example: Assume a corporation earns $1 million on the sale of its assets. If the corporation is a C corporation, the corporation pays taxes on the income at the corporate level (let’s say $350,000) and then distributes the balance of the purchase price ($650,000) to the corporation’s sole shareholder, who then pays income taxes on the distribution on their federal income tax return. Assuming the shareholder is in the 35 percent tax bracket, he/she will pay another $230,000 in taxes (35 percent of $650,000), leaving the shareholder $420,000 after taxes on the $1 million earned for the sale of the corporation’s assets.

If the selling corporation is an S corporation, the corporation simply distributes the $1 million to the shareholder, who then pays income taxes on the distribution on their federal income tax return. Assuming the shareholder is in the same 35 percent tax bracket, he/she will pay $350,000 in taxes (35 percent of $1,000,000) leaving the shareholder $650,000 after taxes on the million dollars earned for the sale of the corporation’s assets. That’s $230,000 more than the shareholder in the C corporation — a dramatic difference.

S corporations are subject to limitations. For example, the corporation can have no more than 100 shareholders who must be individuals and U.S. citizens or resident aliens. If there are different classes of stock, only differences in voting rights (not in economic interest) are allowed. There are other criteria, but generally they are easy for small businesses to meet.

Finally, C corporations can convert to S corporations but it can take a long time for the conversion to be complete (up to 11 years) and there are significant tax issues that need to be addressed (dealing with the C corp.’s “built-in gains” among others). Conversion alone won’t necessarily get you over the finish line.

Most importantly, this isn’t something you want to do on your own or with an inexperienced or unsophisticated professional. Retain someone who knows that they are doing. And do it now. Your exit will be here sooner than you realize.

Eric Pritchard co-chairs the electronic security group of Kleinbard Bell & Brecker LLP. Pritchard focuses his practice on the electronic security industry with an emphasis on acquisitions. This column does not constitute legal advice; please contact an attorney with specific questions.

About the Author

Eric J. Pritchard

Eric Pritchard is a partner in FisherBroyles, a law firm with offices throughout the United States and in London. He spends his days trying to make the world safer for the security industry. You can reach Eric at [email protected].