The Double-Tax Deal Killer: Convert from a C to an S Corporation

Most M&A transactions are asset purchases. That’s not a tax problem for owners of S corporations or partnerships but can be a Deal Killer for owners of C corporations.

In last week’s article, Extend Your Exit Planning Reach With Your Advisor Network , we saw how one C corporation owner reacted to news that the tax bill on a $10 million asset sale was twice that of an S corporation. Brent’s reaction reflected the reaction of most owners who find themselves in that position: “How do we fix this problem now?”

The most straightforward remedy—but one that requires time—is to convert Brent’s C corporation to an S corporation. Doing so eliminates the double-tax hit five years after the effective date of the conversion.

Of course, by the time most owners contact you, they are likely ready to exit as soon as possible. In those cases, it’s necessary to explain why it takes five years to save millions of dollars in unnecessary taxes. This process entails the following:

  • Explaining the reasons buyers insist on acquiring assets rather than stock of a C corporation. Unless owners understand this, they won’t understand why you are crafting possible solutions to this double-tax Deal Killer.
  • Explaining possible hurdles to converting to an S corporation.
  • Explaining both the relevant tax law and its operation of requiring a five-year wait after an S election in order to pay just a single tax upon the sale of the assets.
  • Why Buyers Insist on Assets

    Buyers see a number of benefits from purchasing only assets related to income, liability, and selectivity. Income benefits of an asset sale include receiving a stepped-up tax basis on depreciable assets and the ability to amortize the amount of the purchase price attributed to goodwill.

    In terms of liability, when purchasing assets, buyers avoid liabilities lurking within the company because they’re not buying “the company.” Closely related to selectively avoiding liabilities is selectively buying what they do want. For example, a buyer may not want all of the corporation’s assets, such as real estate, the owner’s yacht, questionable inventory, and so on.

    In short, buyers want—and will demand if they are in a position to do so—the tax advantages of buying assets that are depreciable or amortizable, and they don’t want to buy assets that are not useful to them or that might harbor unknown liabilities.

    Hurdles in the S Conversion

    The two primary hurdles in converting from a C to an S corporation are the restrictions on S corporation shareholder eligibility and the tax consequences upon conversion.

    Shareholder Eligibility Restrictions

    In general, all S corporation shareholders must be US citizens or residents. That requirement rules out non-resident aliens. Further, shareholders must be natural persons rather than corporations or partnerships. Finally, many types of trusts are ineligible shareholders, although certain trusts, estates, and some tax-exempt corporations can be shareholders in S corporations.

    S corporations can issue only one class of stock, although voting and non-voting common stock is allowed. In addition, S corporations are limited to a maximum of 100 shareholders. To ensure compliance with all of these restrictions, you need to turn to your client’s CPA and to the expert analysis of the tax advisor on your team.

    Tax Consequences

    If any of the following conditions exist at the time of conversion, the tax cost of conversion may be unacceptably high.

  • The company has a large net operating loss (NOL) carryforward. These losses cannot be used to offset the future income of an S corporation.
  • The company has passive income. If passive-income limits are exceeded, there are significant income-tax consequences and possible S termination issues.
  • The company uses a last-in, first-out (LIFO) inventory-accounting methodology.
  • The company is a cash-basis taxpayer and has significant accounts receivable at the date of conversion. In that case, there may be an immediate income-tax consequence on the unrealized gain in the amount of the accounts receivable.
  • The bottom line is that the conversion from a C to an S corporation requires careful analysis to make sure that a conversion is possible and that the tax costs associated with conversion don’t outweigh the benefits. To avoid unpleasant surprises upon converting to S status, this analysis must be conducted by and confirmed with the company’s CPA or other tax experts.

    After you and your team scrutinize the restrictions and tax implications of a C-to-S conversion, your next task is to ascertain whether your clients are willing to wait five years to avoid the built-in gains (BIG) tax.

    In Brent’s case, Brent’s advisors determined that his corporation was eligible for S corporation ownership.

  • He was the only shareholder.
  • There was only one class of stock.
  • The company, like most successful corporations, was an accrual-basis taxpayer, not a cash-basis taxpayer.
  • There were no NOL or LIFO-inventory issues.
  • Brent asked his advisor, “Why do I have to wait five years after electing S corporation status to sell my company?” Brent’s advisor said, “You have to wait because of the ‘built-in gains recognition,’ which triggers a built-in gains tax.” Brent responded, “Fine. Tell me what it is and let’s avoid it.” Now it was the advisor’s turn to pause. What would you say at this point?

    Before you say, “Work with a CPA, of course,” we agree that you will work closely with your clients’ CPAs and other tax and legal counsel before exiting the C corporation asset-sale jungle. But what else can you offer Brent, who sees you as the leader of his Advisor Team?

    We are not suggesting that you offer advice outside of your expertise, but as the leader of an owner’s Advisor Team, you must have enough knowledge to both explain these tax concepts and prompt owners to take action. After all, Brent took no action before meeting with his Exit Planning Advisor, and he likely would have not taken action had this Advisor not provided vital tax information.

    Further, in his role as Advisor Team leader, Brent’s Advisor coordinated the actions of all advisors in designing strategies to resolve the double-tax problem and in implementing Brent’s overall Exit Plan. Owners and their existing advisors will not act (and have not acted) without the involvement of a lead advisor well-versed in Exit Planning. We suggest that the well-versed advisor be you.

    Now, let’s return to Brent and the BIG tax.

    The BIG Tax

    The BIG tax is an entity-level tax on an S corporation that was formerly a C corporation. It is levied when the S corporation disposes of assets that had built-in gains at the time the C corporation converted to an S corporation. The IRS imposes a five-year recognition period on these assets that begins when the C corporation converts to an S corporation. If the S corporation disposes of assets subject to the BIG tax during that five-year recognition period, the IRS imposes a 35% tax, which is the highest corporate tax rate.

    As you may recall, in the sale of Brent’s C corporation, almost all of the $10 million purchase price was attributed to goodwill. Consequently, if he decides to go ahead with the sale at any point within five years after electing S status, he will pay the federal BIG tax of 35% and the state tax of 5% (the average state income tax). That is the same tax bill he’d receive if he sold the assets of his C corporation today. Once his advisor explained this, Brent quickly saw the value in waiting until the five-year recognition period lapsed before selling assets.

    There are other planning strategies designed to minimize or eliminate the BIG tax, but generally speaking, unless a C corporation has significant NOLs before the S election, the planning strategies don’t result in significant tax minimization. That was the case with Brent.

    After explaining all of this to Brent, the advisor said, “The best tax-minimization strategy available to you is to convert to an S corporation and wait five years to sell the corporate assets.” There was silence in the room while the advisor waited for Brent’s response, all the while hoping that Brent would be pleased with the cogent analysis he’d offered to this point.

    Rather than offering his thanks, Brent offered his own numbers-based response, “I don’t want to wait! I want to exit when I’m 65 years old. We’ve got 3 years, 2 months, and 11 days before I walk out that door!”

    Having had these encounters with owners, we know several things. First, owners usually wait to contact advisors about their exit decisions only when they are ready to exit. Brent’s willingness to wait even three years was unusual. Second, “EXIT NOW!” time frames give advisors little time to implement complete tax solutions. Third, Brent’s advisor was certainly thinking about how much better this meeting would have gone two years earlier. Instead, Brent had waited until he had a letter of intent in hand to meet.

    Rather than express that observation to Brent, his advisor said, “If you don’t feel you can wait five years, there may be another way.”

    “I am all ears,” Brent replied.

    In our next article, we’ll discuss another way to address the double-tax problems for owners of C corporations in a compressed exit time frame, in this case, 3 years, 2 months, and 11 days.