An old tax maxim holds that “the tax tail shouldn’t wag the dog.” However, it makes sense to be aware of various exit strategies when you’re starting a business.
Choosing how you register your business (the form of your new organization) is an important decision during the life of your business and when planning for your exit strategy. Where the default form of new businesses might have been an ‘S’ corporation, or more recently an ‘LLC,’ recent tax law changes add more nuance to the choice of organization form. The reduction in the tax rates applicable to ‘C’ corporations makes that organizational form significantly more attractive than prior to the Tax Cuts and Jobs Act.
Tax Consequences of Liquidating Your Business
The tax consequences when an owner liquidates their interest can vary significantly based on the form selected at the time they entered the business. For example, a sale of Qualified Small Business Stock (QSBS) can be accomplished free of capital gains tax under the right circumstances. But only a C corporation can qualify for QSBS treatment. The amount of gain that a taxpayer might exclude on such a sale could be $10 million or more, so it’s certainly something that is worth thinking about when a business is getting formed.
Although an S corporation can convert to a C corporation, that won’t allow the owners to become eligible for future QSBS treatment. One of the requirements for QSBS eligibility is that the corporation has always been a C corporation. This problem doesn’t really exist for partnerships, sole proprietorships, or most LLCs, which will need to “convert” to a C corporation in order to be eligible for future QSBS treatment. S corporations have their own advantages, though, which will continue to make them the organization of choice for some businesses.
Consult Your Attorney or Accountant
The choice of form of a new business should be done in close consultation with an experienced attorney and/or accountant, and that advice should in turn be informed by your near-term and long-term business plans. For example, a business that is intended to provide primarily operating income or salaries to the owners may still benefit from the single level of tax applied to S corporation shareholders. Under the new tax law, S corporation earnings may be taxed at an even lower rate if the section 199A or Qualified Business Income (QBI) deduction is considered.
A C corporation may be a preferable form for a business that is intended to be sold to a larger company or taken public if QSBS treatment is desired. The QSBS rules are very intricate, as you might expect something offering the possibility of tax-free income would be. And, the IRS would be likely to audit this pretty aggressively, so strict compliance with the law is critical. As mentioned above, the issuing company must be a C corporation for its entire existence. Converting an existing business to a C corporation requires careful planning to make sure that appreciated property can be inserted into the corporation without triggering a taxable gain. IRC Sec 199A can have the effect of reducing the top rate on S corporation earnings by as much as 20%.
Beware of Double Taxation
The typical tax problem associated with running a C corporation is the system of double taxation that hits its earnings. When a C corporation has earnings, it’s generally subject to a corporate tax and then when its earnings are distributed to shareholders, the earnings are taxed again as dividends when received by the shareholders. Several years ago, the tax rate on qualified dividends was reduced to capital gains rates in many cases. Still, the double tax on C corporation earnings was higher than income from an S corporation. If the business model provides that the value extracted will be the result of asset appreciation, where QSBS treatment offers tax-free possibilities, the lower rate on C corporation earnings during the run up to the liquidity event may be worthwhile.
At least two other requirements for QSBS treatment should be noted. The selling shareholder must satisfy a minimum holding period for the stock of at least five years. Also, the issuing corporation must have a value under $50 million at all times. The vetting to determine whether you are eligible for QSBS treatment needs to be left to experts.
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The examples provided are all hypothetical and do not take into account any specific situations. The hypothetical examples are provided to help illustrate the concepts discussed throughout and do not consider the effect of fees, expenses, or other costs that will effect investing outcomes. Any actual performance results will differ from the hypothetical situations illustrated here. Please consult a professional to help you evaluate your situation before implementing any of the strategies discussed here.