C-Corporations vs. S-Corporations -
Tax Consequences When Selling a Business
If you’re trying to understand the tax consequences of selling a business as a C-Corporation vs. an S-Corporation, be sure to seek the advice of a professional tax advisor. The tax laws are complex and providing advice is far beyond the scope of this article.
Based on listening to business owners from years of business brokerage experience, sellers are often surprised by the tax bite they face when selling a business. Many business owners assume they will be taxed at lower capital gains rates, but that’s not always the case.
C-Corporation Tax Consequences When Selling a Business
Did you know that there is no such thing as capital gains rates for C-Corporations? When you sell a business (structured as an asset sale, as most small businesses sale are) the gain on the sale is taxed at C-Corporation rates ranging from about 34% to 39%. The entity sells the business assets, receives the proceeds of the sale and pays the C-Corp tax. The proceeds remain in the C-Corporation until they are paid out to the shareholders. The distribution of cash (the remaining proceeds from the sale) are taxed again (as dividends) when they are distributed to the shareholders. We’ve all heard the term “double taxation.” In the sale of a C-Corp’s assets, the gains are taxed twice, first at the corporate level, then again when the proceeds are distributed. In addition, of course, state income taxes are usually required to be paid. It’s ugly!
To reduce the tax bite of a C-Corp sale, there are some challenging options. A sale of the corporate stock (business sale structured as a stock sale) qualifies the shareholders for a capital gains rates taxation. However, for many reasons, buyers seldom are interested in acquiring the stock of small businesses. (Read: Stock Sale vs. Asset Sale When Selling a Business.) For businesses where the owner maintains extraordinarily strong relationships with customers, allocating a portion of the selling price to “personal goodwill” can result in capital gains rates being applicable. (Read: Personal Goodwill When Selling a Business.). And finally, as a planning tool, not as an immediate benefit, C-Corporations can convert to S-Corporations, and gain some tax relief by complying with the Built-in-Gain rules. (Read: Issue #65 - Achieving a Partial C-Corporation Tax Benefit.)
S-Corporation Tax Consequences When Selling a Business
S-Corporations are pass-through entities, meaning the entity pays no tax on its earnings. Instead, the earnings are passed through to the shareholders who then pay taxes on their share of the earnings at their own personal income tax levels. When you sell an S-Corporation (structured as an asset sale, as most small businesses sale are), with the exception of tax implications of depreciation recapture, generally the gain from the sale qualifies for capital gains rates. But that exception, depreciation recapture, can have a huge impact on your tax liability because it is taxed at the individual’s ordinary tax rates.
The theory behind depreciation recapture is you benefitted (through depreciation tax deferral) at ordinary tax rates, so when you sell depreciated assets, your gain should be taxed at ordinary rates. Let’s provide a simple example. Let’s assume you acquired $500,000 of assets over the years, but none recently, and you’ve taken $400,000 in depreciation so far. Your basis in those assets is only $100,000. Let’s assume the business sells for $700,000. Keeping it simple, ignoring all other aspects of a sale, your gain is $600,000. But only $200,000 would be taxed at long term gain rates because $400,000 of depreciation recapture would be taxed at ordinary rates. In other words, in this example, only 1/3 of the gain is taxed at capital gain rates while 2/3 of the gain is taxed at ordinary income rates.
As with C-Corporations, to avoid the depreciation recapture provisions, one option is to structure the sale of the business as a sale of the stock of the S-Corporation, in which case the sale qualifies the shareholders for capital gains rates. However, for many reasons, buyers seldom are interested in acquiring the stock of small businesses. (Read: Stock Sale vs. Asset Sale When Selling a Business.)
The above content is provided for informational purposes only, and should not be construed as tax or legal advice. As it relates to a business sale, tax regulations are very complex. You should always seek the advice and counsel of an experienced and competent tax professional.
ATTENTION: Business Owners & Prospective Sellers!
When selling a business, understanding the tax implications of selling your company is extremely important. Indeed, about 60 of the 90 articles in the
How to Sell a Business Newsletter Series, contain the word “tax.” Information and recommendations regarding tax considerations are interspersed throughout the newsletter series. We strongly encourage you to subscribe to the free, bi-weekly email newsletter.
The following newsletter articles primarily address tax issues:
Newsletter Issue #64 - C-Corporation Tax Implications - Explains details of C-Corporation double taxation.
Newsletter Issue #65 - Achieving a Partial C-Corporation Tax Benefit - Explains partial benefits of converting to an S-Corporation.
Newsletter Issue #15 - Can You Afford to Sell Your Business? - Explains the need to consider your net proceeds after taxes.
Newsletter Issue #34 - Preparing to Sell Your Business - Improving Accounting Procedures - Explains how tax minimization policies can be detrimental to your selling price.
Newsletter Issue #72 - Excessive Personal Expenses and Skimming Cash - Explains reasons to eliminate or minimize personal expenses.