Small Business and BIG Taxes – Timing is Everything

This column typically focuses on the issues of running a business, especially those that revolve around leading employees and growing profits. When I am consulting on issues that include tax planning, I am supposed to include a “Circular 230 Disclaimer”, which cautions any advice as not encouraging tax evasion. So I start this by reminding readers to consult with their CPAs, who are far more qualified than I to determine whether any change for tax purposes is advisable.

Whew! Having at least partially covered my legal butt, I will now venture my opinion.

Many small business owners I know who have had their companies for 20 years or more are structured as “C”, or regular corporations. Years ago, I also had a C-Corp. It was the only way you could cover your health and other benefits as an employee expense. Many others use it because the first $50,000 of taxable profit is dinged at a very low rate. That makes it much easier to accumulate working capital without paying the full personal ordinary income tax rate from the first dollar of earnings.

Here is the issue. Owners from the Baby Boom generation are planning their exits, and a privately held C-Corp can be a tax nightmare to sell. Some 80% or more of small business sales are asset sales. When you sell the assets of a C-Corp, it creates ordinary income for the corporation (C-Corps don’t get capital gains treatment). Then when you distribute the balance to yourself or other shareholders, you pay dividend tax.

I’m not expert on the details of the new tax law passed in the last month, but if proceeds from the sale are enough to trigger a 39% taxation range, you could be paying that twice. In other words, about 37 cents of each dollar in proceeds finally goes to you, and 63 cents to the IRS. Owners who decide to sell before checking the tax implications (and there are many) get a very rude surprise. (I’m mixing corporate and personal tax rates here, but remember you should talk to a professional. The point is still valid.)

This double taxation doesn’t occur in “pass-through” entities like Subchapter S corporations, LLCs or partnerships, but changing a C-Corp is (of course!) a bit more complicated than just doing the paperwork.

1120sTaxFormYour C-Corp can be converted to a Subchapter S by filing an election form. Here’s the catch. The conversion triggers the Built In Gains (appropriately shorthanded as BIG) tax. The entire value of the corporation becomes your personal property, and therefore personal income to you.

Here’s the good news (at last!), you don’t have to pay tax on that income immediately. You are allowed to amortize it over time, or until you sell the assets of the business. Here’s some more good news, that amortization period has just been reduced from ten years to five. So if you sell in more than 5 years, you are only taxed on the proceeds of the sale one time, at your personal rate.

What if you plan to sell in less than five years? The conversion is at a present value, it doesn’t change. If your business is growing, that new growth is in the Subchapter S. So each year you save some potential taxes via amortization, and some more on the growth in the “new” entity.

Why am I devoting a whole column to this technical stuff? Because there is one…more…catch. (Aren’t you surprised?) A subchapter S election may only be made in the first 75 days of the fiscal year. If yours started on January 1, you have until March 15th to file, or lose the option. If you lose the option, you lose a whole year of both growth and amortization at the potentially lower rates.

If you are a Baby Boomer who still runs your business in a C-Corp, talk to your accountant. There are some other benefits of conversion, but I’m happy to let him look smart. And like the man says, “Don’t try this at home!”

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