Volume 11 Issue 6-- November/December 1999
The first question on our free Checklist For Business Purchases or Sales is, "What is being sold -- Assets or Stock?" A simple question, but the answer can make a significant monetary difference to the business purchaser. The answer can also have a significant tax impact on the business seller. How?
As a result of the 1986 legislative repeal of the General Utilities case, the sale or distribution of assets by a C (regular) corporation is taxed twice. First, tax is imposed on the actual or deemed sale of the corporate assets. The word "deemed" is used because if corporate assets are not sold to a third party, but instead distributed free of charge to shareholders, there is a deemed sale of the assets by the corporation for their Fair Market Value (FMV) on the date of the distribution. Second, tax is imposed on the shareholders, computed by subtracting the respective basis in their stock from the assets or sales proceeds they receive.
Thus, the Federal and State combined double tax on the sale of business assets can be onerous and is, unfortunately, unavoidable in many cases if the proper planning has not been done.Most knowledgeable buyers of businesses want to buy the assets, as opposed to the stock of the corporation, for two main reasons:
The purchaser gets a stepped-up basis in the assets; thus, greater depreciation; and
An asset purchase negates the possibility of the purchaser being the owner of stock in a corporation that could be involved in as yet undisclosed, and expensive, litigation.
Occasionally, with certain assets, the only alternative is a stock purchase, but such situations are rare. An example would be purchasing a corporation that has an attractive airport lease with a government agency.
To avoid double taxation, it is essential that an asset sale by a C corporation be planned well in advance of the sale. The best planning is to not be a C corporation in the first place!
Many professionals, however, suggest C status because C corporations can accumulate profits (after tax) and use the earnings to fund corporate growth. Often little thought is given to selling the assets or liquidating at some future point.S status can be selected later if it was not selected at the time of corporation formation.
When the double tax was instituted in 1986, Congress mandated that when C corporations elect S status, they become subject to a special tax measured by the difference between the FMV of the Corporation's assets on the date of conversion and the basis in those assets. Thus, if an S corporation sold a piece of land with a basis of $40,000 and a FMV of $100,000, the special built-in gains tax imposed on the corporation would be $60,000.
This feared, built-in gains tax can be avoided if 10 years pass before assets are sold or the corporation is dissolved. Gains accruing during the 10-year waiting period because of increases in the value of assets after the S election are not subject to the built-in gains tax. As to such gains, there is no entity level tax on the S corporation.
There are other less provident ways to avoid the double tax. I recently reviewed a case where the Accountant tripled the corporation President's salary in the year of the asset sale to eliminate the corporate gain and take a large retirement plan deduction based upon the increased salary. It probably would not take a towering genius of an auditor to become suspicious of such tactics.
To avoid professional embarrassment when your Client's C corporation's assets become a sales candidate, you may want to urge them to plan ahead. Sadly, few will follow your advice. If we can help in this effort, give us a call.
By Tax and Business Professionals, Inc.
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Manassas, VA 20110
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