The decision to incorporate – and how to do it – is one of the first important decisions most business owners make. Most people seek advice from attorneys, accountants, or friends or relatives who own their own companies in order to decide which corporate structure best suits them, and the majority end up choosing a Sole Proprietorship, LLC, or S Corporation. Every once in awhile, owners choose to incorporate as a C Corporation.
Through the course of our business at Bridge Ventures, we have the opportunity to observe how each of these structures impact an owner’s tax liability when selling their company. Disclaimer: we are not attorneys or accountants, and you should seek the advice of one or both if you need incorporation or tax guidance. That being said, if you own a small business then we have some words of advice: unless you are building the next high-growth tech start-up and you are going to attract millions of investment dollars from Venture Capital investors and your business will therefore require multiple shareholders and multiple classes of shares and a complex capital structure, do not choose the C Corporation. The benefits are minimal, at best, to most small business owners while operating the company, and they come at a huge expense when you try to sell.
Most small business transactions are structured as asset purchases. This means the buyer purchases the assets of the corporation rather than purchasing the corporation itself (or buying the corporate stock). Federal tax law has established that portions of the purchase price must be allocated among various assets, including fixed assets (furniture, equipment, etc), inventory, covenants not to compete, and business goodwill, the latter of which is taxed at the capital gains tax rate. Many small businesses, especially in services sectors, can allocate the bulk of the purchase price to goodwill and therefore pay capital gains tax, which is lower than ordinary income tax, on the majority of their proceeds from the sale. The exception, of course, is the C Corp.
C Corporations are subject to what is know as double taxation; that is, the business pays taxes at the corporate tax rate on the proceeds from the sale; then, the net proceeds are distributed among the shareholders, who pay capital gains taxes on their personal gains. This can have the effect of doubling the seller’s tax liability.
The seemingly simple solution is to structure the transaction as a stock purchase rather than an asset purchase, therefore eliminating double taxation and only requiring the seller to pay capital gains taxes on their proceeds from the sale of their stock. On paper, this sounds great; in reality, it is highly unlikely to happen. There are numerous advantages to the buyer to structuring the transaction as an asset purchase, namely protection against liabilities and the ability to amortize the goodwill. Furthermore, it is rarely a point of discussion – many buyers would simply choose to walk away from the transaction rather than be persuaded to purchase the company’s stock.
So what should you do? Have a conversation with your advisors about the appropriate corporate structure for your business, taking into account your likely (e.g. realistic) growth trajectory, financing needs, and capital structure, your tax management strategy, and your exit plans. If you are just starting out and plan to be the sole owner of your business (or perhaps have one or two “equal” partners) then you would have a hard time convincing me that you need C Corp status. If you are already established as a C Corp but need not be (e.g. again, you are the sole owner or have one or two “equal” partners) then perhaps you should consider converting to an S Corp. There are certain requirements and limitations on how and when you can convert from one type of corporation to another, as well as how quickly you can exit after this conversion (without increasing your audit and penalty risk), but if you have 5-10 years of ownership ahead of you before selling, then converting now can save you many headaches – and tax expenses – in the future.