Is it Time for a Change of Business Entity Form?
Your business form will affect taxes at sale time
When you started your business you probably looked at the least expensive way to get up and running. So you became a sole proprietor or maybe a partnership. Or maybe you started out as a C corporation, or even a sub-chapter S corporation. Then came the limited liability company/partnership options (LLC/LLP), and maybe you changed again.
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According to a New York State Revenue report about 15 percent of businesses were C corporations in 2001, 22-23 percent were S corporations, and about 10 percent were partnerships (including LLCs and LLPs). In 1995, about 25 percent of businesses were C corporations and 25 percent were S-- a 40 percent drop in Cs, probably due to tax planning. A Georgia study found eight to 10 percent of small businesses there appeared to have changed entity to reduce taxes. |
Is it time to revisit your choice of business entity again? It might be. Business tax planning and choice of entity can save your company lots of money at several points in time:
- When you pay your annual tax bill for the business
- When you pay your personal tax bill
- When you contemplate selling a business or business interest
Paying the IRS—Business Taxes
The Jobs and Growth Tax Relief Reconciliation Act (JGTRRA) of 2003 significantly reduced individual dividend tax rates. One of the major shortcomings of the C corporation business form is the double taxation of dividends—once at the corporate level, and again at the dividend rate for the recipient. Since you are the corporation, this means you are paying tax twice.
Since S corporations and LLCs are flow-through entities, the revenue not otherwise paid as expenses or employee salaries “flows through” to the owners or shareholders. At the Federal level there is not a separate tax for LLC/LLPs or S corporations. There is also very favorable treatment of revenue paid to shareholders or owners as dividends.
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Big Caveat: Always consult your tax and legal advisors before making choices or changes to your form of business entity! |
Paying the IRS—On Your Personal Income and Dividends
What makes S corporation dividends so attractive? Not only is there no corporate income tax, but the S corporation can cut other taxes as well. By paying the owner and select employee/shareholders with dividends, in addition to salary, the amount of income subject to Social Security, Medicare, and self-employment tax (and employer matches) can be reduced. Paying revenue as dividends removes that income from the Social Security/Medicare tax “pot” (7.65 percent employee/7.65 percent employer). The recipients pay personal tax on the payouts, but at the dividend rate, rather than the ordinary income rate.
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Bigger Caveat: The Internal Revenue Service has been looking into S corporations and comparable business entities for possible abuses—including using S corporation dividends to avoid income tax. Under IRS rules, owners (and any other beneficiaries) of S corporation dividends must first receive a reasonable salary before revenue is paid as dividends. The IRS announced plans for a major audit of S corporations last summer, so it is an excellent idea to consult a tax professional and discuss this strategy at your annual corporate board of directors meeting. Dividends are a return on investment, not a substitute for a salary or a tax avoidance technique. |
Does a Change Make Sense for a Going Concern?
Thinking of changing from a C corporation to an S corporation or LLC? Or maybe changing from an S corporation or LLC back to a C corporation? Or maybe you want to change between an LLC and an S Corporation? Consider this:
According to Pam Feely, a Lakewood (Col.)-based CPA, “For a sole shareholder the S corporation is an excellent entity choice. As long as the shareholder takes a reasonable salary, some of the business earnings can be taken as dividend distributions.” These dividends are only taxed once, at ordinary income tax rates (unlike the double taxation for C corporation dividends) and there is no self-employment, Social Security, or Medicare tax owed. The S corporation is also a good choice when there are several shareholders and all are actively working in the business, she says.
“In my experience, LLCs are appropriate when there is a disparity between ownership and sweat equity,” Feely explains. “Earnings in an LLC can be distributed out-of-proportion to ownership; this cannot happen in an S corporation.”
Paying the IRS—At Time of Sale
You must consider more than current taxes, however. “What’s good from a tax perspective for a business owner contemplating a sale may not be so great for a prospective buyer,” says Barbara Wells, an attorney with Minor & Brown PC in Denver.
In other words, realize that both parties want to get the best tax treatment for themselves, and don’t torpedo the sale of your business to avoid a few percentage points; 70 percent to 85 percent of something is almost always better than 100 percent of nothing. Even if you have to pay taxes on part of your sales proceeds, the rate (for an S corporation or LLC) is usually low—often 15 percent capital gains
On the other hand, Well says, there are drawbacks to being a C corporation at the time of sale. There is less flexibility for the seller and the taxes owed are usually higher than when an interest in an S corporation or LLC is sold.
| Tax Consequences of Changing Business Entity For | |||
| S to LLC Taxes at the time of conversion, and then a higher basis on the actual sale |
LLC to S |
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| S to C No tax at the time of conversion and the basis doesn't change |
C to S No tax at the time of conversion per se, and the basis doesn't change. At time of sale, if there is built-in gain (e.g., in equipment, inventory, good will) and if those assets are sold then the first dollars (up to that gain) are taxed as if still a C corporation (it is more complicated than that, but this is the gist of it) |
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| C to LLC Taxes at the time of conversion, and then a higher basis on the actual sale |
LLC to C Typically no tax at the time of conversion and basis doesn't change. However, if a member's liability for company debts decreases as a result of the conversion, then taxes may result |
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If you are currently a C or S corporation, it is not a good idea to change to the LLC format prior to selling a business interest. The change is treated as a “sale” for tax purposes so the growth in business value is taxed as either capital gains or ordinary income, depending on the type of asset. This is true even though no actual sale has occurred
Overall, both Feely and Wells concur—the S corporation format is almost always the most advantageous from a tax perspective at time of sale. But take care making the switch. You can switch from the S corporation or LLC format to a C corporation at any time, but once you’ve switched you can’t go back for five long years. (You can switch from LLC format to a C corporation at any time, but going back can cause the tax problem noted in the preceding paragraph).
