We were a Sub C corporation until 1/1/09, when we converted to a Sub S corp. Valuation of the business at conversion (we had it appraised) was about 2.5mm. The main reason we converted was to avoid double taxation on the sale of the business. I think we need to wait ten years to avoid double taxation on the sale of the business assets, but I'm not sure that is correct.

If I understood this correctly, the first 2.5 mm in proceeds from the sale of the business would be taxed just once, and everything above that would be taxed twice. Is that correct?

Any ways around waiting for the ten years to run? Can we safely redirect business sale proceeds through covenants not to compete, consulting agreements, etc?

asked 29 Oct '09, 19:05

Kevin's gravatar image

Kevin
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You got yourself in a mess but yes, the sale then is treated as if the C corp was the owner due to the recapture window the IRS has in place to make sure they get their dough.

Look up built in gains tax

BIG

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answered 29 Oct '09, 20:12

SandySea's gravatar image

SandySea
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accept rate: 7%

Is the $2.5m fair market value based upon the accrual basis of all assets and liabilities inclusive of any goodwill and other intangibles such as workforce in place? (If not, it should be.)

Additionally, if goodwill was not included, or even is it was, was goodwill created by the company, or by the shareholders? If by the shareholders, it's possible that it could be considered "personal goodwill" and subject to one level of tax at long-term capital gain rates. (There is case law to support this issue under the correct set of facts and circumstances.)

The good news is that income generated by "covenants not to compete" and "consulting agreements" is most likely only subject to one level of tax, but the not so good news is that it is taxed at ordinary income rates.

The "built-in gain" is defined as the difference between the fair market value ($2.5) and the tax basis of the assets.

Additionaly, upon the conversion to an S-corporation, was there any C-corporation "accumulated earnings & profits"? (Please note that accumulated earnings & profits is not the same as retained earnings.)

C-corporation accumulated earnings & profits are taxable to the shareholders as "dividend income" and currently considered "qualifed dividend income" subject to maximum tax rate of 15%, which is currently scheduled to sunset after 2010. (This means there is a window if opportunity to distribute the C-corporation accumulated earnings & profits at a reduced tax rate until the end of 2010.

It is possible for the S-corporation to elect to distribute the C-corp e&p as a priority to S-corporation taxable income, otherwise known as AAA (accumulated adjustments account).

Unfortunately, if the S-corporation sells its assets prior to the end of the ten year period from the date of conversion, the built-in gain will be triggered and C-corp tax paid as a result.

The only way around it is for the S-corporation common shareholders to sell their common stock instead of assets of the corporation, but then the buyer "steps into the shoes" of the current shareholders with regards to the built-in gain issue.

Lastly, the built-in gain issue combined with the exit strategy and E&P issue are typically part of the analysis involved with whether or not to convert to an S-corporation from a C-Corporation.

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answered 29 Oct '09, 23:59

Brent%20Berkman's gravatar image

Brent Berkman
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accept rate: 13%

great analysis brent

(30 Oct '09, 13:36) SandySea

Thanks; This is area I have l have lots of analysis experience with.

(30 Oct '09, 15:57) Brent Berkman

I don't have access to a Code or Regs (too lazy obviously to click on RIA) but wasn't the BIG tax holding period reduced in one of the last couple of tax bills?

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answered 30 Oct '09, 00:15

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jim
33913
accept rate: 5%

2

Bill §1251 reduces temporarily the 10 year to 7 year for BIG recognition in 2009 and 2010. Thanks for the heads up Jim!

(30 Oct '09, 13:41) SandySea
1

The link provided by PDXCPA provides an excellent summary!

(30 Oct '09, 16:03) Brent Berkman

Yes, there was a change to the BIG tax holding period, but it was only for a select few - those who converted to an S-Corp (or received assets in applicable transfers) from 1999 through 2003. So far, this change has not helped any of my clients. However, you can check it out here:

http://www.faegre.com/showarticle.aspx?Show=9618

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answered 30 Oct '09, 13:36

PDXCPA's gravatar image

PDXCPA
380128
accept rate: 16%

Yes, excellent point, since the window is still open for a little while longer!

(30 Oct '09, 15:59) Brent Berkman

The original question asks if the gain realized by valuing the property (2.5MM-basis) is only subject to one tax and amounts received in excess of the 2.5MM subject to two layers. The first answer says "yes".

It seems to me that the layer below the appraised and transferred in balance is the "built in gain" subject to tax and paid by the sub s itself and indeed at the highest corporate rate. Without an allowable adjustment that increases the value of the appriased properties and the stockholder basis, when the assets are sold, the selling price is only reduced by the original cost adjusted basis and the result passed to the stockholder on the K-1 thus creating the second tax albeit a pass through capital gain. The amounts above the 2.5MM are subject to only the pass thru in the year of sale as a matter of mechanics.

Did the respondent answer that too quickly due to concentrating on the 10 year period question?

Note: If all taxed at the highest corp rate the benefit of the layered rates is lost, therefore isn't this bad strategy unless the projected sale is substantially higher and the waiting period no problem.

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answered 30 Mar '10, 22:13

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classy
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Asked: 29 Oct '09, 19:05

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Last updated: 30 Mar '10, 22:13