I was recently asked by “Chester” to help him sell the $10 million service company he founded 24 years ago. Chester, who is 65 years old, has had some health concerns and wants to travel the world with his wife Margie. Two of his competitors have been acquired in the past 3 years by strategic buyers. His business is doing well and he thinks the time is right to sell. In Chester’s industry, almost all acquisitions are asset (versus stock) purchases.

When Chester told me that he converted from a C- to an S-Corporation 6 or 7 years ago, we asked his CPA to estimate his tax burden if he sells now. It turns out Chester faces a large Built-In Gain (BIG) tax bite, which was a surprise to him. In my experience as an M&A advisor, Chester is not alone.  Many S-Corporation owners are unaware that such a monster is lurking in the shadows.

What is a Built-In Gain?

C-Corporation owners face a “double tax”, where gains on a sale of assets are taxed at the corporate level and subsequent dividends are taxed at the shareholder level, whereas in an S-Corp there is no federal corporate level tax. Congress’ enactment of built-in gains tax was intended to prevent C-Corp owners from making an S election just before selling their companies’ assets to avoid corporate-level taxes.

When a C-Corp converts to an S-Corp, a “built-in gain” is determined, based on the Fair Market Value of the corporation’s assets (both tangible and intangible) less the tax basis in the assets on the date of conversion.  Essentially, built-in gain is the gain that would have been taxed had the C-Corp sold its assets on the conversion date. Built-in gain should be determined, in the eyes of the IRS, by a business valuation prepared by a qualified independent business appraiser, as of the conversion date.

How much is the tax and how long after C to S conversion does it apply?

Built in gains was codified in 1986 in Internal Revenue Code Section 1374. Per the code, an S-Corporation is subject to a Built-In Gain tax for 10 years from the first day of the year of conversion from C to S. And yes, Built-In Gain tax is commonly called the “BIG Tax”. Who says the IRS doesn’t have a sense of humor!

For Federal purposes, at the corporate level, built-in gains are taxed at 35%. Additionally, a dividend tax at the shareholder level is assessed, and state taxes are assessed at both the corporate and shareholder level.

IRC Section 1374 was amended to reduce the 10-year recognition period to 7 years for asset sales occurring in companies’ 2009 and 2010 tax years, and to 5 years in 2011. The American Taxpayer Relief Act of 2012 extended the temporary 5-year recognition period to 2012 and 2013. By the way, California continues to require a 10-year holding period. Welcome to California; now open your wallet!

Unless Congress acts, if a Company sells in 2014, the original 10-year recognition period will apply. That means there might be a real incentive to close a sale before the end of this year. Otherwise an S corporation owner might want to hold on long enough to outlast the 10-year BIG recognition period. This is the decision Chester made. At 65 years old with declining health, Chester made a gut-wrenching choice that involves real financial risk and adds emotional stress to his next few years in business.

So what should S-Corp owners with a BIG problem do?

1. If you own a C-Corp and your expected holding period is 10 years or more, seriously investigate converting to an S-Corp now.
2. If you previously converted from a C-Corp to an S-Corp, and you plan to go to market within your BIG window, be sure to have an independent, IRS-compliant business valuation prepared as of the date of conversion. Valuations can be prepared retrospectively.
3. If you’re considering selling now, close your deal before the temporary 5-year BIG window reverts to 10 years in 2014. Time is running out if you want to hit this window.
4. When an asset sale is reported for tax filing, the selling price is allocated among the various assets sold (AR, inventory, equipment, goodwill, etc.) If you sell next year, one way to reduce (though probably not escape) the BIG tax is to allocate part of the sale price to personal assets, such as personal goodwill. However, personal goodwill is not justifiable in many businesses, and any attempt to allocate price outside the corporation will be closely scrutinized by the IRS, and should be supported by an independent valuation.

Please be sure you understand the tax consequences of a sale of your company, whether you plan to sell this year or several years from now.  Exit right, retire well!

Business valuations play an important part in many tax matters, and exit planning for business owners increases their chances of a successful exit. For additional information or for advice on a current need, please do not hesitate to call Al Statz at 707-778-2040 or Email alstatz@exitstrategiesgroup.com.