One of my core practice areas is helping small business owners at every stage of the business life cycle. While we certainly spend a lot of time as business lawyers with our clients who are starting businesses, it’s also important to devote plenty of time to those who are planning their exits.
Small business owners must be able to predict both benefits and consequences from multiple aspects of a sale transaction, meeting their applicable goals for legacy, leadership transition, and of course, income. But as with many other sources of income, small business owners often fail to gauge tax consequences of how they structure their deals.
Many aspects of a sale transaction can trigger tax considerations. Today, let’s take a look at how your entity type can influence how you structure a sale.
Many small businesses operate within a variety of entity types, including sole proprietorships, partnerships, and S corporations, which are considered “pass-through” entities. Perhaps the best-known of these entity types—and most utilized over the last decade or so, is the limited liability company (LLC). These entity types are known for their flexibility, including ownership structures among multiple individuals. An interesting note is that the IRS does not recognize LLCs as a tax status so an LLC will have a default election (either sole proprietorship or partnership depending on if it has one or more members) but can elect to be taxed as an S corp. Due to their pass-through nature, these entity types also provide greater flexibility with regard to taxation, when compared to corporations.
Specifically, owners of LLCs, partnerships, and entities taking the S corp election may sell a business and its assets without risking double taxation of the income from the sale. Just as regular earned and passive income from the active work or investments of the business passes through the entity to the tax returns of the individual owners, so, too, do the proceeds of the sale. To the contrary, a corporation would sell its assets and be subject to taxation at both the entity level and the shareholder level (assuming the net proceeds are distributed to shareholders).
So, should everyone switch to a pass-through entity? Of course not. There are many pros to having a corporation, and some of them activate at the time of a sale. While it’s true that shareholders of corporations may see a double taxation related to income from the proceeds in an asset sale—at both corporate return level and individual shareholder return level—a corporation may be able to reduce its tax exposure through leveraging operating losses or carryovers of business credits. Structuring the transaction as a stock sale or merger may also be an avenue to avoid double taxation.
Things aren’t always clear in the world outside of C corporations, either. Many people convert C corporations to entities that take the S corp tax election. This event triggers a 10-year period that could influence the taxation of sale proceeds. Double taxation may occur for companies and owners, even when designated as S corps currently, due to built-in gains rules that cover this 10-year period. Once 10 years have elapsed, S corp owners are free of this consideration.
Many reading this article may be thinking that perhaps you can change your entity type just prior to a sale transaction (e.g., moving from a C corp to an S corp), but governments are wise to this practice and generally prevent changing entities immediately prior to a transaction to improve your after-tax position after an asset sale.
These considerations can be a part of much more complex conversations surrounding the sale of a business. You can see why business attorneys and accountants will often advise you, upon formation of an entity for your startup business, that you need to have the end in mind at the beginning. It’s best to know whether you’re starting a lifestyle business, such as an LLC to hold rental properties or real estate flips, or a growth business centered on a specific technology, product, or set of services. If you’re beginning with the end in mind, your key advisors—corporate attorneys and CPAs—can advise you on entity structures that are optimized for both the present and the future, including an eventual exit.
If you’re looking for help in starting your business with the correct entity type for both legal and tax consideration, the attorneys of the Forrest Firm are here to help. We also routinely work with small business owners looking to exit their businesses while retaining their hard-earned dollars from the proceeds. Regardless of your situation, our team is here to assist as you weigh your options and make good decisions. Contact me today for a consultation to get the process started.