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Tax considerations when selling a privately owned C corporation

 
 

by Emily Murphy and Rebecca Pugliesi and Josh Bemis and Bella Rocco   |   Michigan Bar Journal

 

The dynamics of entity choice for privately held businesses have changed dramatically in the past several years. The maximum federal tax rate on C corporations permanently decreased from 35 percent to 21 percent in 2018, and general complexity with flow-through entities continues to increase.1 Because of these changes, more privately held businesses are choosing C corporation structures, including those backed by private equity. As those companies pursue exit strategies, now is the time to revisit specific tax-planning strategies for selling C corporations.

EXCLUDING GAIN THROUGH SECTION 1202

The qualified small business stock exclusion under Section 1202 allows certain owners to permanently exclude gain on the sale or liquidation of C corporation stock from taxable income.2 This benefit is significant because for qualified stock acquired after September 2010, a shareholder can exclude 100% of the gain up to the greater of $10 million or 10 times the shareholder’s adjusted stock basis.3 Additionally, gain on the sale of stock acquired between August 1993 and September 2010 is eligible for 50% or 75% gain exclusion depending on when the stock was acquired.4

Both the shareholder and the corporation must meet a number of requirements to take advantage of this tax benefit.5 The main qualifications:

  • The stock must be held by an individual, trust, or estate either directly or indirectly through a pass-through entity.6
  • The stock must be held by the shareholder for at least five years.7 Ownership of stock options and instruments convertible into stock do not begin the holding period until exercised.
  • The stock must be acquired via original issuance (direct investment) in a C corporation (i.e., the stock cannot be purchased from another shareholder).8
  • The corporation must be a domestic C corporation.9
  • The corporation’s gross assets must be less than $50 million at the time of investment and at all times prior to the investment. The valuation of the assets is typically based on tax basis, not fair market value or even book value.10 As a result, many companies with very high values can still meet this requirement.
  • The corporation must use at least 80% of the fair value of its assets in a qualified trade or business. A qualified trade or business includes all businesses except for professional services; banking and financing; farming; oil, gas, and mining; hospitality; real estate; and other passive businesses. There are additional limitations on the amount of working capital, investment assets, or investment real estate.11

With such significant potential tax benefits, taxpayers should not forget to consider Section 1202 when starting a new business, making new investments, restructuring, or selling a C corporation.

RECOGNIZING GAIN OUTSIDE THE CORPORATION: PERSONAL GOODWILL ALLOCATIONS

In the right fact pattern, selling personal goodwill in conjunction with selling the related business is a common strategy to avoid double taxation. Typically, a C corporation asset transaction is very costly from a federal tax perspective because of the two layers of tax. First, the gain is taxed at the corporate level at the federal corporate rate of 21%. Then, the net cash proceeds are distributed to the shareholders who are taxed at the dividend rate plus the net investment income tax in many cases (collectively 23.8%). Add in state and local taxes and the effective tax rate can exceed 50%!

If a portion of the sale price is determined to be attributable to personal goodwill, the seller can avoid a layer of tax. Personal goodwill is not a corporate asset because it is held personally by the shareholder; therefore, those proceeds are taxed only at the shareholder level. Further, such proceeds generally are not subject to net investment income tax.12 A buyer is tax indifferent because they receive a stepped-up basis in the asset and are able to amortize the basis over 15 years regardless of whether the goodwill is purchased from the corporation or the shareholder.

This can be a win-win solution, but there are some common pitfalls. First, the parties must have proof that personal goodwill exists separate from corporate goodwill and is owned by the shareholder, not the corporation. Shareholders may fall into a trap if they have entered into an employment agreement or covenant not to compete with the corporation; courts view these agreements as a transfer of personal goodwill to the corporation.13 Additionally, in order to complete the sale of personal goodwill, courts generally require shareholders to enter into an employment agreement or covenant not to compete.14

The value of personal goodwill may be based on factors including the personal characteristics of the business owner such as their reputation and relationships. Since that value may be difficult to separate from the sale of the business assets and corporate goodwill, engaging a third-party appraiser to determine the fair value of personal goodwill may be crucial.15 That value should be agreed upon between buyer and seller and included in a written purchase agreement.

Finally, sellers should consider how personal goodwill impacts the economics of the deal when the target corporation has multiple shareholders. Since personal goodwill value is determined by personal attributes, it is likely that each owner will not receive the same consideration for their respective personal goodwill. In fact, shareholders who were more passive in nature or newer to the corporation may not have any personal goodwill at all. In this situation, selling personal goodwill as a separate asset effectively shifts the proceeds of the sale to one owner at the expense of the others.

MITIGATING THE IMPACT: PRESALE S ELECTION

If selling a C corporation seems to have more drawbacks than benefits, the owners might consider not selling a C corporation at all. If the shareholders and corporations otherwise qualify, the corporation could elect to be taxed as an S corporation.16 The benefits of an S corporation election particularly stand out when considering an appropriate exit strategy, especially in a sale of assets.

Making an S election is a non-taxable event, but the change does create a built-in gains period of five years.17 During that period, if the corporation recognizes gains on assets held at the time of election, it pays corporate tax on the built-in gain at the time of conversion. Therefore, an S election is often seen as a planning opportunity for business owners looking to sell several years into the future when the built-in gains tax is further limited or no longer applicable.

Despite the built-in gains period, there are still benefits to making a last-minute S election that may outweigh the drawbacks.

  • In a C corporation, all shareholders pay the 3.8% net investment income tax on dividends and the gain on sale of stock.18 However, this tax is not imposed on S corporation shareholders that materially participate in the corporation.19 Notably, active shareholders can avoid this tax whether engaging in a stock or asset sale.
  • • Many states, including Michigan, do not have a built-in gains tax. Therefore, while built-in gains in an asset sale will be taxed at corporate rates for federal purposes, the sellers may avoid state-level double taxation.
  • • In a C corporation sale, individuals would generally pay state income taxes on their gains. Because the federal deduction of state and local taxes is limited to $10,000,20 these additional state taxes on exit often provide no federal deduction. However, in Michigan21 and many other states, an S corporation may make an election to pay flow-through taxes at the entity level. The state taxes reduce ordinary flow-through income, generating a federal tax deduction at the entity level.
  • Corporations considering an S election strategy should weigh the benefits against additional costs, particularly gain on sale expected to be subject to ordinary individual tax rates. Strict timing requirements are also a pitfall to this opportunity. In order to elect S corporation status, IRS Form 2553 must be filed no later than two months and 15 days after the beginning of the tax year in which the election is to take effect (i.e., March 15 for calendar year taxpayers).22 This leaves most corporations with a very short window to make and execute a decision if there is the possibility of a sale within the year. If this window is missed, business owners wanting to make the election prior to a sale may have to delay closing until the following year.

DON’T FORGET!

While a complete list of tax compliance nuances from selling a business is more than can be summarized in a few pages, there are other unique considerations for selling a C corporation that are worth mentioning. The following honorable mentions, although not necessarily favorable, should not be forgotten. Generally, the sooner these items can be identified, the more likely the proper steps can be taken to protect tax deductions or ultimate economic benefit.

Tax Attributes and Section 382

Buyers of C corporation stock inherit the acquired corporation’s tax attributes such as net operating losses and credit carryforwards. Sellers can benefit from understanding the value of the tax attributes that the C corporation holds, allowing them to negotiate additional consideration for the value provided. However, buyers should be aware of Section 382, which can either delay the timing or eliminate the potential benefit from corporate tax attributes.

When there is an ownership change in a C corporation of 50% or more within a three-year window, Section 382 and its sister statute, Section 383, provide annual limitations on the amount of tax attributes a corporation can use.23 Limitations apply to net operating losses (NOLs), built-in losses, credits, and, since enactment of the Tax Cuts and Jobs Act Section 163(j), interest carryforwards.24

The annual limit on use of tax attributes is determined by multiplying the value of the C corporation by the long-term tax-exempt rate the month of the ownership change.25 Therefore, if a C corporation had a value of $1 million when an ownership change occurred in July 2023, the annual limitation would be $30,100 ($1,000,000 x 3.01%). Additionally, if the selling C corporation has a net unrealized built-in gain in its assets at the time of ownership change (i.e., the fair market value of the assets is greater than the tax basis of the assets), Section 382 annual limitation is increased for any built-in gains realized in the five years following the change.26 Conversely, if the C corporation has a net unrealized built-in loss in its assets, recognized losses are subject to Section 382.

Taxpayers with net unrealized built-in gains can often realize a significant benefit under Notice 2003-65 to release tax attributes from limitations on an accelerated basis, creating more value in NOLs and other attributes. Currently, however, there is a cloud over the future utilization of corporate tax attributes. In 2019, the IRS issued proposed regulations on calculating built-in gains and losses for purposes of Section 382.27 The proposals require a methodology highly unfavorable to C corporations in a net unrealized built-in gain situation and would result in much more restrictive annual Section 382 limitations. While the proposed regulations have not been finalized, the IRS has indicated that the rules could be officially adopted at some point in the future.

Parachute Payments and Section 280G

It’s common for a C corporation sale to trigger significant compensatory payments for key employees. Section 280G was enacted to penalize excessive payouts to executives by imposing a 20% excise tax to recipients of excess parachute payments. This tax is imposed in addition to ordinary taxes owed on an executive’s compensation. Further, the C corporation cannot deduct any payouts classified as excessive.28 Section 280G applies generally to all corporations — including C corporations and controlled foreign corporations — whether held by a flow-through entity or not. However, S corporations and even C corporations that would otherwise be eligible to make an S election are exempted from these rules.29

A parachute payment is any payment to a “disqualified individual” contingent on a change in ownership or control of the corporation or a substantial portion of its assets with an aggregate value that equals or exceeds three times the individual’s average wages over the last five years.30 The 20% excise tax is only applied to the portion of the payment that exceeds the average payment threshold. Disqualified individuals generally include employees or independent contractors who are officers, shareholders, or highly compensated individuals of the corporation during the 12-month period preceding closing of the transaction.31

The excise tax imposed by Section 280G can be avoided by planning. First, the company may have a “cleansing vote” in which 75% of disinterested shareholders waive the right to payments and allow the disqualified individual to receive parachute payments excise tax-free.32 However, before a vote can occur, the corporation needs to determine excess parachute amounts. Such calculations must be provided to shareholders so they can make an informed decision during the cleansing vote. Alternatively, the payment could be classified as reasonable compensation33 by attaching it to a covenant not to compete. Under this approach, however, the payment will likely require an independent valuation to establish the value within the total amount paid that can be classified as reasonable compensation.

LOOKING AHEAD

In the new environment where the corporate tax rate on operations is significantly lower than flow-through entities, it is likely that privately held companies will continue to look to C corporation structures. Tried and true planning opportunities specific to C corporations can help sellers maximize after-tax return on investment.


 

ENDNOTES

1. See e.g., Cook, A Practical Approach to the New Centralized Partnership Auti Regime (So long TERRA … we might miss you!), 44 Michigan Tax Lawyer 5 (Winter 2018).

2. All references to “Section” or “§” relate to the Internal Revenue Code (U.S. Code: Title 26).

3. § 1202(b)(1).

4. § 1202(a).

5. § 1202(c)-(j).

6. § 1202(a)(1).

7. Id.

8. § 1202(c)(1).

9. §§ 1202(d)(1); 1202(c)(2)(A).

10. § 1202(d)(1)(A).

11. §§ 1202(c)(2)(A); 1202(e)(1)(A).

12. §§ 1411(c)(1)(A)(iii); 469(c)(1).

13. See e.g. Martin Ice Cream Co. v Comm’r, 110 T.C. 189 (1998); Muskat v US, 554 F3d 183 (CA 1 2009), and H & M, Inc., T.C. Memo. 2012-290.

14. See e.g. Norwalk v Comm’r, T.C. Memo. 1998-279.

15. See Kennedy, T.C. Memo. 2010-206.

16. See generally §§ 1361; 1362.

17. § 1374(d)(7)(A).

18. § 1411(a)(1).

19. § 1411(c)(4).

20. IRS.gov, Topic No. 503, Deductible Taxes (website accessed October 24, 2023).

21. MCL § 206.813.

22. § 1362(b).

23. See generally §§ 382; 383.

24. Id.; Treas. Reg. § 1.163(j)-3(b)(8).

25. § 382(b).

26. § 382(h).

27. See generally Prop. Treas. Regs. § 1.163(j).

28. § 280G(a).

29. § 280G(b)(5).

30. § 280G(b)(2).

31. § 280G(c).

32. § 280G(b)(5).

33. § 280G(b)(4).