Prior to 1986, shareholders generally could liquidate a C corporation, or sell all of the assets of a C corporation followed shortly thereafter by a complete liquidation and distribution of the cash received, and pay only one level of tax. The entire transaction was taxed at capital gains rates at the shareholder level, and the corporation paid no tax (with the possible exception of tax on recapture income). Those were the days, my friends.
The sweeping tax reforms enacted in 1986 included the repeal of what was known as the General Utilities doctrine, which was embodied in the former sections 336 and 337 of the Code. Since that time, the liquidation of a C corporation, or an asset sale followed by a liquidation, results in two levels of taxation – the corporation pays a tax based upon the difference between the stock’s fair market value and tax basis of its assets, and the shareholders report the liquidating distribution as a sale of their stock and pay tax on the difference between the fair market value of what they receive in liquidation (whether assets, cash or a combination of both) and their own basis in the stock.
Assume you own a C corporation now, and all of your friends are telling you that you should be operating in the form of a pass-through entity, such as an S corporation or an LLC (taxed as a partnership). They cannot understand why you are still paying two levels of tax, but you explain politely to them that ever since the repeal of General Utilities in the 1986 tax reform act, you cannot close down your C corporation without excessive tax costs. So what are your options if you want to move from your double-tax C corporation to a pass-through entity?
Converting to an S Corporation
It is easy to convert your C corporation to an S corporation as long as it qualifies (e.g., 100 or fewer eligible shareholders – generally U.S. individual citizens or residents and certain trusts – and only one class of stock), but the conversion comes with a toll charge. This toll charge, the built-in gains (BIG) tax, prevents the avoidance of double taxation on the net unrealized built-in gain (NUBIG) inside of the C corporation as of the date of the subchapter S election. The NUBIG is the net of the unrealized built-in gains (BIGs) and built-in losses (BILs) in all of the corporation's assets as of the date of conversion, calculated as if each asset had been sold for its fair market value on that day. If any BIG or BIL assets are sold within 10 years of the conversion, the C corporation pays tax on the net recognized BIG at the highest corporate tax rate (currently 35%) and the total gain recognized (net of the tax on the recognized BIG) is taxed at the shareholder level.
For example, assume you convert to an S corporation on January 1, 2013, and at that time the corporation owns a printing press that is worth $100,000 less than its depreciated basis and patented technology that is worth $1 million more than the corporation’s basis (a NUBIG of $900,000). If the corporation sells the printing press for a $200,000 loss and the IP for a $2 million gain in 2015, the corporation pays a 35% corporate level tax on the net realized BIG of $900,000. The S corporation reports net gain of $1.8 million, but it gets to claim the $315,000 BIG tax as a loss (35% of $900,000). Ultimately, the S corporation shareholders report net income of $1,485,000, the same amount of income that they would have recognized had the C corporation sold the assets, paid the resulting tax, and distributed the after-tax proceeds to the shareholders.
If you plan to stay in business for at least 10 years without selling any of the major assets of the business during that time, you should definitely consider converting your C corporation to an S corporation. After 10 years, there is no corporate level tax on the NUBIG, and the gain is treated the same as if the corporation had always been an S corporation. And that holding period has been reduced in recent years, which means it might be reduced again in the future. For example, for asset dispositions in 2009 and 2010, the NUBIG holding period was reduced to 7 years, and in 2011 it was reduced to 5 years.
The amount of realized BIG that must be recognized in a tax year is limited to the S corporation's total taxable income. Therefore, the BIG tax can be mitigated by taking steps to reduce taxable income, such as paying additional bonuses (assuming they are reasonable). Any realized BIG that is not recognized due to the taxable income limitation carries over and is recognized the following year (subject again to the taxable income limitation). If taxable income can be managed until the expiration of the 10-year window, you may be able to avoid recognition of the BIG completely.
If an S corporation seems like a good idea, some of the considerations discussed below in connection with converting to an LLC could work just as well in converting to an S corporation.
Converting to an LLC
Converting your C corporation to an LLC will generally be treated as a liquidation of the corporation followed by a contribution of the corporate assets to a new LLC, and we already know what happens when you liquidate your C corporation. Does this mean you are stuck?
Even under a worst case scenario, the economic climate that has existed over the last few years makes this a good time to consider converting your C corporation. The downturn in real estate, historically low interest rates and other factors have caused the values of businesses to dip dramatically. While this is never good news to business owners, it may soften the blow caused by the deemed liquidation of a C corporation, because the corporate level tax is based on a deemed sale at the corporation’s fair market value.
If an outright deemed liquidation is too prohibitive a tax expense, there may be situations where a business owner simply starts a new LLC and gradually increases the business being done by the new LLC while decreasing the business conducted by the historic C corporation. When the C corporation income has dropped sufficiently, the owner may be able to liquidate with little or no tax cost. This typically works best in companies whose business does not depend heavily on the use of equipment or other tangible property.
Finally, in companies with more than one line of business, the owner may be able to separate business lines into multiple C corporations tax free, and then employ one or more of the above strategies with one or more of the new corporations. For example, assume a C corporation has a successful printing operation as well as a successful marketing operation. The marketing operation is primarily service oriented, while the printing operations depend heavily on state of the art equipment. If the owner is able to spin off the marketing operation into a separate C corporation tax free, he might be able to employ the strategy discussed above where he forms a new LLC and begins to write new contracts in the new LLC, gradually phasing out the marketing corporation. Although he may continue to pay double tax with the remaining printing corporation, he has effectively cut his “double tax bill” in half by moving half of his profitable operations to a pass-through entity.
Next Phase Tax Reform
When thinking through the options discussed in this article, bear in mind that there are proposals being discussed currently that may affect how C corporations are taxed in the future. Given that it is a Presidential election year and that Congress has been somewhat inefficient in coming to any type of agreement on tax legislation over the last three years, it is unlikely that any major tax legislation will be passed this year. With that caveat, President Obama’s 2013 budget proposal includes reducing the maximum corporate tax rate to 28%, and even lower for manufacturing companies. House budget chairman Paul Ryan has proposed reducing the maximum corporate tax rate to 25%, and his proposal has been endorsed by Republican Presidential candidate Mitt Romney. While the proposals cannot be said to have bipartisan support, it appears that both parties want to reduce the corporate tax rate by 7 – 10%. On the other hand, absent legislation, the tax on dividends will return to ordinary income rates, which under the Obama budget proposal would return to the prior 36%/39.6% maximum rate, but under the Ryan proposal would be only 25%.
This article deals with complex tax topics at a very high level, and you should never make important business structuring decisions without consulting your own tax advisor and making sure that person knows all of the facts that apply to your business operations and ownership, as well as your future goals and plans. At CBIZ MHM, we are happy to help guide you through these difficult decisions and recommend solutions that work for you. Contact your local CBIZ MHM tax professional today to see if conversion to a pass-through entity may be feasible for your C corporation business operations, or for any other tax planning you may need.
Copyright © 2012, CBIZ, Inc. All rights reserved. Contents of this publication may not be reproduced without the express written consent of CBIZ. To ensure compliance with requirements imposed by the IRS, we inform you that-unless specifically indicated otherwise-any tax advice in this communication is not written with the intent that it be used, and in fact it cannot be used, to avoid penalties under the Internal Revenue Code, or to promote, market, or recommend to another person any tax related matter. This publication is distributed with the understanding that CBIZ is not rendering legal, accounting or other professional advice. The reader is advised to contact a tax professional prior to taking any action based upon this information. CBIZ assumes no liability whatsoever in connection with the use of this information and assumes no obligation to inform the reader of any changes in tax laws or other factors that could affect the information contained herein.
CBIZ MHM is the brand name for CBIZ MHM, LLC, a national professional services company providing tax, financial advisory and consulting services to individuals, tax-exempt organizations and a wide range of publicly-traded and privately-held companies. CBIZ MHM, LLC is a fully owned subsidiary of CBIZ, Inc. (NYSE: CBZ).