Discussion:Are S corp built-in gains really that big of a deal?
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Discussion Forum Index --> Tax Questions --> Are S corp built-in gains really that big of a deal?
| 17 August 2007 | |
| A client, C corp for many years, concerned about tax hit if it sells its assets and liquidates. Wants to convert to S corp. Business is worth a million.
So what is the big deal about BIG? If the corporation does NOT convert to an S, and sells, it pays 34% federal tax on the sale. If it DOES convert to an S, and sells, it pays 35% up to the million of BIG. So on a million dollar sale, it costs the corporation only $10,000 more as an S. Peanuts, especially considering the HUGE net tax difference to a sole shareholder if the 10-year threshold is met. So,what is the big deal with BIG? I can see that it IS a big deal for a corporation with BIG of less than, say, $100,000. Any comments appreciated. I have always been afraid to convert C clients to S because of BIG. But, especially if there is a good chance they can make it past the 10-year threshold, I don't see any reason NOT to convert any C corp to S, unless of course it is a very small company or there are other non-tax reasons to remain a C, fringe bennies, NOL's, etc. Thanks for your time. | |
| 17 August 2007 | |
| First, maybe dumb question, but are you sure you have BIG? Just not sure what "the business is worth a million" means. | |
| 17 August 2007 | |
| Business is a restaurant, basis is minimal, the 100% shareholder nets $300,000 a year, there have been some loose offers for a million. I know there is the possibility that the goodwill can somehow be a personal asset that she has created, but, I have not been able to grasp this concept. Assuming that the personal goodwill is not an option, then, to answer you, the value is primarily in the goodwill and leasehold. | |
| 17 August 2007 | |
| Based on the theortical scenario in the original post, BIG had a very large effect on what happened. Because of BIG it was not worth the taxpayer converting to an S corp and then liquidating, thus saving large amounts of tax dollars. Consequently, it worked just as the IRS intended.
Depending on the business, BIG can have a very large effect even if assets are not currently being disposed of. Alternately, mere concern that a client might have BIG is not a reason to remain a C corp. You always need to do a FMV analysis and crunch the numbers before proceeding, as there is no one-size-fits-all answer. | |
| August 17, 2007 | |
| Did you forget the personal tax hit on the C leftover distribution after paying the C corp taxes? Figure that in and you'll know why it's a BIG deal. | |
| 17 August 2007 | |
| Yes JR1, this is the whole point. In this million dollar scenario, sole shareholder pays an arm and a leg whether she sells as a C,or an S before the 10-year threshold. The BIG deal is she can save boohoos of dollars by converting to an S and getting through another 10 years - then only capital gains pass through to her (no federal tax in corp).
What I am hoping someone will say is, yes Kendrick, you are right! If she converts to an S, and establishes a million dollar BIG, then if she sells before the 10 years is up, it only costs her an additional $10,000 in federal corporation income taxes (35% vs 34%). Her personal tax hit will be the same either way. BUT, if she makes it to year 10, she saves corp and personal tax BIG TIME. Even if she has to liquidate before the 10 years, any increase in value over the million dollar BIG will pass to her personally, again big savings corp and personal. Hmmmm. These thoughts are difficult to convey sometimes. | |
| 17 August 2007 | |
| "Yes, Kendrick, you are right!" - BUT, you cannot go from there to thinking it will always be the best way to go. In some instances, the BIG tax will be triggered before the 10 year period expires, for example, a cash basis qualified personal service corp (atty, doc, architect, CPA) with large AR & WIP who currently operates as a C corp managing income to close to zero each year will get smacked with BIG tax upon collection of the AR & WIP. As Taxref said, "there is no one-size-fits-all answer." | |
| August 17, 2007 | |
| Ahhh, I think I know what you're saying. Well, of course, if she sells before the 10 years, the tax should be the same either S or C, depending on the state's tax rates. In IL, huge savings between S's and C's. So if that's going to happen, why bother. If there's a chance that she can wait the ten years, there's the payoff. If I understood you... | |
Corptaxhelp (talk|edits) said: | August 20, 2007 |
| Kendrick, does the restaurant own is building/property? If so, is that included in your million dollar number? Would they buyer pick up the real estate along with the business?
As to your question, yes, there really is no down side to doing the S election in this case. It won't put her in a worse situation and the upside is huge if she makes it ten years. | |
| 20 August 2007 | |
| No, corp leases the building. Cash basis, no receivables, immaterial inventory. Slam dunk.
Thanks for your response. I read your bio, and am very curious to know what services you provide. It sounds like you are a business broker? | |
Corptaxhelp (talk|edits) said: | August 20, 2007 |
| Kendrick, I'm not exactly sure what you'd call me. I'm not a broker. I'm not a CPA or any other recognized financial advice provider. (And, quite frankly, I'm not looking to become one -- too many hoops to jump through.)
I have an strong understanding of tax issues related to closely-held c-corporations. I research opportunities and provide advice and analysis to high net worth individuals and a couple boutique investment firms. My background is in computer science (data analysis and statistics). While working for a small hedge fund, I was put through intensive training in this c-corp niche. After a few years there, I was burned out and went out on my own. Since commercial real estate is often a large component of my c-corp work, I have a lot of experience there as well. Lately, I have spent way too much time modeling 1031/1033 exchanges versus just paying the tax and moving on. I recently started working with a national commercial real estate brokerage firm to help their agents understand what real estate inside a c-corp really means and how to best present the situation to their clients. At cocktail parties and backyard BBQs, I just tell people I pump out septic tanks. It is a bit more interesting and a lot more understandable. (And, instead of having to talk about work, they quickly leave that line of discussion and follow-up with 'gee, do you have any hobbies?'.) (Only once did the septic tank story backfire. It turned out the guy I was speaking with had a summer job pumping tanks back in college. He started talking about the oddest things he ever found in a septic tank. My secret identity was busted and I had to confess. When I told him I was actually involved in corporate transactional analysis, he quickly changed the subject, asking about my hobbies.) | |
| August 21, 2007 | |
| Actually, you do pump out septic tanks, just not the way most folks understand! RE inside a corp is worse than what's in the bottom of the tank. | |
| 21 August 2007 | |
| I want to know what the oddest things at the bottom of the septic tank were, and how they got there. | |
Corptaxhelp (talk|edits) said: | August 21, 2007 |
| I won't go into the gross stuff found. Call your neigborhood septic tank professional for details.
The oddest thing he every found was a full-sized bicycle. They couldn't get it out of the tank without cutting the frame; it wouldn't fit through the clean-out hole. They have no idea how it got into the tank. It almost looked as though it was assembled inside the tank as a prank. The tank hadn't been cleaned in more than eight years and the house was built 20 or so years before that. Given the bananna seat, it had been down there a while. | |
| 21 August 2007 | |
| I love the analogy -- getting trapped RE out of C corps IS kind of like pumping out septic tanks <G>. | |
