SHOULD YOUR AGENCY BE AN 'S' OR A 'C' CORPORATION?
by Gary Jacobson and Larry Morrison
There are several options for setting up an agency, including sole proprietorships, partnerships (including clusters), limited liability companies (a great option, but not practical if you're already incorporated), or a corporation. Since most agencies are incorporated and thus are closed to the other options, the real question is what type of corporation they should be: 'S' or 'C.'
Nationwide, about two-thirds of all agencies are 'C' corporations. Most would qualify for 'S' status if they chose to.
Tax legislation in 1996 greatly improved the rules for 'S' corporations, which prompted our original article. Tax legislation in 1997 changed things again, primarily by making things more complicated.
Rules of Thumb: For those of you who insist on rules of thumb, even if something crucial gets left out, here they are (and explained later in this article):
1. Yearly taxation: 'C' corporations often (not always) save a little in taxes every year.
1a. Money left in the agency will be taxed less with a 'C' corporation than with an 'S' corporation, especially for smaller agencies. At most, the income tax savings will be a little more than $17,000 per year (but usually the savings will be substantially less).
1b. Fringe benefits for owners (such as Medical insurance) get better deductibility with 'C' corporations. This difference is gradually being phased out.
1c. Social Security taxes for owners, particularly Medicare taxes, are often lower with 'S' corporations than 'C' corporations.
When the agency is eventually sold, capital gains taxes will be $28,000 higher for every $17,000 per year saved now.
2. Future Taxation (when the agency is eventually sold): When sold, 'S' corporations will often save a lot more in taxes than 'C' corporations.
2a. One of the big sources of an 'S' corporation's savings is elimination of the double tax a 'C' corporation must pay if sold as an asset sale (the most typical sale structure). You must be an 'S' corporation for a sufficient period before this benefit will apply.
2b. Simplified Example, Sale to an Outsider: Sale of an 'S' corporation to an outsider in a $1 million asset sale will save the seller at least $244,000 more than a 'C' corporation by eliminating double taxation on the sale.
2c. Simplified Example, Sale to an Insider: Sale to an insider who already owns a large part of the agency will typically be structured as a stock sale rather than an asset sale. A $1 million stock sale will allow the buyer of an 'S' corporation eventually to save more than $280,000 in future capital gains tax-because the sale may be structured as a cross purchase instead of a stock redemption.
3. The rules restricting 'S' corporations were improved in late 1996.
Unfortunately, most agency owners (and many advisors) focus only on an agency's yearly taxation. Obviously this matters, but the tax dollars saved each year, if any, are usually much smaller than the tax dollars that can be saved (or lost) when the agency is sold.
In our experience, most agency owners are completely unaware of the major importance 'S' vs. 'C' status carries when an agency is sold. Some of the issues are so subtle that many advisors are not aware of them either. Your best protection is to know the key issues yourself.
This article will not make you a tax expert. But it can save you money-a lot of money, as the examples just given show. Easily more than you earn in an entire year.
Note: Many of you will have heard of a new form of business known as an LLC (Limited Liability Company). If you are already a corporation, it is almost impossible to convert to an LLC without incurring taxes when you make the switch.
'S' Corporation Basics
The basic difference between 'S' and 'C' corporations is how they are taxed. In some cases, 'S' corporate taxation will be better than 'C' corporate taxation, and vice versa.
To qualify for 'S' corporate status, certain restrictions must be met, although most agencies will qualify as an 'S' corporation if they so choose. If they are now a 'C' corporation, they only need to fill out a form and send it to the IRS.
A subtle tax trap at the time you switch from 'C' to 'S' status can result in 'built-in gain' tax on some of your income, but proper advance tax planning can almost always eliminate this for agencies. The problem arises from the different ways an agency can handle its accounting and taxes. If you pay taxes on the 'cash' basis but books kept on the 'accrual' basis would have shown more tax at the time of the switch, you may end up owing extra income tax in the first year after the switch. This extra income can be offset by 'built-in loss,' but advance planning is needed. Since 'built-in loss' is a concept that applies only to this specific situation, your CPA might never have worked with it before. (If this sounds like unnecessary complexity, it is. Tax simplification anyone?)
Annual Taxes: An 'S' corporation pays no corporate-level federal income taxes. Instead, all profits are passed through to the owners. This may sound good, but can actually be a disadvantage. It means any money left in the business will be subject to personal tax rates (probably higher than the corporate rate would have been), creating phantom income for the shareholders. To protect against this, most 'S' corporations pay at least enough dividends to cover shareholder taxes.
On the positive side, dividends from an 'S' corporation are not subject to Medicare tax. This creates a minor way to reduce taxes by cutting shareholder pay and distributing dividends instead. The IRS is not completely asleep on this, so do not carry it to an extreme.
'S' Requirements: The requirements that must be met to qualify for 'S' status were loosened substantially in the 1996 tax legislation. The corporation's major requirements now are to have no more than 75 shareholders, only one class of stock, and no prohibited shareholders. Although there is no limit on the corporation's size, the 75-shareholder limit means that publicly traded companies cannot be 'S' corporations.
The 'one class of stock' requirement means that each share must be valued the same and carry the same dividend rights, but the voting rights can still differ.
'Prohibited' shareholders means that no foreigners may be shareholders, other 'C' corporations cannot own stock, and certain trusts cannot be shareholders. The restrictions on trusts were greatly loosened by the 1996 legislation.
'S' corporations can now own subsidiary corporations, a major 1996 change. They can now have an ESOP, too, although the potential capital gains tax deferral from sale of stock to an ESOP does not apply. 'S' corporation stock can now be donated to a charity, although not to a charitable remainder trust.
Agency Sale: The biggest impact of 'S' status comes when an agency is sold. This is discussed more fully later.
If an agency has always been an 'S' corporation, been an 'S' corporation for 10 years, or switched from 'C' to 'S' before January 1, 1989, it may be sold in an asset sale without incurring tax on the built-in gain. This is beneficial because the sale will still be taxed to the seller as capital gain, but the buyer will be able to deduct the purchase over 15 years. An asset sale of an 'S' corporation that fails to meet the criteria just described will be taxed at the corporate level at the maximum corporate tax rate (currently 35%), and then taxed again at the personal level.
The Argument in Favor of 'C' Corporations
If some of the agency's profits are going to be left in the corporation, a 'C' status can save annual taxes. Because taxes for a 'C' corporation are graduated, it can take advantage of the lower tax rates on small amounts of corporate income. In these conditions, the tax rate for the corporation will be less than for the individual. If the money needs to be retained in the corporation, the 'C' status will result in lower annual taxes. This is the major advantage usually cited for 'C' over 'S' corporations.
The savings reach a maximum if the owner is in the top personal income tax bracket and the agency will be showing taxable income of $100,000 or less. Under these ideal conditions, a 'C' corporation saves $17,350 per year more than an 'S' corporation.
Unfortunately, profits retained in a 'C' corporation do not increase the owner's 'basis.' The result is that although the tax paid every year may be lower, future capital gains taxes will be higher. For every $17,350 saved in the example above, capital gains taxes will be at least $20,000 higher when the agency is finally sold. The higher capital gains taxes in the future are almost always overlooked.
Note: The much-publicized capital gains tax cut in 1997 amounted to a lot less than it appears. The problem is that capital gains are a 'tax preference' item, subject to alternative minimum tax. If an agency is sold, particularly if it's an all-cash deal up front, the alternative minimum tax will almost certainly apply and the effective tax will be higher (probably 28%). In other words, they cut capital gains taxes on paper, but not when big dollars are involved.
Another relative benefit of 'C' corporations is that owners can more easily deduct all their employment-related fringe benefits, particularly Medical insurance. Employee-owners who own 2% or more of an 'S' corporation cannot deduct all these benefits. This disadvantage is gradually being reduced. In 1998, only 45% of Health insurance premiums for employees who own 2% or more of an 'S' corporation's stock can be deducted. By 2007, 100% of these expenses will be deductible.
The Argument in Favor of 'S' Corporations
The big advantage of 'S' status appears when the agency is sold to an outsider, or an owner is bought out by the other owners. The money at stake is so large-hundreds of thousands, even millions, of dollars-that most other issues simply become irrelevant.
Sale to an Outsider: Switching to an 'S' now will greatly simplify the sale of the agency if it's sold to an outsider 10 years or more in the future. Why? The typical buyer (or the buyer's advisors) expects to structure the purchase as an asset sale. An asset sale structure means that the buyer will receive essentially a fully deductible purchase, although the deduction will be spread out over 15 years. In addition, the buyer will receive protection against carry-over liability.
For these reasons, an outside buyer's advisors will almost certainly recommend an 'asset' sale. This is no problem if you have been an 'S' corporation for 10 years or more, or switched before 1989. However, if you're a 'C' corporation, or switched to 'S' status after January 1, 1989 and less than 10 years before the sale, the seller will be double taxed. The proceeds will first be fully taxed at the corporate level. What's left will be taxed again when paid to the seller.
This double tax is often so large that the seller is forced to insist on a stock sale instead of an asset sale. A stock sale will not be deductible to the buyer and may have additional carry-over liability, so any informed buyer will insist on a lower purchase price in a stock sale than in an asset sale. The bottom line: You're almost certain to get a lower price if you insist on a stock sale. But if you're a 'C' corporation at the time of sale, or have been an 'S' corporation for fewer than 10 years, a stock sale may be the only way to avoid an extra entire level of taxation. The typical reduction in price ranges from 14% to 20%.
If you sell to a publicly traded alphabet house, you may well do a stock swap. A stock swap will delay capital gains taxes for the sellers until the stock received in payment is sold. You will generally not be able to sell the stock immediately, but the capital gains deferral is certainly a benefit. However, stock swaps are subject to a major misconception: You do not have to swap stock for stock. You can swap stock for assets and still get the same capital gains deferral. The difference is that the stock for assets swap has the same tax and liability advantages for the acquiring firm as an asset sale would have. If the buyer wants the tax break, the seller gets a better price.
Note: Many publicly traded companies would rather show higher profits, even if that means paying extra tax.
Sale to an Insider: 'S' status offers additional benefits if the agency is sold to insiders. They're subtle, but very real and very large.
Sale to insiders who already own stock would almost certainly be a stock sale to avoid triggering taxes on the shareholders who aren't selling. Similarly, it would almost certainly involve seller financing for the stock purchase. In an 'S' corporation, the structure can be a stock redemption or a cross purchase. If it's a cross-purchase, the interest on debt taken on to purchase 'S' corporation stock will be deductible for shareholders actively involved in the company. A stock redemption vs. a cross purchase creates differences of an inside vs. outside basis, but the practical effect is that either approach will create a basis for the remaining shareholders. The basis created will reduce future taxes up to 28% for every dollar of principal paid.
This is a major future tax savings compared to 'C' corporations, with which a basis will almost certainly not be created. Again, the reason is subtle but very real.
Interest on debt taken on to finance the purchase of 'C' corporation stock is deductible only against investment income. In a practical sense, this means that it will not be deductible for most shareholders since they will not have nearly that much investment income. The non-deductibility of interest payments will force the structure to be a stock redemption in order to deduct the interest. Unlike an 'S' corporation, a stock redemption in a 'C' corporation will create no basis for the remaining shareholders. Hence, no future tax savings. Sadly, many owners give these future benefits up without even knowing it happened, throwing away a great deal of money.
A possible alternative is to delay switching to 'S' status until buying out a retiring shareholder. This allows interest deductibility on a cross purchase arranged at the time. However, this delay closes off the option of an asset sale to an outsider (explained above).
Excess Accumulated Earnings: Sale to insiders sometimes involves a prior accumulation of corporate cash to help with the buyout. An 'S' corporation can accumulate these profits without a penalty. Not so for a 'C' corporation.
Excess profits accumulated within a 'C' corporation without a valid business purpose are subject to a penalty tax of 39.6%. For service corporations such as an agency, 'excess' is defined as $150,000 above the business needs of the corporation.
Accumulating profits for purposes of a future stock redemption is explicitly not a valid purpose. This is mainly a problem for the careless or uninformed. The problem can be avoided by documenting a legitimate business purpose for the accumulated profits. One common purpose is accumulating cash for a potential future buyout of other agencies.
Accumulating cash value inside a Life insurance policy is another common way to avoid the problem. The IRS does not count the cash value inside a policy as part of the accumulated earnings subject to penalty.
Note: The tax is on the excess accumulated profit each year, not on the total accumulated cash. Thus a sale of stock resulting in a large amount of cash in the corporation is not taxed because it is not profit. However, any accumulation of cash in the corporation from sources such as the sale of stock will still make it harder to show a business purpose for whatever other accumulation of profit there may be.
Assuming you somehow avoid the excess accumulated earnings problem, it's important to see what the apparent 'C' corporation savings actually translate to. Accumulating cash within a 'C' corporation to help pay for a future buyout of a shareholder is much less advantageous than the apparent maximum savings of $17,350 per year.
The first reason is that the accumulated cash would be used in a stock redemption. Since a stock redemption creates no basis for the remaining shareholders, their future capital gains taxes will be much higher. Since all the remaining shareholders will also be selling at some point in the future, this additional future tax greatly reduces the savings from 'C' status.
A second problem is that the accumulated cash raises the value of the agency. The more you save, the more you pay. To make matters worse, in many cases, the money accumulated would have gone to the seller if it had not been accumulated anyway. In these cases, the seller is using his or her own money to buy himself out.
Life Insurance: Many agencies own Life insurance on the owners. However, Life insurance is not always a high-performance investment, especially if there's less than 10 years until retirement. In addition, death benefits inside a 'C' corporation are a tax preference item for larger agencies (generally, more than $5 million in annual revenue to the agency), subject to 75% of the alternative minimum tax.
Structuring the Sale: The tax effects in an actual sale, especially to insiders, can be improved by additional structuring techniques not discussed in this article. Some of the most common include covenants not to compete, employment contracts, and deferred compensation. Planning well in advance helps. For instance, deferred compensation for a controlling shareholder requires more than a year to put in place.
Summary
The rules governing 'S' corporations were loosened in late 1996. The tax dollars at stake are huge, and all owners owe it to themselves to be familiar with the issues. The lead time required for this decision is 10 years, so most agency owners need to know about these issues now. Researching the issues when the time has finally come to sell is just too late.
The benefits of 'S' status depend on the details of the particular sale. Some of the biggest include avoidance of a potential double tax on the seller in an 'asset sale' to outsiders, and interest deductibility for buyers buying out a retiring partner's stock.
In the years before a sale, 'C' status may reduce each year's taxes more than 'S' status would because of a 'C' corporation's lower tax rates on small amounts of profit.
Various other items also affect the decision. 'C' corporations can deduct all the owner's Medical insurance, and 'S' corporations cannot. 'S' corporations can reduce Medicare tax more than 'C' corporations can. Not all corporations qualify for 'S' status.
Because 'C' corporations may save more money every year than 'S' corporations, many agencies select 'C' status. However, the savings from 'S' status when an agency is sold can be so large that the apparent savings from 'C' status can become almost irrelevant. Unfortunately, many of the tax advantages from 'S' status at the time of sale require an owner to have switched to 'S' status before 1989, or 10 years before the sale.
Gary E. Jacobson, JD can be reached at Vander Wel, Jacobson Bishop & Kim, PLLC, Bellevue, WA; (866) 498-0008, toll-free; Fax: (208) 361-5064; e-Mail: [email protected]
Larry Morrison, CPA can be reached at the Business Transition Network, Inc. Arlington, WA; (866) 475-9992; (360) 435-7098; e-mail: [email protected].