Now is the time: converting a C corporation to an S corporation or LLC.

• Author: Lynch, Michael F.
• Position: Limited liability company

For closely held corporations that still have C status, (1) the current uncertain economic environment, depressed asset values (especially in certain real estate markets), and historically low income tax rates on distributions to individuals (qualified dividends) from C corporations (which are scheduled to expire at the end of 2012) (2) may present an opportunity to exit C status and its attendant double taxation at an acceptable current tax cost.Tax advisers should be talking to their C corporation clients about the opportunities that now exist to avoid substantial future taxes.

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Tax Inefficiency of C Corporations

C corporations are taxed on their taxable income at federal rates up to 35%. (3) Distributions of qualified dividends to individual shareholders are taxed again at a federal rate of 15%, and those dividends are not deductible by the corporation. Thus, the total federal tax rate on distributed earnings from a C corporation is 44.75% [(1 x 0.35) + (.15 x (1 -- 0.35)]. If a corporation has elected to be an S corporation or a business is not operated in corporate form (e.g., partnership, limited partnership, or limited liability company (LLC)), there is only one level of taxation at the owner level, and a savings of 9.75% of taxable income, assuming the owners are individuals taxed at the highest individual rate.(4) This difference is even greater when taking into account state taxation

Managing Tax Inefficiency: Lowering Taxable Income

A usual approach to managing the inefficient taxation of C corporation operating income has been to pay as much of the income as possible to shareholder-employees in the form of compensation, which, unlike dividends, is deductible. Such an approach may reduce the taxable income of the C corporation to an acceptable level and result in the earnings being taxed only once at the shareholder-employee level. But this approach has its limitations.

Compensation must be reasonable: Sec. 162 allows a deduction for compensation that is (among other things) "reasonable." Where a large percentage of corporate earnings is paid as compensation, particularly where the compensation is proportionate to shareholdings, the reasonableness of it may be difficult to defend.s Moreover, while in some businesses high amounts of compensation as a percentage of corporate income may be reasonable (e.g., where personal services are the principal contributor to income, such as in a dental practice),(6) in other businesses where capital is a principal contributor to income (e.g., rental real estate or manufacturing and sales with large capital investment), compensation that is a high percentage of pre-tax corporate income may be more difficult to justify.(7)

Shareholders may object to some compensation arrangements: Managing the level of corporate taxable income by paying compensation to shareholder-employees may be a difficult strategy to implement where there is more than one shareholder and the individual shareholder-employees do not believe that compensation payments that are proportionate to stockholdings accurately reflect their respective contributions to the success of the enterprise. Certain shareholders may be unwilling to agree to a compensation arrangement that they believe does not adequately reward their efforts or which they believe excessively rewards the efforts of others.

Compensation can be costly: Compensation is subject to payroll taxes, including Social Security and Medicare tax. The combined rate of Social Security and Medicare taxes payable by employers for 2012 is 7.65% on the first $110,100 of wages, and the combined rate for employees is 5.65%.(8) For wages in excess of $110,100, the employer and employee are both subject to a Medicare tax of 1.45%.(9)

Even if double taxation of C corporation earnings can be acceptably and justifiably managed through payment of compensation to shareholder-employees, there remains the problem of managing double taxation of C corporation earnings when disposing of the C corporation itself or of its underlying business.

Managing Tax Inefficiency When Disposing of the Business

The management of the tax inefficiency of C corporations on the disposition of the business held in the corporation in an asset sale is a function of the double taxation of C corporation income and the concepts of "inside" and "outside" gain. Gain on the sale of the business assets (including corporate goodwill) is "inside gain" taxed at the corporate level. Outside gain is gain the shareholders have on the distribution of the aftertax sales proceeds from the sale of corporate assets. Inside and outside gain will also occur where appreciated assets are distributed to shareholders in exchange for their shares.

Double Taxation on C Corporation Liquidating Distributions

If a corporation sells all its assets and distributes the proceeds to its shareholders in a liquidating distribution, the corporation is subject to tax on the asset sale and the shareholders are subject to tax on the distribution. The distribution of assets in liquidation is treated at the corporate level in the same way as if the assets were sold for cash and the proceeds distributed to shareholders in exchange for their shares.[degrees] The shareholders would also have a tax on their gain measured by the difference between the liquidation proceeds (or the net fair market value (FMV) of the assets if they are distributed in kind) and the basis of the shares in their hands." Thus, whether the C corporation sells all of its assets and distributes the proceeds in liquidation or distributes all of its assets in liquidation, the tax consequences to the corporation and its shareholders are substantially the same. In both cases, there is double taxation. In general, the federal double-tax rate of 44.75% (plus applicable state tax net of any federal benefit from deducting state tax) should apply if the shares of the corporation are a long-term capital asset in the hands of the shareholders. In considering these alternatives, both corporate and shareholder tax attributes such as net operating or capital loss carryovers should be considered.

Described above is how inside gain (gain at the entity level) and outside gain (gain at the owner (shareholder) level) cause double taxation of C corporation earnings on the sale of corporate assets. But what would be the result if the sale of the business took the form of a sale of the shares of the C corporation by the shareholders? Would double taxation be avoided?

Business Limitations and "Practical" Double Taxation on Share Sales

Before even getting to the tax implications of the sale of shares of the C corporation, the general reluctance of a buyer of a corporate business to buy the shares cannot be denied. A buyer who buys the shares could inherit undisclosed and perhaps even unknown liabilities. While seller warranties may assuage a buyer's reluctance, they are only as comforting as the seller's ability to make good on them. There are cases, however, where the buyer may have no choice but to buy shares rather than the underlying assets.This can occur, for example, where the corporation holds a valuable asset such as a lease that is not transferrable, or where the corporate charter itself has value, as in the case of a bank or insurance company.

If the disposition of the C corporation business takes the form of a sale of its shares rather than a sale of the business assets, it might at first appear that there is only one level of taxation. The shareholders would pay tax on gain equal to the difference between the sales price and their basis in their shares.(12) Assuming that the shares are long-term capital gain property, the shareholders would face only a 15% federal tax. This is a good result as far as it goes, but it does not go far enough. There is still "practical" or "economic" double taxation because the share sale shifts the problem of "inside" or corporate-level gain to the buyer.

The buyer of the C corporation shares would have a basis in those shares equal to the amount paid (assuming FMV was paid),(13) but the assets of the C corporation (inside basis) would remain their historic basis.(14) Thus, the difference between that historic basis and the FMV of those historic assets remains subject to tax upon disposition or carries a tax cost in the form of reduced future depreciation or amortization. Financial accounting recognizes this by requiring a deferred tax liability to be set up in the accounts of the postacquisition entity.(15)

In essence, the buyer who buys shares will inherit a deferred tax liability (in the form of...