Tax minimization is likely a key part of running your business. When you can position your company to pay only what it must in taxes, it could give you more money to take home or reinvest in your business. But have you begun to prepare how you’ll minimize your taxes when you eventually leave your business?
Selling your business comes with tax implications that can change the trajectory of your post-exit life if you aren’t prepared for them. Let’s look at some of the foundational elements of preparing your tax minimization strategy in the context of eventually leaving your business.
Know Your Entity
Sun Tzu once said “Know your enemy.” When it comes to tax minimization strategies for business owners, it’s crucial to know your entity. Because if your business is the wrong entity, it can become the enemy of tax minimization.
For owners of small to mid-sized businesses, there are five different types of business entities that you may consider:
- Sole Proprietorship
- Partnership
- C Corporation
- S Corporation
- Limited Liability Company
If you aren’t sure which entity your business falls under, your Advisor Team—specifically, your tax advisors and attorneys—can help you find out. And knowing the type of entity your company is could have huge implications for your tax minimization strategies.
For example, in a general partnership, you and your co-owners would be personally responsible for any taxes the company must pay. However, if your company were a corporation, your business would be considered a separate entity, and thus the business owner would not be personally responsible for its tax or debt obligations.
For today’s discussion, we’ll focus on two of the more common entities that small to mid-sized businesses tend to be—C corporation or S corporation—and how each entity can affect your tax minimization strategies.
Starting as a C Corporation
Many small businesses begin as C corporations. In terms of tax minimization, C corporations may not be the best strategy for many small to mid-sized businesses. That’s because C corporations face double taxation. With a C corporation, both the business owner and the business itself pay taxes. Currently, C corporations pay a 21% corporate tax rate. Then, business owners themselves must pay taxes based on any earnings they receive from the corporation.
So, if you wanted to sell your business as a C corporation, you could end up paying two taxes on the funds you receive: once for the business itself and once based on your personal income changes from the sale.
This does not necessarily mean that C corporations are always a bad idea for business owners. For example, if you wanted to access foreign investment in your company to help it grow, a C corporation would allow you to do so. Likewise, if you consistently intend to reinvest all profits back into your company and take no distributions whatsoever, a C corporation may help you minimize your taxes.
Always consult with your tax advisor when considering the type of entity you would like your business to be. But generally, small to mid-sized businesses that are C corporations can create tax disadvantages for business owners when they are ready to sell their business, primarily due to double taxation.
Converting to an S Corporation
Many small to mid-sized business owners find greater tax advantages when they convert their C corporation to an S corporation. An S corporation is what’s called a “pass-through entity.” Simply, this means that S corporations pay no corporate tax. Instead, the owners of the business pay taxes from business profits on their personal income.
In the context of exiting your business, the tax advantages of selling an S corporation are pretty straightforward: You’re only taxed once when selling an S corporation versus being taxed twice when selling a C corporation.
Though it’s fairly simple to begin the process of converting a C corporation to an S corporation—you file Form 2553—it can take years for the tax consequences of your conversion to settle.
For example, if you convert a C corporation to an S corporation and then sell your company within 5 years after conversion, you may still have to pay a Built-in Gains (BIG) tax, which is a 21% tax on any assets that appreciated in value while the company was a C corporation. In other words, if you convert a C corporation to an S corporation to avoid double taxation, there’s essentially a 5-year period before you are no longer on the hook for the BIG tax.
So, while there are tax advantages to selling an S corporation compared to a C corporation for small to mid-sized business owners, in order to take full advantage of those advantages, you need time. In short, if you plan on exiting your business within the next 5 years but have not yet converted your C corporation to an S corporation, you may feel the sting of double taxation via the BIG tax.
From Entity to Deal Structure
Once you’ve established the type of entity you need your business to be to leverage tax advantages, it’s also important to consider the structure of your eventual deal.
Deal structures are complex and will depend on your specific situation and needs. However, it’s important to note that you will likely face two common types of deal structures: an asset sale or a stock sale.
Briefly, an asset sale is when a buyer purchases specific things about your business, like equipment and inventory, but does not take on the business’s liabilities or debt. In many asset sales, you retain ownership of the business itself.
In a stock sale, a buyer does take on the company’s debts and liabilities, and you no longer own the business. Stock sales usually have more tax advantages for business owners, primarily because gains from sales of stock are taxed at capital gains rates, which are typically lower than ordinary income rates that you would have to pay in an asset sale.
Leverage Your Advisors
As you plan for your eventual business exit, here are a few key points to keep in mind:
- Your business entity can have big effects on how much money you take home when you eventually exit your business.
- Reaping the benefits of converting your business entity from a C corporation to an S corporation can take time, which means that you should start planning well in advance if you intend to convert.
- Deal structures have tax implications. And buyers who are willing to pay top dollar will likely have a team of professionals who negotiate to do everything they can to minimize their tax liabilities. You should consider arming yourself with similar expertise instead of trying to negotiate with professionals by yourself.
Tax implications are complicated, and that’s before you consider each state’s tax laws and how they can affect your tax minimization strategies. Fortunately, you don’t have to approach tax strategies alone (and we argue that you shouldn’t approach them alone).
Above all else, you should avoid ignoring what the tax implications of selling your business might be until the last minute. Just because it’s complicated doesn’t mean it’s impossible. With the right expertise and enough time, you can take steps to minimize your tax obligations and maximize your wealth from the sale of your business.
We strive to help business owners identify and prioritize their objectives with respect to their businesses, their employees, and their families. If you have questions on this topic, we can help with more information or a referral to another experienced professional.