The owners of a successful distribution company wanted advice on how to maximize cash flow during ownership and when they sell the company in the future. They also hoped to streamline negotiations and minimize taxes as much as possible. We determined that a conversion from a C-Corporation to an S-Corporation could result in significant tax savings, an easier negotiation and potentially more takeaway cash upon sale.
 
S-Corporations are pass-through entities taxed once at the shareholders' ordinary tax rate, whereas C-Corporations are taxed twice; first up to 35% on corporate earnings and a second time at capital gains rates (15% in 2010) for distributions made to owners. Converting to an S-Corporation eliminates one level of Federal tax.
 
Upon sale of the company in an asset sale, S-Corporation gains are also taxed once to the owner. However, gains are taxed twice if assets are sold out of a C-Corporation. Since many privately held companies engage in asset rather than stock sales, a conversion to an S-Corporation could facilitate negotiations while minimizing taxes to the seller.
 
There is no free tax lunch on conversion, however. IRS Code Section 1374 also imposes a corporate level tax on gains earned up to the conversion date, referred to as built-in-gains (BIG). This tax is imposed if the sale occurs within 10 years of conversion (seven years for 2009 and 2010) so it is critical to calculate the built-ingains on all assets as of the conversion date. 
 
Planning Note 1: One benefit of doing a conversion now is to lock in potentially lower built-in-gains reflected in today's depressed economic climate. The difference between the lower relative gains now vs. potentially higher gains on a future sale will be taxed once at capital gains rates. 

 
Result #2: We prepared an in-depth and supportable business valuation report to determine the built-in-gains at the year-end conversion date. The gains were allocated between assets to assist with future calculations and to reduce risk of negative results from any IRS audit upon company sale. Our tax department helped the owners understand the complex tax implications during ownership and upon sale so they could make the decisions with greatest benefit to them.
 
Planning Note 2. A C-Corporation has three and a half months from its year-end to make the election to convert from a C-Corporation to an S-Corporation. The tax issues are complex. Please call if you would like more information about this topic.
 
Our Business Transition and Valuation Services department specializes in business owner exit planning and implementation, merger and acquisition transaction advice, and business valuations for a variety of purposes. Please contact Allan Vander Hamm at 425.289.7613 or avanderhamm@bpcpa.com to learn more.