This article reviews the annual and long-term income tax burden on businesses in light of their distribution policy and choice of entity for business income tax purposes. First, it examines the annual income tax burden and provides a simple overview of sale proceeds regarding reinvested earnings. Next, it reviews how the type of business sale—cross-purchase or redemption—interacts with the choice of entity for business income tax purposes.

How Distribution Policy and Choice of Entity Interact

Annually, C corporations that distribute all their earnings have the highest income tax burden of any type of entity. A C corporation that distributes half its earnings has mixed annual results relative to pass-through entities such as S corporations and partnerships (including LLCs). A C corporation that distributes none of its earnings has a lower annual income tax burden than any other kind of entity. Among the factors that can come into play in providing different tax rates for pass-through owners in the top bracket are:

• Self-employment tax or 3.8% net investment income tax
• Up to 20% deduction for qualified business income

C corporation stock does not receive a basis step-up for reinvested earnings, whereas ownership in a pass-through entity does. Thus, when C corporation stock is sold, its reinvested earnings embedded in the sale price will be taxable capital gain, whereas for a pass-through entity, reinvested earnings embedded in the sale price will not be taxed. In other words, a C corporation reinvesting earnings provides an annual tax benefit but creates a tax liability for the shareholder when the stock is sold. Of course, the IRC § 1202 exclusion from gain on the sale of qualified small business stock (QSBS) and basis step-up at death can reduce or eliminate that problem. However, if that amelioration does not occur, when adding tax paid on sale, a C corporation’s earnings are taxed at a higher cumulative rate than owners of pass-through entities, but deferring the tax can help the entity grow faster than its pass-through counterpart.

From an estate planning viewpoint, a pass-through entity is a great fit for a sale to an irrevocable grantor trust, whereas a C corporation is a poor fit. An irrevocable grantor trust uses tax distributions from a pass-through entity to pay down the note owed to the grantor, and the grantor uses the note payments to pay tax on the trust’s earnings. A C corporation pays its own taxes rather than making tax distributions, and dividends of any remaining earnings would destroy the corporation’s lower annual income tax rates. Thus, a trust buying C corporation stock would not be able to access the company’s annual earnings to repay the note.

How Type of Sale and Choice of Entity Interact

This section focuses on a seller-financed sale, although many of the principles apply to any sale.

The buyer will use the business earnings to repay the loan—whether the seller or a third party is the lender. The buyer directly or indirectly pays tax on these earnings, and the seller pays tax on the gain on sale, so double taxation tends to occur—even when using pass-through entities.

If a C corporation shareholder buys stock from another shareholder (a cross-purchase), triple tax applies: C corporation tax on earnings, the buyer’s tax on dividends used to buy the stock, and the seller’s tax on sale proceeds.

If a C corporation buys stock from a shareholder (a redemption), double tax applies: C corporation tax on earnings and the seller’s tax on sale proceeds.

A redemption increases all remaining shareholders’ percent ownership proportionately. If a shareholder intends to increase their proportion of ownership, they must use a cross-purchase instead of a redemption, except to the extent that various other shareholders are also being redeemed. A buyer who is not a shareholder might consider buying a modest portion of shares and have the corporation redeem all of the other shareholders.

If the sun, moon, and stars align properly, IRC § 1202 may provide an exclusion for part or all of the shares sold.

For an S corporation, double taxation applies whether a redemption or cross-purchase is used: the continuing owners pay tax on the earnings, and the seller pays tax on the gain on sale of the stock.  However, any earnings reinvested during the years that preceded the sale will provide tax basis to the seller, which is an advantage relative to a sale of C corporation stock.

Many partnerships would have the S corporation double tax as well. However, a service partnership, an IRC § 736(a)(1) arrangement—generally a preferred partnership interest— would generate only one layer of tax. That’s because the seller is taxed on the partnership’s earnings instead of the buyer being taxed on the earnings. Because the seller is taxed on the partnership’s K-1 income instead of at capital gain rates, the seller would require a higher purchase price, but the parties have more money available with no capital gain tax being incurred. The trade-off is that the partnership’s assets do not get a basis step-up as a result of the seller’s gain, but that basis step-up generally would apply only to assets with a 15-year (or longer) amortization period, which the parties tend to discount because those who buy businesses are looking for a much quicker payoff.

A corporation can use a deferred compensation arrangement to replicate the tax results of an IRC § 736(a)(1) arrangement. The founders receive retirement payments, and the obligation to make retirement payments is a balance sheet liability that reduces the company’s value and therefore reduces the sale price. The corporation (or continuing S corporation owners) receives a compensation deduction, and the founder receives ordinary income. Beware, however, that the arrangements must comply with IRC § 409A, and the balance sheet liability may violate loan covenants or cause a construction company’s fidelity bond to be lost.

When a service business is an S corporation without noncompete agreements, the author has converted the business to a partnership, taking the position that goodwill is a personal rather than an institutional asset. The S corporation takes back a general partner interest with a capital account equal to the net asset value (using fair market value) of the S corporation assets, and those with personal goodwill and other key person receiving a profits interest, which can later be sold using an IRC § 736(a)(1) arrangement.

A partnership redemption under IRC § 736(b) is more favorable than an installment sale:

• The seller applies all sale proceeds against basis before reporting gain.
• The seller does not pay interest on deferred tax that applies to installment sales in excess of $5 million.
• If the seller dies during the payment period, the seller’s partnership interest receives a new tax basis, eliminating gain on post-mortem payments.

Finally, consider that the buyer prefers a basis step-up in the business’s assets—especially in a capital-intensive business. If the buyer does not receive that tax benefit, the buyer often pays less to reflect the loss of tax deductions. Thus, by receiving a lower sale price, the seller of QSBS inherently pays tax on the sale of the business assets and might or might not be able exclude from federal and state income tax gain of the sale of the QSBS. In contrast, when all of the stock in an S corporation is sold, an IRC § 338(h)(10) or 336(e) election is a deemed asset sale, and all gain is taxed as capital gain (applying IRC § 1060). The seller pays tax on the deemed sale of assets rather than taking a haircut on the sale price. However, generally, the seller pays no tax on the sale of the stock, because the gain on the deemed asset sale increases the basis of the seller’s stock; this dynamic, which is effectively an exclusion of gain on the sale of the stock, applies without jumping through any IRC § 1202 requirements and limitations. Thus, the financial results when all of stock in an S corporation is sold often exceed those when selling QSBS (essentially shifting the QSBS analysis to the last two initials of QSBS). However, if less than 80% of an S corporation’s stock is sold, then the deemed asset sale is not available, and QSBS may be more favorable than stock in an S corporation.

Conclusion

When selecting the type of entity, always consider an exit strategy.

Throughout the lifetime of a business, consider whether to tweak a business’s structure to plan for an optimal exit strategy.