There really is no good reason for most small, privately held tire dealers to be organized as C-corporations (C-corps) anymore.
The problem with this in M&A is that most buyers want to purchase a seller’s assets so they can be marked up and depreciated or amortized, plus buyers don’t want to unknowingly buy hidden liabilities they might incur when buying stock.
From a C-corp seller’s perspective, in an asset sale the seller is taxed three to four times.
First, the corporation pays income tax on the gain. Second, the shareholder pays a dividend tax to get the money. And third, since C-corps are considered passive investments, the seller also pays a 3.8% NIIT (Obamacare) Tax. Fourth, in states that also have a state income or capital gains tax, a C-corp seller of assets gets taxed again.
A seller of a profitable C-corp is far better off with a stock sale.
I’ve been involved in three stock sales of tire businesses, so they can be done. But your buyer had better really want your business and you had better seek active competition in your selling process to pressure a buyer to make that stock sale happen.
It is far easier if a C-corp changes to an S-corp or LLC five years prior to selling.
Jonathan Wilfong is a partner at Focus Investment Banking and was also a former partner at the tax and accounting firm Price Waterhouse.
Wilfong explains that prior to 1974, owners of closely held companies, even sole owners, preferred C-corps because you could have tax deductible pension or profit-sharing plans that were “top heavy.”
With as few as two participants, says Wilfong, “An owner could make a million dollars, take out $200,000 in taxable salary and then put $800,000 in a retirement plan — and get a tax deduction so that the C-corp income was zero.”
With the 1974 Employee Retirement Income Security Act (ERISA), the government eliminated top-loaded, discriminatory plans. “All of a sudden, one of the big tax advantages to a C-corp simply evaporated,” says Wilfong.
Back then, C-corps were also exempted from paying tax on the first $125,000 of income.
Wilfong recalls representing the multi-location company Pick ‘N Pay Shoes. “They had several thousand stores at one time and every location was a separate C-corp,” he says. “This was simply good tax planning, but Pick ‘N Pay Shoes had 20 people in a tax department doing thousands of corporate returns and state returns annually. This exemption was phased out in the early 1970s as a result of the Tax Reform Act of 1969 and another good reason to be organized as a C-corp went away.
“Now here’s where I always get upset at CPAs,” continues Wilfong. “They came out with S-corps — and we also now have LLCs — and said, ‘If you don’t have more than 35 individual shareholders, we’re going to tax you at your individual rates with a complete pass through. And by the way, you’ll still have the corporate protection against liabilities that C-corps are known for.’
“With most closely held corporations, as soon as they came out with the S-corp rules, any CPA worth his salt should have immediately advised his clients to convert. I’ll tell you why. The government also said, ‘We don’t want to penalize everybody that converts.’ “Technically, there would be a step-up in the cost basis if you had equipment that’s fully depreciated and in writing up other assets, you’d have what they call a built-in gain. The government said, ‘Well, we don’t want to penalize people doing that, but we also don’t want them to convert to an S-corp the day they sell their corporate entity, so we’re going to give them five years.’
“If you could get five years distance between your S-election and when you were a C-corp, then no harm, no foul when you sell. It’s like you were always an S-corp for capital gains tax purposes,” says Wilfong.
“I sat in a client meeting four years ago with a managing partner of a regional CPA firm and three of his partners and basically told them, ‘You gave incompetent professional services. You all should be ashamed and embarrassed what you did to this company by letting them stay as a C-corp. Granted, there weren’t S-corps around when the company was founded, but you replaced a local CPA who didn’t know the difference and you picked this client up eight years ago. The first thing you should have told him to do is convert to an S-corp and now he’s paying the price.’
“The client took me aside and said, ‘Man, that was kind of harsh.’
“I said, ‘Well, listen, unless we can figure a way out, if this is going to cost you a million bucks in taxes, you tell me, was it too harsh?’ And he was like, ‘Oh no.’”