Selling Your Business? How To Minimize the Dreaded Double Tax Minimize Tax Strategy: C-Corps
Many attorneys who organize corporations do so as C-Corps as they may not be versed in the tax strategies of S Corps or the S election may not be appropriate for certain companies. Unfortunately, C-Corp profits are taxed once at the corporate level and again when distributed to the shareholders (i.e., the dreaded double tax). For years you’ve been able to avoid the double tax problem by giving salary increases to the shareholders, renting buildings or equipment from them and generally using the standard strategies that most C-Corp owners use to eliminate any corporate taxable income by year-end.
So what happens when you decide to sell your business and the C-Corp makes a windfall taxable gain as a result? The purchaser wants to structure the deal as an asset sale as almost all business sales in the PCO industry are structured this way. For the most part, purchasers are only looking to buy a customer list, avoid any unknown liabilities and write-off the purchase price paid for the business for tax purposes.
Minimize Tax Strategy: Eliminate the double tax in this situation:
1. Sell the shares of stock of the C-Corp to the buyer instead of the C-Corp. selling its assets to the buyer.
2. Make an S-Corp. election and wait 10 years (recent tax law changes shortened this 10 years to 5 years) to sell your business to avoid the 35% built-in gain tax imposed on converting C-Corp’s who fail to wait the full non-recognition period before selling the business.
The first solution sounds easy enough but a seller will soon learn that most buyers want to buy assets and get more favorable tax benefits. Additionally, in an asset purchase deal, liabilities stay with the seller and the buyer takes the business assets free and clear of potential unknown or contingent liabilities as mentioned above.
As for the second solution of making an S-Corp. an election, waiting 5 or 10 years to avoid the double tax problem is an inordinate amount of time and therefore impractical for a seller who needs/wants to sell in the next 1-3 years.
Minimize Tax Strategy – Sale of Personal Goodwill
Sellers faced with unacceptable alternatives have come up with a creative way to minimize the impact of the corporate level tax by separating the personal goodwill of the seller’s owners from the business goodwill of the corporation itself. The acquisition of a selling shareholder’s personal goodwill is tax efficient because it provides the buyer with the tax benefits he seeks while the selling shareholder only pays the lower personal capital gain tax on the personal goodwill sold thereby avoiding the dreaded double tax for that portion of the sale. The two seminal cases that approved this approach in 1998 were Martin Ice Cream Co. v. Commissioner, 110 TC 189 (1998), and Norwalk v. Commissioner, 76 TCM 208 (1998).
In Martin Ice Cream, a father and son had a dispute over an ice cream distribution business that was owned by a C-Corp with them as shareholders. To settle the dispute, the father and son caused the C-Corp to transfer a division of the operation to the father in exchange for his shares. The transaction was intended to be a tax-free spinoff avoiding the dreaded double tax but failed when challenged by the IRS and a corporate level tax was imposed on the value of the business (including goodwill) distributed to the father. However, the two challenged the IRS in Tax Court and were able to convince the Tax Court that a portion of the corporate assets being valued was in fact personal goodwill of the father and not business goodwill owned by the C-Corp, thereby reducing what would amount to the dreaded double tax. Similarly, in Norwalk, the IRS asserted that the corporation (an accounting firm) had business goodwill and upon liquidation, taxed the value of this asset at the corporate level again creating the dreaded double tax. As in the prior case the shareholders sued the IRS in Tax Court and the court found that the client relationships belonged to the shareholders in their individual capacity thereby making it personal goodwill and not business goodwill owned by the C-Corp.
Let’s quickly understand what goodwill is and why it makes a difference in the above situations being owned by the individual or the corporation. Goodwill is an intangible asset that can be purchased as part and parcel of a business sale and is commonly recognized as a trade name, an assembled workforce, the customer relationships created over time both with the company and with management or ownership. If the goodwill belongs to the owner individually a purchaser can purchase that goodwill from him with any tax consequences (Capital Gains) paid by the selling individual (a single tax). If the goodwill belongs to the corporation, it must be purchased from the corporate seller subject to tax at the corporate level, if a C Corp or in the built-in gain waiting a period of a C Corp making an S election. When the corporation is liquidated there is an additional tax at the shareholder level (the dreaded double tax). If the goodwill belongs to the individual, the dreaded double tax can be avoided upon sale.
So, how does one differentiate Personal Goodwill vs. Business Goodwill if they seem to be intertwined? The partial listing of certain identifiable characteristics below highlight part of the analysis a taxpayer needs to undertake to make any conclusion whether the Martin Ice Cream case is helpful or not in establishing that a business owner has significant personal goodwill that is personally owned rather than a business asset of the C-Corp.
Minimize Tax Strategy: Personal Goodwill (Sample of Characteristics)
- More common in companies with a higher portion of intangible assets
- No non-compete agreement exists between the selling shareholder and the corporation
- Business is dependent on owners personal relationships, reputation, skills, know-how
- Owner’s service is important to the sales process
- Owners are very involved with the business operations
- Loss of owner would negatively impact revenues/profits of the business
Minimize Tax Strategy: Business Goodwill (Sample of Characteristics)
- Existing Non-compete agreements
- Larger business with formal organizational structure, processes, and controls
- Sales are generated from company brand name recognition, the company sales team
- Manufacturing businesses or companies that are asset-intensive
- Selling shareholder is not intimately involved with the business
- Loss of owners would not materially impact revenues/profits
Minimize Tax Strategy: View of IRS Today and Recent Cases
The IRS scrutinizes these types of transactions and can and will challenge them if there is little or no proper documentation detailing the business versus personal goodwill. If the IRS determines that the personal goodwill was a last minute Minimize Tax Strategy, will be denied.
Since 2008 there have been several cases where taxpayers unsuccessfully attempted to apply the Martin Ice Cream concepts and lost primarily because of lack of preparation and documentation. However, the Martin Ice Cream concept is still alive and a viable strategy as long as taxpayers take care to (i) get professional appraisal(s) that value the company assets as well as supports the personal goodwill allocation; (ii) properly document the strategy from the beginning and not be a simple after-thought; (iii) be careful the actual facts support the intended Minimize Tax Strategy in terms of distinguishing the types of characteristics; and (iv) be sure the seller does not have a non-compete agreement in place with the corporation.
Although the significant risk of challenge exists in adopting the sale of personal goodwill, case law still supports technique as long as a taxpayer does their homework to stay away, if possible, from the mistakes and bad facts outlined in the recent cases where taxpayers were defeated. So if you are considering a sale of your business and you are in a situation where double taxes apply and you want to explore the above strategy, make sure you work with an accountant or attorney who fully understands the concept and can implement the most effective tax minimization strategy for your pest control business. Visit our division PCO M&A Specialists for more information.