In his regular email newsletters on security and home automation, attorney Ken Kirschenbaum (Kirschenbaum & Kirschenbaum) enlists his alarm-industry tax expert Mitch Reitman (Reitman Consulting Group) to answer a question from a dealer who wants to sell his business. Both Kirschenbaum and Reitman are advisors and contributors to CE Pro's sister publication Security Sales & Integration.

Dan the Dealer

I HAVE A HUGE DILEMMA. We've been toying with the idea of selling sometime in the future. However, I've been told because of the type of corporate entity we have we are screwed! 

Probably 20+years ago we incorporated as a C Corp. Because of the double tax consequences on the sale of a C Corp. it's almost not worth even selling. I've counseled with some of the brokers in the industry and they told me that to try to convert a C Corp. to an S Corp.(to avoid the double tax) now can take up to 10 years.

What do we do so Uncle Sam doesn't double dip and make this exercise futile?

Reitman's Response

ALL IS NOT LOST. Dan is correct that when a C Corporation sells assets, the gain on the sale is taxed at the corporate level and the C Corporation (not the shareholders) receives the proceeds. When those proceeds, less the corporate taxes (state and federal) are distributed to the stockholders, they are treated as dividends.

This means, not only are they taxed again, they are taxed as ordinary income and at rates as high as 35% for federal taxes alone. It is not unusual for the total tax rate to exceed 60% on the sale.

One way to avoid this is to convert to an S Corporation. An S Corporation is not a tax-paying entity. The taxes on profits are paid by the individual shareholders.

An extra bonus is that when the assets of the business (think monitoring agreements that document the relationship between the corporation and its customers) are sold, they are taxed as capital gains to the shareholders. Capital gains are generally taxed at 15% and 20% for Federal Income Tax purposes.  Depending on the state, this can mean an overall tax rate of 15 – 30% as opposed to the 60% rate for the sale of a C Corporation.

So why not just elect S Corporation status (it’s easy), sell, and take advantage of the “loophole?”  

Well, Congress and the IRS may not seem smart, but they aren’t dumb. If a corporation elects Subchapter S status and then tries to sell its assets, the gain on the sale is considered “Built In Gains” and taxed as if the S Corporation was still a C Corporation. Traditionally the “holding period” for Built In Gains was ten years. A few years back the “Bush Tax Cuts” temporarily reduced the holding period to five years, and this was extended numerous times.

The good news is that on December 16th of last year Congress “permanently” extended the five-year holding period. Bottom line, if you elect Sub S status, you can sell in five years and avoid the tax hit. In fact, if you elect by March 15, your “clock” can start running retroactively, on January 1, 2016. Electing is easy, but don’t just go out and do it.

There are numerous considerations so talk to your tax advisor or call us (817-698-9999). We have ways to guide you through this process and minimize or even eliminate the effect of Built In Gains.

Dan didn’t do anything wrong other than to listen to a tax advisor that didn’t understand our industry.  If you are still operating as a C Corporation, ask your tax professional why.  If they can’t give you a good reason, call us.