In my last entry, I provided a top level discussion of what an S Corporation is. Here I will provide an example to show how important electing S Corporation status could be when you look to sell your business to an outside buyer.
Perhaps the greatest reason for electing “S” status is the planning for the exit strategy; the liquidation event. Let me take you through an example that will illustrate the issue. In the first example let’s say that a contractor can sell her business for $5MM dollars. She owns the company, a C Corporation in this case, and the proposed buyout is an asset purchase (the prospective buyers do not want to purchase the stock as they want no part of any contingent liabilities, construction defect issues, etc.) The assets that are being purchased are owned by the C Corporation (Jane owns the stock of the C Corporation, not the assets themselves). The C Corporation sells the assets for $5MM and since the tax basis for the assets being purchased is nominal, we’ll assume that it’s all taxable gain. The full $5MM is taxed inside the C Corporation at 40% (Fed and CA combined) therefore the tax liability is $2MM. The remaining $3MM in cash is distributed out to Jane in the form of compensation and is taxable to her, again at 40% combined tax rates. The liability on the $3MM she takes out is therefore $1.2MM leaving her with roughly $1.8MM on the $5MM sale. That doesn’t seem like a great result.
Let’s go through the same example but this time with Jane having elected S Corporation at the time she started her business. The prospective buyers again are only interested in purchasing the assets of the corporation for $5MM. Since the S Corporation is not an income tax paying entity, no income taxes will be due by the corporation. In California however, S Corporations must pay a 1.5% franchise tax based on taxable income, so Jane’s S Corporation will owe $75,000 to the state of California on the company’s $5MM gain on the asset sale (again assuming nominal tax basis in the assets). Let’s set the $75K liability aside until the end of our example to keep the math easier. Jane wants to retire on this transaction so she pulls the $5MM out of the S Corporation and again, at the personal combined tax rate of 40%, the tax liability is $2MM with $3MM remaining. When we consider the $75K CA franchise tax discussed above, the net take home for Jane is $2,925,000. The difference between the take home for Jane owning a C Corporation ($1.8MM) and an S Corporation ($2.925MM) is over $1MM! Stated another way, the effective tax rate after the double taxation as a C Corporation is approximately 64% while the tax rate for the S Corporation transaction is approximately 42%. The difference is significant and can actually affect whether a transaction is actually done. Owners don’t care as much what they could sell their company (or its assets) for, they care much more about what they can take home after taxes. Owning an S Corporation will generally provide for a maximization of the “take home” amount and provide a greater likelihood a transaction can be structured to a seller’s liking.
As I write this, there is not a meaningful difference in the top tax rates for corporations versus individuals. Many years ago the top tax rates for corporations were significantly less than those for individuals, making the decision to be treated as an S Corporation a more challenging one. Time will tell if a divergence in those rates will affect whether “S” status makes sense. For now I’d suggest in the vast majority of cases, operating as an S corporation is the best entity choice for contractors.