Tax Benefits of an S-Corporation
From Darren Dahl, American Express Open Forum
If you have ever wondered about the differences in incorporating your small business as either a C-corporation or an S-corporation, pay attention. What follows could save you thousands, if not millions, of dollars if you ever decide to sell your business.
The basic difference between the two business entities really comes down to taxes.
C-corporations pay a corporate tax on their earnings, and their shareholders pay a personal tax on whatever dividend income they receive.
S-corporations, which are also known as flow-through entities, pay out earnings as dividends to their shareholders, who then pay a personal tax on the income they receive.
Ultimately, an S-corporation can be more attractive because you’ll most likely end up with more money after you pay taxes.
For example, in a company with a million in pretax income, a C- Corp would end up paying about $400,000 in corporate taxes and the owners would also pay personal income taxes of at least 15%, or $90,000 on the net income of $600,000. Total C-Corp tax liability is thus $490,000. Net proceeds to shareholders in the C- Corp would be $510,000. In an S-Corp there would not be a corporate tax so the S-Corp net income would be $1,000,000 compared to the C-Corp’s $600,000. However, the S-Corp owners would pay $400,000 in personal taxes so their net after tax proceeds to shareholders would total $600,000, or $90,000 more than in the C-Corp owners.
Because shareholders in C-corporations are essentially taxed twice, once at the corporate level and again on a personal tax return, there has been an explosion in the number of S-corporation filings in recent years. In 1995, for instance, there were 2.15 million tax returns filed by S-corporations as compared to 2.63 million C-corporations, according to IRS figures. By 2008, those numbers had risen to 4.44 million S-corporations as compared to 2.54 million filings for C–corporations.
But the differences don’t stop there. What some business owners and their accountants also tend to overlook is how, when it comes to selling your company, your decision about how you incorporated comes into play in a significant way, says Anja Bernier, president of Efficient Evolutions, a company sale and acquisition consultancy in Newton, Mass.
Businesses can be sold one of two ways: in a stock sale or an asset sale. In a stock sale, the buyer is purchasing all aspects of the business, including all assets and liabilities. In an asset sale, on the other hand, a buyer is acquiring the assets and liabilities specified in a contract, but the seller retains the “legal shell” of the company, including its legal liabilities, says Bernier. When it comes to selling small businesses (which Bernier defines as any business worth up to about $5 million), more than 90% of such transactions are asset-based.
This distinction matters because, as a general rule of thumb, if you were to compare two similar businesses that were part of an asset sale, one an S-corporation and the other a C-corporation, “the S-corporation could be valued significantly higher,” says Bernier.
Why? Because S-corporations don’t pay taxes on dividends or capital gains, only their shareholders do, which offers advantages when it comes time to sell your business, says Bernier.
Said a different way: during an asset based sale, shareholders in an S-corporation usually end up with significantly higher after-tax proceeds from the sale of their business than their C-corporation-owning peers – which can make them more valuable when determining their fair market value. “An S-corporation is more attractive to most buyers because you generally have more money in your pocket after you pay your taxes,” says Bernier.
Given this difference, then, it would seem obvious that those more than 2.5 million businesses that continue to file as C-corporations have more than a few reasons to convert themselves into S-corporations – which is a fairly straightforward process. The rub, however, is that there is a seven-year moratorium placed on any such transfer. In other words, if you, as the owner of a C-corporation, want to capture that extra value from filing as an S-corporation when it comes time to sell your business, you need to wait seven years for that switch to take effect.
This fact should be of particular interest to the millions of Baby Boomers out there who may be reaching an age where they want to cash out of their business that, in all likelihood, is the single biggest component of their retirement nest egg. “I run into business owners all the time who get bad advice from their accountants about this issue,” says Bernier. “These days, there are very few reasons for a small, privately-held business to be a C-corporation. The point is that if you, as a business owner, don’t make this switch, you could be leaving an awful lot of money on the table when you sell your business.”
The key takeaway, then, is that if you are the owner of a C-corporation, don’t walk – run – to your accountant’s office to discuss whether you have the best corporate structure in place for your specific business and exit plan.