Volume 7 Issue 3-- May/June 1995
As crazy as it sounds, many small corporate business owners needlessly pay two taxes when they sell or distribute major assets (usually when terminating the business).
In previous issues, we considered the sale of Howard & Sons, Inc., a small incorporated garage. Let's suppose that some years ago Howard put $20,000 into a corporation, which used the money to buy land and erect a garage (now fully depreciated) on it, near what is now an important intersection. Recently Howard has been asked if he would sell the land for $1,200,000
Howard gasps when told that more than 50% of the gain will go to the IRS, ignoring state income taxes! How can this be, he mutters in anger?
The reason is simple. Howard & Sons, Inc. has to pay tax on its corporate gain, and then Howard has to pay individual income tax when he gets the remainder of the sale proceeds. Ignoring expenses and state and local taxes, Howard ends up with less than 49% of the sales price:
|Corporate level tax (@ 35%)||($413,000)|
|Net after Federal Tax||$767,000|
|Individual tax (@ 28%)||($214,760)|
Is this result inevitable? NO!
With proper planning, Howard could have saved about 1/3 of the sales proceeds. Howard could have done one of two things to avoid the double tax: (1) he could have bought the land in his own name and then rented it to the corporation, or (2) elected to have Howard & Sons, Inc. be taxed as an "S corporation."
For a variety of reasons, it would have been better for Howard to have owned the land individually. Had he rented the land to his corporation he would have (or should have) received rental income and paid only one individual capital gains tax when the property was sold. If the land were owned individually then the tax would have been $330,400 ($1,200,000 less the basis of $20,000 = $1,180,000 x 28%) in contrast to the $627,760 combined tax shown above. (Note again that state and local taxes are not included.)
Tragically, this simple lesson is ignored over and over again. While it is relatively easy to let the corporation own and pay the mortgage on real estate used by the corporation, in the long run the tax consequences are unfavorable.
The second alternative would have been to form an S corporation. "S corporations" are corporations that make an election to be taxed under Subchapter S of the Internal Revenue Code, which allows the electing corporation to avoid being taxed at the corporate level and instead be taxed like a partnership.
If Howard & Sons, Inc. had elected S status when it started, the corporate level tax could largely have been avoided. A sale by Howard & Sons, Inc., as an S corporation, would have roughly the same results as if Howard had sold the land individually.
Can Howard elect S status now and avoid the double tax? Yes and no.
If S status is elected now there is only one tax on current ordinary gains.
For corporations that convert to S status, capital gains, like land, are subject to a special corporate "built in gains" tax equal to the difference between the fair market value of the land on the date of the S election and the basis of the assets on that date.
In the case of Howard & Sons, Inc., the built-in gains tax would be a tax of 35% on $1,180,000 that would be due from the corporation if it sold the land at any time within 10 years of conversion. In this situation, converting to S just before the sale would accomplish little since Howard & Sons, Inc. would pay approximately the same corporate capital gains tax.
The "built in gains" tax disappears 10 years after the election. Howard might want to consider both long and short range planning if he wanted to sell in the future as opposed to now.
Even if the land is sold before 10 years, S status could still avoid the double tax on all appreciation that occurs after the date of conversion to S status.
There may also be potential immediate tax benefits to S status. If Howard & Sons, Inc. is currently paying income tax on profits not taken out of the corporation there is also a double tax on such retained earnings (a surplus) when eventually distributed to Howard as salary, bonus, or dividends. If S status is elected such earnings are taxed only once, at Howard's individual level, even if the earnings are not distributed to Howard.
Generally speaking, don't title major assets, such as land, in a regular corporation without careful planning. Putting such assets in a small C corporation is not legally prohibited, but it may make bad economic sense.
By Tax and Business Professionals, Inc.
9837 Business Way
Manassas, VA 20110
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