Volume 3 Issue 3-- May/June 1999
Why would this Newsletter ask such a ridiculous question when we all know we are immortal? The reason is simple -- few business owners like to pay tax twice when they sell their businesses. If you can wait 10 years, the double tax can be avoided.
When a regular C corporation sells or liquidates its assets, there is a corporate income tax based upon the difference between the Fair Market Value of the assets (usually the sales price) and the corporation's cost basis in the assets (usually purchase price less depreciation). Let's say, a corporation, Landco, sells a piece of vacant land, its only asset, for $100,000. If Landco paid $9,000 for that land, Landco's taxable gain is $91,000. State and federal tax will have to be paid on that gain (assuming no commissions, sales expenses, or depreciation).
Using 1998 U.S. corporate tax rates and a Virginia tax of 6%, Landco's tax would be $24,650 (Federal $19,190, Virginia $5,460). Let's assume further that the sole stockholder, Melvyn Snively, will receive all the sale proceeds after the corporate tax is paid. Only $75,350 is left to distribute to Snively.
If Snively invested $5,000 in Landco when it was incorporated in 1954, that amount is his cost basis in his Landco stock. He can subtract $5,000 from the sale proceeds; the remainder, $70,350, will be capital gain to him. For simplicity sake, let's assume a combined Virginia and Federal tax of 25%. So, Snively's income tax on the liquidating distribution is $17,588 (75,370 - 5,000 x 25%). Corporate and individual taxes are about $42,238 of the $100,000, or 42%. Stated differently, Snively gets only 58% of the sales price.
Back in 1954, Snively probably should not have purchased the land in the name of Landco. Generally, smaller businesses are better off having the principals own real estate and lease it to their corporation. By doing so, there is no double tax when a property is sold.
Another choice available to newly formed corporations is to elect S status initially or form a Limited Liability Company (LLC). S corporations, like partnerships and LLCs, do not pay tax at the entity level. Gains and losses flow through to the underlying equity owners.
Assuming Snively does not want to sell Landco's land today and can afford to wait 10 years, there is yet another alternative. Current Federal tax law permits stockholders of C corporations to elect S status. Since S orporations are not taxable entities, there is only one tax (to the stockholders) if the land is sold 10 or more years later.
What if Snively elects S status, but cannot wait 10 years to sell the real estate? Then, there is double tax on the built-in gain. In the example, the built-in gain is $91,000. If Snively elected S status and sold immediately thereafter for $100,000, the tax effect to Landco-Snively would be the same as in the above example.
What if the property appreciated to $205,000 by the year 2005, and Snively sold the land then for that price. The $105,000 of appreciation between 1999 and 2005 would not be subject to the double tax. The built-in gains computation is a snapshot of the gain existing at the time the S election is filed. Appreciation thereafter is subject to only one tax.
Recently a client came to me with a situation involving C corporation-owned land purchased for less than $50,000 in the 1950s which has now appreciated to approximately $30 million. In such a situation, avoiding the double tax, if possible, or planning for the reduction of it during a potential sale during the 10-year period, is critical.
For those clever enough to think that the double tax can be avoided by having Snively sell stock of Landco to a would-be purchaser, you are correct. Because the buyer of the stock of Landco gets Landco's basis in the land, $9,000, not the $100,000 paid for the stock, the first level of tax described above will still be due unless the buyer of the stock elects S status and waits the 10-year period. An astute buyer would demand the value of the stock be discounted because of this future tax liability.
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