« Sunlight good. Blue light bad. | Main | Digital marketing is a huge part of public relations »

The C corporation dilemma and how not to solve it.

Joe Kristan is a CPA at Roth & Company P.C.

One big reason the business world has moved away from using "regular" corporations is because they pay two taxes on their income. These "C corporations," as tax geeks call them, pay taxes on their income as it is earned. If they distribute the after-tax earnings to their shareholders as dividends, the owners pay tax on their 1040s. If the owners sell their shares, they pay capital gain tax on the undistributed earnings embedded in the stock price.

100_0263When it comes time to sell, C corporation owners face this issue in a big way. Buyers usually want to buy assets. That way they get to amortize or depreciate the purchased assets at their fair value, rather than their historical cost. They also don't have to buy any hidden sins that would come with corporate stock.

The sellers are less excited about an asset sale. It means they have to pay tax on all of the gains at the corporate level, and another capital gain tax when they liquidate the corporation. A prompt liquidation is usually done to avoid "personal holding company tax" problems.

It would sure be nice if you could find an accommodator to buy your stock,  who could then sell the assets to the real buyer -- an accommodator who has a bunch of tax losses they could use to make the gain go away. That was the thinking of a Texan who ended up in Tax Court recently.

The Texan got in touch with a company that promised just such benefits. They worked out a deal. A recent Tax Court decision describes how such deals are set up:

"Midco transactions" or "intermediary transactions" are structured to allow the parties to have it both ways: letting the seller engage in a stock sale and the buyer engage in an asset purchase. In such a transaction, the selling shareholders sell their C Corp stock to an intermediary entity (or "Midco") at a purchase price that does not discount for the built-in gain tax liability, as a stock sale to the ultimate purchaser would. The Midco then sells the assets of the C Corp to the buyer, who gets a purchase price basis in the assets. The Midco keeps the difference between the asset sale price and the stock purchase price as its fee. The Midco's willingness to allow both buyer and seller to avoid the tax consequences inherent in holding appreciated assets in a C Corp is based on a claimed tax-exempt status or supposed tax attributes, such as losses, that allow it to absorb the built-in gain tax liability.

The IRS has never liked this, and back in 2001 (Notice 2001-16) they warned taxpayers off of these "Midco" deals. The courts have sided with the IRS.

But what if you liquidate and there is no corporation to collect from? You're not out of the woods. The Tax Court found that the Texan had "transferee liability" for the corporation's tax on its sale because he ended up with the cash out of the company.

The moral? The potential for C corporation double tax is most easily dealt with by not being a C corporation in the first place. That's why so many businesses are set up as LLCs or S corporations, where the income is taxed only once -- on the owner's returns.

Many C corporations set up in the past few years may end up qualifying for a special tax exemption for sales of their stock. If held for more than five years, "Section 1202 stock" is 50 percent to 100 percent tax free on sale; it can apply to stock purchased from February 18, 2009 through December 31, 2013. Congress is likely (but not certain) to further extend this break with legislation later this year. This doesn't solve all C corporation problems -- benefits are usually limited to the original owners of the stock, for example -- but it sure is handy when it does apply.

If you are stuck with the double-tax problem, planning might make it hurt less, but as the Texan learned, there are no easy off-the-shelf solutions.

Cite: Cullifer, T.C. Memo 2014-208.

 

TrackBack

TrackBack URL for this entry:
https://www.typepad.com/services/trackback/6a00d83452ceb069e201bb0795245c970d

Listed below are links to weblogs that reference The C corporation dilemma and how not to solve it.:

Comments

The comments to this entry are closed.

« Sunlight good. Blue light bad. | Main | Digital marketing is a huge part of public relations »

Technorati Bookmark: The C corporation dilemma and how not to solve it.

This site is intended for informational and conversational purposes, not to provide specific legal, investment, or tax advice.  Articles and opinions posted here are those of the author(s). Links to and from other sites are for informational purposes and are not an endorsement by this site’s sponsor.