If the corporation is not an S corporation and the company assets are sold, there will be a double tax on sale. The first tax will be at the corporation level. A regular or C corporation will pay a tax on the gain on the sale of its assets. The second tax will be when net proceeds are paid to the shareholders.
A C corporation or a Subchapter S corporation is a separate legal entity. The difference is that the C corporation is a separate taxable entity; the S corporation is not. In an S corporation, the profits or losses "pass thru" to the shareholder who declares them on their individual income tax return.
If your business is currently a C corporation and you are considering an asset sale, be cautious. Electing Subchapter S and then selling won't avoid the double tax. The IRS has a so-called Built-In Gains Tax ("BIG"). This tax is not applicable for any newly formed Subchapter S corporations. However, existing C corporations that make a Subchapter S election need to address this potential tax. The tax is essentially assessed against the amount of unrealized appreciation at the time of the S election. The fair market value of the assets less the tax basis is the unrealized appreciation. Goodwill is the most common asset that can create a potential BIG tax. The BIG tax goes away after the tenth year of a Subchapter S election. This tax will be applied on a pro rata basis for elections made less than ten years ago.
Keep in mind…if the transaction is a stock sale, it doesn't matter if the corporation is a C corporation or a Subchapter S corporation. The seller of the stock will have a capital gain or loss on the shares.
Corporations Eligible for the Election
To make the election, a corporation must meet all of these conditions to be eligible:
- The corporation must be a domestic corporation
- The corporation has no more than 100 shareholders
- The only shareholders are individuals, estates, and certain tax-exempt organizations
- There are no nonresident alien shareholders
- There is only one class of stock
- It will adopt a December 31 tax year-end or meet other filing requirements
How to Make the Election
To make the Subchapter S election, the corporation must file Form 2553, Election by a Small Business Corporation. This election is due within two months and 15 days after the beginning of the tax year it is to take effect. There is some limited relief for elections that are filed late if it can be shown that the failure to file timely was due to reasonable cause. This election must be signed by all of the shareholders. Many states will recognize the federal Subchapter S election for state taxation purposes. Connecticut corporations that elect federal Subchapter S filing status are automatically treated as an S corporation for Connecticut income tax purposes.
Small business owners…are you going to make this election to be a Subchapter S corporation?
Thomas F. Scanlon, CPA, CFP®
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