Q: I have a corporation that is organized as a regular corporation with two levels of tax. I am negotiating to sell the business and have an offer letter that will create $2.1 million of taxable gain. We are negotiating what portion of the consideration goes to different assets but it appears that most of the gain, if not all, will be paid for goodwill. I have been advised that I should elect to treat this corporation as an S corporation and that I can do this effective Jan. 1, 2019, through a late election procedure. I’m trying to understand how this works.
Projections that I see show that if the $2.1 million gain is in an S corporation, I still pay a 21% corporate tax ($441,000 on a $2.1 million gain) because the gain is considered built-in when the election is made. But I am told that I get a tax loss for the $441,000 corporate tax on my tax return. This could save me $88,200 in capital gains tax. If I pay a net of $352,800 ($441,000 minus $88,200) that seems to be a 16.8% tax rate on the gain. That seems to be a better result than staying as a regular corporation. Do you agree with the math?
Yes, to a point, but you are omitting an important tax cost. The conversion from a regular corporation to an S corporation causes the inherent gain in corporate assets to be subject to a “built-in-gains” (“BIG”) tax.
The BIG tax is imposed at 21% when the (now) S corporation recognizes gains within a 5-year recognition period. So you are correct that the corporation would pay $441,000 in corporate-level tax.