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Filing may need fact-based case

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.

Regular corporations are said to have two levels of tax. One is imposed when the corporation recognizes gains, the second when the corporation distributes those gains to the shareholders.

Because the shareholder will receive only the gain net of the corporate tax, there really isn’t “double” tax. If the corporate tax rate is 21%, the total tax, corporation and shareholder, is based on 179% of the realized gain. This is a tax imposed on 100% of the gain at the corporate level and 79% (100% minus the 21%) at the shareholder level.

This is why a loss is allowed to the shareholder for the tax paid by the corporation. But that loss is allowed only when the corporation is an S corporation. This is so because the gain recognized by the S corporation is passed through to the shareholder’s tax return.

So if this sale occurs in 2019, the (newly electing) S corporation will pass through the $2.1 million gain to you, and you will need to include that amount on your 2019 personal tax return.

To prevent true “double” tax, you will get a loss deduction for the $441,000 tax paid by the corporation. You will report a net capital gain of $1,759,000 ($2,100,000 minus $441,000) and will pay a 20% tax on that amount.

So the total tax is not $352,800, but instead $772,800 ($441,000 corporate plus $351,800 personal), a combined tax rate of 36.8%. You can reconcile this as 21% corporate plus 15.8% personal, which is 20% of the 79% remaining after paying the corporate tax.

The S election may nonetheless help you in two ways. First, if you materially participate in the activities of the corporation you can avoid the 3.8% surtax that applies to “investment” income. If you remain as a regular corporation your capital gain from receipt of a liquidating distribution will also be subject to this surtax.

Avoiding the surtax can save $66,842 (3.8% of $1,759,000 personal gain) in tax and can only be done if the entity is an S corporation at the date of the asset sale. Again, you must materially participate in the business.

Second, it might be argued that the gain that existed on Jan. 1, 2019, is something less than $2.1 million. Goodwill often grows with the passage of time. Perhaps it was less on Jan. 1, the effective date of the S election.

You would need to build a fact-based case to support that the Jan. 1 “built-in” gain was less than the full $2.1 million.

Jim Hamill is the director of Tax Practice at Reynolds, Hix & Co. in Albuquerque. He can be reached at jimhamill@rhcocpa.com.

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