Selling a C Corporation: Key Tax Implications You Should Understand
Depending on your healthcare company's corporation type, there are different tax implications you will want to be aware of long before you are ready to sell your business. One type of company that brings with it tax implications that often catch owners off-guard or create challenges when owners are ready to pursue a transaction is C corporations (C-corp).
Many companies, including most major corporations, are treated as C-corps for U.S. federal income tax purposes. C-corps and S corporations (S-corp) both enjoy limited liability, but only C-corps are subject to corporate income tax. The primary difference between a C-corp and S-corp from a tax perspective is the C-corp's profits are subject to "double taxation." This means that the corporate entity is taxed and then the shareholders are taxed whenever monies are dispersed out of the company.
Factors That Can Affect the Sale of a C-Corp
Now let's look at some of the key tax implications owners of C-corps should understand about their classification that could affect a sale, positively and negatively.
The issue that often arises when owners of a C-corp are ready to sell is that a buyer may not want to buy the stock in the company but rather the assets, such as inventory, equipment, and goodwill. According to most industry analysts, well over 90% of sales are asset sales rather than stock. Why? In this scenario, the buyer wants to get the tax deduction for depreciation and amortization associated with the assets while also avoiding any future liability due to actions associated with the company when it was under the control of its prior owners. For sellers, an asset sale will lead to double taxation whereas a stock sale will not.
Some sellers try to change the status of their C-corp to S-corp immediately prior to a sale to avoid the potential for double taxation. This strategy will not prove successful. There is a look-back period in tax law that prevents owners from executing such a conversion and immediately reaping the tax benefits. The current look-back period is 5 years.
There is upside for a seller of selling a C-corp. Some buyers are willing to pay a higher purchase price based on the amount of the purchase price allocated to goodwill or fixed assets. In addition, the reduction in corporate tax rate to a flat 21% under the Tax Cuts and Jobs Act of 2017 makes a C-corp asset sale more palatable. While the corporation will need to pay 21% on the gains, the shareholder(s), when they receive the remaining sale proceeds through a liquidating dividend, can use Section 1202 (i.e., Small Business Stock Gains Exclusion) to avoid tax on that cash.
Now let's look at a few other significant and related factors that can affect the sale of a C-corp: a covenant not to compete and personal goodwill. Following the sale, any remaining purchase price not allocated to the company's tangible or intangible assets is often allocated to a noncompete or goodwill. One of the differences between these two is that money received on a covenant not to compete is taxable as ordinary income to the seller in the year received whereas goodwill is taxed to the seller as capital gains.
One strategy a seller will often take is to allocate as much of the proceeds to personal goodwill as possible. Personal goodwill is purchased directly from the seller, not from the corporation, so it can be written off by the buyer. However, the IRS tends to challenge personal goodwill cases. The key to personal goodwill allocation is to carefully document it, use appropriate agreements, and keep money flow segregated.
The IRS previously argued that the distributed goodwill should be taxed as any other distribution. But the U.S. Tax Court held that the goodwill was due to personal ability and relationships. The goodwill was of the person, not the corporation. Personal relationships of a shareholder-employee are therefore not considered corporate assets when the employee has no employment contract with the corporation.
If the company is being taxed as a C-corp and is only owned by a single owner or shareholders, the company's goodwill is an asset of theirs, not the C-corp. In other words, personal goodwill is the bulk of the firm's value.
Building Your Transaction Team
Selling a C-corp is complicated. The points discussed here scratch the surface of what sellers need to understand about the tax implications for a transaction and how buyers might pursue a C-corp acquisition. Tax implications are just one key consideration before sellers proceed with taking their healthcare business to market. That's why it's imperative for sellers to assemble a team of professionals who can help them successfully sell their company.
One member of this team should be a merger and acquisition (M+A) advisor — preferably one with healthcare experience and experience selling C-corps. Such an advisor will advise you on how to best prepare for a sale and guide you through the process. In addition, experience in these types of transactions can help you pinpoint bumps in the road that might hinder a successful transaction. Ultimately, the more educated the seller, the more successful the sale.
Another member of the team should be a qualified tax accountant with C-corp experience. This accountant will walk you through the tax liabilities of the sale and review tax responsibilities following the sale. This will help with short- and long-term post-transaction planning.
Finally, make sure you work with a qualified, healthcare M+A law firm. They'll help ensure everything from the letter of intent to the purchase agreement is executed properly and in accordance with state and federal law. They'll also play a pivotal role with structuring the deal based off asset allocation, if that's the path you end up taking.
