Meatloaf, "C Corporation" Status and Other Big Lunch Mistakes

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in The Business of Business Finance

Over lunch with Kevin and Kyle the other day (Kevin ordered the meatloaf), we realized that a decision they made before they even started their business, was now going to cost them almost $850,000 ... each!   That may seem like an expensive lunch, but it could get even more expensive for these two entrepreneurs if they continue to ignore the problem while increasing the value of their company.  Let's take a look at the problem, which is actually alphabetical.

When they started their company a few years ago, they were advised to become a C corporation rather than an S corporation.  Their accountant thought it would be beneficial for a growing company to:

A) retain earnings to fuel their growth
B) enjoy potentially better tax treatment in the early years
C) create an entity separate from the owners. 

While these points are true, the C corporation election will create a significant tax problem for these owners when they sell their company.

You see, 90% of the time when a small company sells buyers do not want to accept potential past liabilities, so they purchase the assets of the business (assets sale) rather than the company stock (stock sale).  Because of this, the sale proceeds are taxed at the corporate level first, and then at personal rates when distributed to the owners.  Look at the impact for Kevin and Kyle whose business is worth close to $8 million today.

  Tax
Corporation

Tax
Personal

Net Owner
Proceeds

C Corp
$2 million
$1.5 million
$4.5 million
S Corp
$0
$1.8 million
$6.2 million

OUCH!

Because the C corp is a separate entity, it will pay taxes on these gains first and then make distributions to Kevin and Kyle who will pay taxes on those proceeds AGAIN.  (Note: I am using approximate tax rates; they have a basis in the company that has no tax liability; I am not a CPA or tax attorney).  You can learn more about the differences and how to make a the correct decision for your business by reading this white paper.

When I brought this to their attention and told them they could solve this problem I was hired on the spot.

The lesson?  Successful entrepreneurs work on their business as well as in their business.  Sometimes, what you don't know can really hurt.

I've seen this mistake now 3 times in the first quarter of the year which makes me wonder, is your company a C corporation or S corporation?

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