Start with the end in mind. What is the exit strategy for your business?
Chances are you will either (1) close the company, (2) sell the company, or
(3) turn it into a long-term family operation. Each of these options has a
number of considerations when you are looking at the best type of structure.
If you are running a business to create cash flow for other interests
and plan to then close down the initial business at some point, the C
corporation will be a harder structure for you to implement. Suddenly
closing down the C corporation can result in double taxation through
liquidating dividends. Closing out a C corporation takes a long-term
strategy that gradually siphons out the assets over time. If you don’t want
to commit to that type of wind-down, don’t start a C corporation if the
plan is to close it down in the future.
If your plan is to turn your business into a long-term family operation,
how do you anticipate transferring ownership to your family members? If
the transfer will be done by means of a gift, then make sure you take into
account gift tax and estate tax considerations. If you plan to sell ownership
in the company, the next few subsections will be applicable.
When you plan for your business, this is one case where you truly be-gin with the end in mind. What do you want from the business? Do you
want it to continue for your family to run someday? Are you looking for a
short-term business to build other assets and then close the business? Do
you want to sell the business? If you do sell, what would the likely value
be? Would you sell stock through an initial public offering (IPO), to a
competitor, to a larger company, or to others? What would they be looking
for? Or do you want to set up a true business that gives you cash flow
for an extended period with little or no involvement by you?
Selling a Business—Asset Sale versus Sale of Stock
The issue of how you will sell or distribute assets is primarily an issue
within an S corporation or a C corporation. Partnerships can distribute
assets at “basis.” In other words, they can transfer out to partners (in partnerships)
at the amount shown on the books, so there is no tax impact.
If your plan includes the sale of your business, consider how that sale
will occur. Will you sell the assets of the business (most likely) or sell or
merge stock into a larger company? In general, small companies that are
purchased by someone wanting to run your company as it has been will
want to buy the assets of the company. Larger companies are more likely
to want to buy the stock, or to exchange some of their stock for yours.
If you have a C corporation and sell the stock, there can be great
benefits through the 50 percent capital gain exclusion (discussed in the
next subsection), and also the possibility of double taxation through liquidating
dividends. The first is a good thing! The second is something
you will need to plan to avoid. In Chapter 16, we will discuss advanced
strategies for the C corporation.
Small Business Capital Gain Exclusion—Selling Stock
A shareholder can exclude up to 50 percent of income from the gain or
exchange of qualified small business stock—referred to as Section 1202
stock—that has been held for more than five years. The excluded gain is
limited to the greater of $10 million or 10 times the taxpayer’s basis in
stock. Stock must be issued after August 10, 1993, and have been acquired
at original issue in exchange for money, property, or services. The
corporation must have at least 80 percent of its assets used in a qualified
field. Businesses related to health, law, engineering, architecture, farming,
insurance, financing, and hospitality are specifically excluded from the
list of qualified fields.Loss on Sale—Section 1244
What if the business doesn’t turn out to be everything you want? If you
have a corporation (either S corporation or C corporation), the amount of
basis in stock that you have is now considered worthless. Normally, you are
limited to $3,000 per year in capital losses that exceed capital gains. There
is a way around this trap, if you plan ahead. If the business qualifies as a Section
1244 company, then you could take the loss against ordinary income.
Well-drafted corporate documents should include a statement that the
company is intended to be a Code Section 1244 company. To qualify, the
company must have received less than $1 million in capital contributions.
In other words, a few simple lines in the initial documents or in your
minutes will allow you to take up to $75,000 per year in current year
losses against other income in case your business venture fails.
Combine Sections 1202 and 1244
The best plan for a business that is anticipated to be held for more than
five years and then sold through a stock sale for a high price would be to
set it up as a Section 1202 and 1244 qualified company. Then, if your
plan succeeds, you will be able to legally avoid a tremendous amount of
tax. And if your plan does not succeed, you will be able to take a substantial
loss at that point against your current income. Note that a Section
1202 company must be a C corporation.
Initial Public Offering
Perhaps your plan is to take your company public in an IPO. There are
many different strategies you might choose. In general, only a C corporation
can be taken public by selling stock to the outside public. There are
three ways to do this: (1) by selling the stock to accredited investors; (2) by
selling shares in your company on U.S. stock exchanges; or (3) by selling
shares in your company on another country’s stock exchange. There are
separate requirements for each of these options