New tax law means less waiting for newly converted S Corps

Photo: ©iStock.com/DebbiSmirnoff

Big news for C Corps that converted to S Corps and are awaiting the end of the 10-year built-in gain period to elapse: A new tax law permanently reduces the period to five years.

Let’s start with some facts:

• A C Corporation (C Corp) that converted to an S Corporation (S Corp) has a net built-in gain attributable to its assets at the time it’s converted.
• Under prior law, if its assets are sold within 10 years following the S election, it’s subject to a corporate-level tax: the Built-In Gain (BIG) Tax.
• However, for 2009 and 2010, the effective recognition period for the BIG Tax was shortened to seven years, and for 2011-2014 it was shortened to five years.
• Now, with the Tax Extenders Law passed Dec. 18, the BIG Tax waiting period has been reduced permanently to five years.

Why was this done?

The purpose for this law was to stop C Corps from electing S Corp status immediately prior to selling all of their appreciated assets, and thereby avoid paying a corporate-level tax. The tax is imposed at 35 percent, the highest corporate rate.

How does this affect pest management professionals (PMPs)? When pest management firms are sold, most deals are structured as an asset sale — with the biggest asset being the customer list. At the moment a business elects S Corp status, the fair market value of the net assets (including the customer list) must be determined so any appreciation will be taxed if an asset sale occurs during the BIG Tax waiting period. This is bad news for any pest management firms that are previously converted C Corps and are thinking of selling during the 10-year waiting period. Five years is still a long time, but it’s a lot better than waiting 10 years.
 

You want to sell. Now what?

Currently, S Corps and Limited Liability Companies (LLCs) are the most income tax-efficient entity structure for most pest management business owners, with one caveat: S Corps have an added value over LLCs solely in relation to reducing Federal Insurance Contributions Act (FICA) tax for the owner.

I recommend that most firms be set up as an S Corp or LLC, as the pass-through benefits make a single tax much more efficient than the potential double tax of a C Corp. If the assets of a C Corp are sold, they are subject to ordinary income tax rates anyway, so maintaining C Corp status in most instances does not make sense. That is, unless you have net operating loss (NOL) carry-forwards to absorb any potential built-in gain recognition. Speak to your tax advisor to determine whether converting makes sense.

If it makes sense to be an S Corp, you want to make the conversion election as soon as possible and get the BIG Tax clock started, because it takes five years to avoid this extra layer of tax. Of course, if you can’t wait five years to consummate a transaction, another technique can be used: A C Corp shareholder can sell his or her personal goodwill directly to a buyer, which can reduce the BIG Tax concern in part. This kind of technique is beyond the scope of this article, but you can read about it in Pest Management Professional’s December 2013 cover story, “Exit Strategies.”

If you’re thinking about selling your pest management firm in the near future, and the sale will take place within the BIG Tax waiting period, it’s highly advisable that you have a professional appraisal done of all assets owned by the firm — including the customer list as of the date of the S election. This will provide evidence of the net built-in gain amount when calculating the BIG Tax, should the IRS ever challenge it.

Daniel S. Gordon, CPA, owns PCO Bookkeepers, an accounting and sales and acquisition consulting firm that caters to pest management professionals nationwide. For more information, contact him at dan@pcobookkeepers.com.