In the Adam Sandler movie Big Daddy, Adam’s girlfriend leaves the lovable slacker for a much older man because “he has a five-year plan.” In an ideal world, business owners have the time to take both a short-view and a long-view of the future, and develop a formal five-year or ten-year plan. But in reality, many business owners are too busy with the current business operations to begin planning for five years down the road, let alone ten years.
However, for C-corporation business owners nearing retirement age or looking to cash out on their years of hard work, it is particularly important to start preparing sooner rather than later for the eventual sale of the business assets. By properly planning and timing the conversion from C-corporation to S-corporation, a business owner may be able to avoid the C-corporation double taxation of gains upon the sale of the business assets and significantly increase the cash that will help fund their retirement or their next venture.
The PATH Act of 2015, which became effective on December 18, 2015, extended or made permanent certain popular tax breaks for businesses, including one that reduced the holding period for assets to avoid corporate-level tax, therefore making it easier for business owners to plan their exit strategy.
Historically, if an S-corporation that was previously taxed as a C-corporation had built-in gains (“BIG”) on assets that relate back to when the business was a C-corporation, the business would be subject to built-in-gains tax on the sale of those assets within 10 years of conversion to S-status. For example, if Asset A had a basis of $10 and a fair market value of $100 on the day the C-corporation converted to an S-corporation, there would be $90 of unrecognized BIG. If the S-corporation later sold Asset A prior to the expiration of the 10-year holding period, the maximum corporate-level tax would be payable by the S-corporation on that BIG. The net gain would then flow through to the owner and be taxed again at the owner’s capital gains rate, thus subjecting the proceeds to double taxation. However, if Asset A was sold in year 11, there would be no BIG tax payable by the S-corporation. In that case, all gains on the sale of the asset would flow through to the owner of the S-Corporation and would only be taxed at the owner’s capital gains rate.
But now, the PATH Act provides a phenomenal planning opportunity for closely held C-corporations. By permanently setting the BIG holding period at 5 years, business owners can now strategically plan their exit from their business by considering whether they should convert to an S-corporation at least 5 years prior to the anticipated sale of the business in order to avoid double taxation on any built-in gains assets.
So, what’s your five-year plan?