If you are thinking about selling your business, all of a sudden potential suitors or your advisors may be asking questions about C’s, S’s and LLCs.
The Short Answer:
S-Corps and LLCs are good because they’re more flexible and allow the buyer to achieve a ‘step up in basis’ which provides tax advantages to the buyer. In short, the buyer calculates the difference in the purchase price for yoru company less the book value of equity (i.e. stockholders equity) on the balance at the time of the sale), and the buyer gets to deduct 1/15 of that number on his taxes each year going forward. That can add up to some big savings that can attract more buyers.
C-Corps are bad because assets sales are not practical for the seller, and a stock sale of a C-Corp does not allow for achieving a step-up.
The Longer Answer:
Aside from basic legal diligence and potential sale structuring, the key reason that people want to know about your legal type of company is to discern whether you can practically sell assets rather than stock (more on that [here]), and if you want to sell stock whether the buyer can realize a ‘step up in basis’ (or ‘step up’ as it’s casually referred) as part of the stock purchase transaction. An asset sale or a stock sale with a ‘step up’ provides tax benefits to the buyer, but is practically only available if the seller has an S-Corp or an LLC.
Again, your attorney can give you more detailed information, but effectively if you’re an LLC you can sell your units (i.e. your stock), or if you’re an S-Corp you can sell your assets (typically with a minimal tax disadvantage – more on that [here]) or sell stock with a 338h10 election (again more on that [here]), and the buyer can obtain this mystical ‘step up in basis.’
Simply, a ‘step up’ is a tax benefit derived from the difference between the purchase price of your company and the amount of equity value on your balance sheet (i.e. book value of equity). Since most companies are worth more than the stockholders equity portion of their balance sheet, this difference effectively creates a tax benefit for a new buyer. Said differently, think of a ‘step up’ like this: you’re an LLC, and your company’s balance sheet assets less your balance sheet liabilities equals $5 million (i.e. your stockholders equity on your balance sheet is $5 million). A buyer comes along and pays you $50 million for your company. The difference between purchase price and your stockholders equity is $45 million ($50 million purchase prices less $5 million book value of equity). The term ‘step-up’ relates to the ability for the buyer to effectively expense that $45 million of purchase price in excess of book value over 15 years (i.e. $3 million per year), thus giving a tax shield of ~$1.2 million per year ($45 million divided by 15 equals $3 million; then multiplied by a presumed tax rate of 40%).
Thus, over a 15-year hold period by the new buyer, the buyer would get ~$18 million ($1.2 million multiplied by 15 years) in cash savings per the taxes that they don’t have to pay after achieving a step-up. This is good for the buyer, and can potentially command incremental value when selling your business.
If you’re a C-Corporation, you obviously know that you have been paying corporate-level taxes, and then having to pay personal taxes on any dividends out of your company. This company type is admittedly not ideal from a buyer’s standpoint, because: 1) you would never choose to sell them assets (which would allow them to achieve a step-up) because you would get taxed twice. Once at the corporate level once you sell the assets, and again when you dividend the cash out to yourself; and 2) since you have to sell stock, selling the stock of a C-Corp does not allow for the buyer to claim a ‘step-up.’ Thus, the benefits we just discussed from a buyers perspective don’t exist if you own a C-Corp.