The dramatic corporate rate cut enacted as part of tax reform has made the C corporation structure very attractive for many private companies structured as pass-throughs. But it’s not a given that all pass-throughs should make this conversion, as there are numerous important considerations, including the impact on M&A and the exit process.
A conversion is often effectively permanent because it is very difficult to convert back to pass-through status. This means it’s important to understand and model the way an exit is treated differently for a C corporation, even if your private company doesn’t plan to sell. “The difference could be significant,” said Grant Thornton Tax Services Partner Meghan Jodz
during the recent webcast Pass-through to C-Corp Conversion: Things to Consider
. “You never know when you’ll get an offer you can’t refuse.”
Reconsider the reasons for remaining a pass-through
Among the advantages of staying as a pass-through when selling a business:
- A single layer of tax
- A basis build-up for the accumulated earnings not distributed
- Net investment income tax generally doesn’t apply to active owners, even upon sale
“Another area that’s commonly negotiated between buyers and sellers,” said Jodz, “is the concept of a step-up that a buyer can get with an asset or deemed asset purchase. A pass-through generally can afford to deliver that step-up to the buyer and drive additional deal value as a seller.”
See “M&A considerations from conversion” for more details.
“If you have multiple lines of business, you might exit those businesses separately to different buyers,” she said. “If you’re a C corporation, you can’t do that without attracting double taxation unless you’re going to retain those proceeds and reinvest them in another business. The pass-through is much more efficient if a carve-out divestiture will be done.”
Built-in gains tax on S corporations
Consider the example of an S corporation that converts to a C corporation. All the built-in gains existing today are put back into a double-taxation regime. And the S corporation can’t go back for 10 years. The reason for the 10-year lockdown? There’s a five-year period during which you can’t revert back to S corporation status. Then, after you do go back, a five-year built-in gain period begins, in which a sale will require C corporation double taxation.
S corporations with E&P history
Review your earnings and profits (E&P) history and know where it will go post-conversion. Will earnings be distributed in the future or reinvested? Will you revoke your S corporation election, or revoke just the qualified subchapter S subsidiary and leave the pass-through on top?
Keep in mind that accumulated adjustments account (AAA) transition rules apply only to cash. It’s a “one-year freebie.” After that, distributions are allocated to AAA and E&P.
NOLs have less value to the buyer
Businesses projecting future losses should think hard about whether they can be used by the owners to offset other potential sources of income versus trapping the losses in a C corporation for future use.
Jodz explained that net operating loss carryforwards are subject to an 80% offset of income limitation in both pass-throughs and C corporations. But a pass-through might be able to offset those losses with more than one source of income. A C corporation’s single source of income limits the offset.
Upon exit, pass-throughs that have accumulated losses, even if they can’t use them, might be able to offset the losses on gains. For a C corporation, losses will accumulate inside the company, and it’s unlikely that buyers will now pay much more for net operating losses (NOLs). They’re less attractive to buyers, given the 80% limitation and all the other choices buyers have for achieving a tax shield, whether through full expensing, interest expense or cash basis accounting.
C corporation sellers should plan more carefully now for the transaction costs that will be incurred in M&A and other exits. There are generally significant investment banker fees and compensation deductions upon a sale. If the business has been profitable but has a loss triggered by the transaction costs, previously it could carry those back and generate a refund to the seller. Because there are no NOL carrybacks, consider the timing of the closing, how much income can be offset from operations, and plan around the costs to be incurred, or negotiate a payment from the buyer for the NOLs delivered.
Gain more insights:
Ready to re-organize? Global impacts of an entity change
Should pass-through owners switch to C-corp status
Stay up to date with our tax newsletters
Managing Director, Washington National Tax Office
+1 202 861 4144
National Managing Partner, Partnership Tax Services
+1 612 677 5250
Partner, Tax Services
+1 215 376 6065