There are so many timely and topical valuation issues today that it’s difficult to focus on a single subject. Many topics remain timely month after month, like the importance of establishing the value of a company for purposes of buying cross-purchase life insurance. Some topics are always important, but become more timely because of economic conditions, like the increased ability to transfer assets for estate planning purposes while valuations are depressed (as we’ve been saying for some time, the current economic environment provides an outstanding opportunity in the estate planning realm). Another topic that is always important is consideration of entity selection for companies. A number of factors make this topic even more important today.
Business entities can take many forms including C-Corporations (C-Corp), S-Corporations (S-Corp), Partnerships, Limited Liability Companies, Limited Partnerships, Limited Liability Limited Partnerships, and others. Each type of entity has advantages and disadvantages, and each is appropriate in some instances. C-Corps provide perpetual life to a company while offering the owners protection from liability. C-Corps are entities whose earnings are taxed at the corporate level, before distributions can be made to shareholders (the distributions are then taxed again at the shareholder level). There are circumstances for which C-Corps are appropriate entities and for which this form of business is necessary. In other circumstances, however, S-corps may offer many of the same benefits as C-corps, without the downside of double taxation.
Just because a company is currently a C-Corp, doesn’t necessarily mean its owners are stuck. It may be possible for some C-corps to convert to S-corps. Conversion is not difficult, but does require some analysis as to whether S-Corp status is available to a particular C-Corp, as well as some analysis as to whether conversion makes sense. There are numerous factors to consider, including certain valuation issues.
Built in Gains
There is a concept in taxation known as built-in gains (BIGs), and conversion from a C-Corp to an S-Corp triggers the need to determine whether BIGs exist, and to what extent. A BIG is the amount of appreciation related to an asset owned by a corporation, including intangible assets such as “goodwill”. Should the company be sold within ten years of conversion from a C-Corp to and S-Corp, a tax would be due (at C-Corp income tax rates) on the amount of the BIGs from the time of incorporation to the time of conversion. Understanding those potential tax liabilities is obviously very important when considering conversion.
In today’s economic environment the valuation of almost all classes of assets are at or near historical lows. In addition, many companies are struggling as revenues and profits decline. While this is not happy news for business owners, it may be an opportunity for owners of C-Corps to consider converting to S-Corps. The ability to determine the existence and extent of BIGs, and to lock in those values at what could be historical lows, is an opportunity that does not come along often. If, indeed, the company’s value is very low today due to current economic conditions, it is a perfect time to set the value related to BIGs.
There are many factors that should be considered when considering converting from a C-Corp to an S-Corp. Those factors include a wide variety of non-valuation related considerations which should be thoroughly explored and discussed with legal and accounting advisors. In addition, there are a number of valuation-related issues that should also be thoroughly explored. Today’s economic and valuation environment may provide just the incentive needed to finally make the change from double taxation of a C-Corp to the advantageous pass-through taxation of an S-Corp.