During these challenging economic times, a business sale can be difficult as sellers seek the right buyer, the right price, the right terms and the right tax results.
Tax issues are always important in any transaction. However, recent tax developments may frustrate possible sellers.
Many closely held companies operate as S corporations. As such, the income of the business is not taxed to the company. Rather, it is taxed to the individual owners. An S corporation is only subject to one-level of tax, not two as with a regular C corporation.
An S corporation may provide a structure that reduces tax when a business is sold. Congress, however, created special rules to prevent a corporation from converting to an S corporation before a sale.
These rules placed a yoke on the business for 10 years. If any assets that were appreciated at the time of the S corporation election were sold prior to the end of the ten-year waiting period, a tax was imposed on the S corporation for the built-in gain (BIG). The tax rate was 35 percent for federal purposes and 7.9 percent for Wisconsin. If the company, however, waited until the 10 years lapsed, they could sell the business and avoid any BIG tax.
As part of the stimulus legislation in early 2009, Congress sought to provide an incentive for businesses looking to sell. For 2009 and 2010, the BIG tax waiting period was cut to seven years. Thus, a company eight years after its S corporation election could sell and avoid the steep federal BIG tax.
However, Wisconsin has not followed the federal change to seven years and remains with a 10-year holding period for Wisconsin’s BIG tax.
For affected companies in the seven to 10 year time frame, the federal law offers a “green light” to sell, while Wisconsin holds up its “red light.” This predicament is cause for concern to Wisconsin businesses. Do you look to sell now, avoid the federal BIG tax and incur a Wisconsin BIG tax? Or, do you ride it out until the ten year period expires, avoid the federal and Wisconsin BIG taxes and hope you can still find a buyer?
Let’s look at an example.
W Company is a Wisconsin based corporation that converted to S corporation status eight years ago in 2002. Bucky, its owner, was considering selling his businesses but thought he needed to wait another two years until the 10-year, built-in gains tax period had lapsed. Bucky then learned of the recent federal change that shortened this BIG period to seven years and decided to sell. A sale of W Company’s assets would trigger $1 million of gain with $200,000 coming from ordinary income property and $800,000 from capital gain assets. What are the federal and Wisconsin tax consequences of such a proposed sale in 2010?
The federal and Wisconsin tax consequences to W Company and Bucky from this sale would be as follows:
You can see from this chart that the combined Wisconsin tax of $133,247 in 2010 represents over 45 percent of the total tax from the transaction.
What would the tax picture be if Bucky waited until the ten-year BIG tax period expired? Assuming the federal capital gains rate of 15 percent and top ordinary rate of 35 percent remain and no further tax rate changes for Wisconsin occur, the combined federal and Wisconsin tax on the sale would be $248,900.
If Bucky waits until the 10-year period expires, the tax cost would drop by $46,697. But if he waits, the sale price of W Company could change, there may not be an interested buyer in two years, financing issues could arise and higher federal tax rates are possible. Any of these factors could erase the Wisconsin state tax savings achieved by waiting.
As you can see, the impact of the Wisconsin BIG tax creates a tax dilemma for Bucky and other Wisconsin businesses.
