When a family business achieves runaway success, there’s a lot to celebrate. But what the family may not anticipate is the tax burden, which makes Uncle Sam a not-so-silent partner in the family’s newfound wealth. That’s where good tax advice can make a huge difference.
A client came to us because he wanted to sell his company. The firm hit it big with one highly profitable product and was worth millions. The time had come to consider transferring ownership to the next generation. They asked for a projection of his future wealth and an estate plan. Almost immediately we spotted an immense problem.
Like most budding entrepreneurs, the client (and his attorneys) did not give much thought to future tax consequences and asset protection when choosing a corporate structure. Corporate structure has a huge impact on the taxes a business will pay. When a company is in its infancy, the biggest concern is usually what type of organization will save the most income tax. When it comes time to sell, a whole different kind of tax applies, and what worked to save some income tax can exact a painful cost. Here is a brief overview of some of the choices:
C Corp: This is the traditional corporate entity. It is owned by shareholders, yet the liabilities incurred by the corporation, such as debts, fines or legal culpability, do not pass through to its shareholders except under very specific circumstances, such as fraud. C Corporations have the potential to raise capital in various ways and can issue shares to the public. These entities pay for their privileges with additional tax responsibilities, often called double taxation. The company pays taxes on its profits, and then the owners pay taxes on the income they derive from the business.
S Corp: Like a C Corp, an S Corporation has its own legal identity which protects the owners from financial and legal liability. But S Corps do not pay their own taxes; instead, income is passed through directly to the owners. S Corps are limited to 100 shareholders—their corporate structure is typically used in the early stages of a company.
Limited Partnership: This business structure allows business owners to share equity within a group. Families may use them to share ownership of a large business or property, making them an important tool in estate planning. This structure deploys two classes of ownership: General Partners and Limited Partners. The general partners run the company and the limited partners invest passively. They also have two classes of liability: only the general partners are responsible for the business’ obligations. As with an S Corp, the profits of a limited partnership pass through to the owners, who pay taxes at their individual rates.
Limited Liability Company: A limited liability company (LLC) is a catch-all term for companies that protect their owners from responsibility for a company’s debts or other obligations. They can be taxed as corporations, partnerships, or sole proprietorships depending on the owners’ needs.
When selecting a corporate structure, bear in mind that the structure can be changed when necessary. Our client converted their company to one variety of the choices above – a Family LLC – because the next generation of owners were family members. Our client’s tax obligation on the transfer of ownership will be a small fraction of what it would have been otherwise.
If you own a successful business, its corporate structure is an issue you will want to consider before you transfer ownership. Meet with your advisors and raise the question. If there is no advisor formulating an overall estate strategy or if your advisors are not coordinated, this kind of consideration can get overlooked. Missing this critical issue could increase your tax liability.