C Corp Vs. S Corp: A Costly Difference for Financing Your Future

by Dave Driscoll

Many baby boomer business owners are planning to monetize their life’s work to support retirement. It’s a natural evolution: Work hard, sell your largest single asset, invest the money, and live your remaining years the way you want!

But, surprise! The taxes on the sale of your business could greatly impact your ability to retire in style. Unfortunately, when most boomers were forming their businesses in the 1970s and 80s, the C corporation was the usual corporate structure.

The S corporation and limited liability corporation (LLC) didn’t develop traction as preferred entity types until the late 1980s and early 90s. These entities are commonly referred to as “pass -through” corporations, meaning that any income or loss passes through to the shareholder’s individual tax return, is combined with their other income and is then taxed once at the individual’s tax rate.

The tax situation is significantly different for C corporation owners. C corp owners are usually shocked to learn that the eventual sale of the business will be taxed twice: once at the C corporation level and again at the individual level when the proceeds are distributed from the C corp to the individual shareholder(s). Yikes! TWO LEVELS OF TAX ON YOUR LIFE’S WORK!
Consider this scenario: The owner of a small manufacturing company is contemplating the sale of his business. A third-party buyer offers to purchase the business for $1.5 million cash. Because the seller’s entity is a C corporation, he finds out that the combined federal and state taxes due on the sale will approach 60%.

The owner’s goal is to sell the business and retire to enjoy the lifestyle he has created, with the addition of more travel. Throughout the years, the seller has built $500,000 in retirement saving and has consistently earned $200,000 per year from his business.

A quick calculation reveals:
Sale of business $1,500,000
Federal and state taxes - $900,000
Investable proceeds $600,000
Retirement savings + $500,000
Total post-sale invested caoutak $1,100,000

To determine how much the seller can withdraw from his invested capital to support his lifestyle, let’s assume a widely accepted 4.5% withdrawal rate per year from a well-diversified capital account.
Seller’s post-sale income:
4.5% withdrawal from well-diversified account $49,500
Social Security + $33,600
Annual income post-sale $83,100

The seller’s post-sale income calculates to only 42% of his pre-sale income of $200,000. That may present quite a challenge to the seller who expects to maintain his lifestyle.

In contrast, if the seller’s business were an S corporation or an LLC for which only one level of tax were due upon the sale of the business, a total tax burden of 33% (federal and state) would result in annual post-sale income of $101,325 — that’s a 22% increase for post-sale lifestyle between a C corp and an S corp.

At the end of the day, the C corp owner is challenged to weigh whether he can afford to sell the business versus continuing to run the business to earn the income to support his lifestyle.

This simple illustration demonstrates the value of converting from a C corporation to an S corporation. The process of converting is simple, but the catch is that the election must be made five years before the sale of the business. Ask your accountant about converting from a C to an S corporation now to make a big difference in funding your Life Beyond Business if/when you eventually choose to sell your business.

Dave Driscoll is president of Metro Business Advisors, a business brokerage, valuation and exit planning firm helping owners of companies with revenue up to $20 million sell their most valuable asset. Reach Dave at DDriscoll@MetroBusinessAdvisors.com or 314-303-5600. For more information, visit www.MetroBusinessAdvisors.com.