Question

Mai, has a successful business through a C corp. Mai holds 100% of the C Corp.    Mai wants to retire and wishes her two daughters can take over the business. You are tax advisor to Mai. What advice would you give to Mai? Can Mai sell the business to her daughter? Is it capital gain or dividend? What would Mai prefer, dividend or Capital gain? Please write a brief memo for your client – Ms. Mai.

Answer 1

So many people don’t expect tax issues to be a concern if they transferred their companies to family members. However, this isn’t the case since equity transfer to a family member will still have tax implications. Note that there are tax consequences related to allowing a family member to take up the equity. Since many business owners simply transfer equity without considering the huge issue of tax, the repercussion of the business can be significant.

When a small business owner sells their business, they must consider the income taxes that they’ll have to pay after the sale. Like any other transaction that makes you money, the sale of a business is considered income, and you are required by law to pay taxes on it. This income is often classified as a capital gain and it applies whether you’re selling the assets of a company or shares of a company’s stock. Most sellers make the mistake of not consulting with a tax advisor before the sale of their business entity, shares, or assets. Because of this, they could end up paying more taxes than they expected to when Tax Day comes around in April. So, it is important to figure out ahead of time how much you’re going to pay in taxes before the sale of the small business even takes place.

Now if you were to own a C Corporation and you sell its capital assets for a profit, then you will be taxed two times on the sale. The first tax you’ll have to pay is the corporate tax which coincides with the commercial income tax return. Since corporations are considered separate entities from their owners, the IRS requires each entity to pay their share of taxes from it. The corporation must pay whatever the current corporate tax rate is on capital gains. Then, each shareholder of the company will be subjected to a capital gains tax on their income tax return. They won’t have to pay taxes on the full amount of capital gains, though. The profits of capital assets get distributed equally among the shareholders of the company. Therefore, the amount that was distributed to each shareholder will get multiplied by the capital gains tax rate. The result is the amount that each shareholder must pay in personal taxes.

The sale of business assets by a C Corporation results in again to the corporation and, under current law, is taxed at graduated corporate rates up to 35%. (Corporations generally do not get a special rate for long term capital gains.) The buyer gets a full step-up in the tax basis of the assets equal to the purchase price. If/when the net after-tax proceeds are distributed out to the shareholders of the selling corporation, the shareholders will have a capital gain or loss, depending on the basis of their stock if it is a liquidation or will have dividend income. There is thus a potential Federal tax rate of 45% on such a transaction. That is why a seller would prefer a simple sale of shares resulting in long term capital gains taxed at 15%.