At Baum CPA we are routinely asked about the tax implications of starting a ROBS, and all too often we are asked if an S-Corporation would make more sense. In Part 2 of this blog series, we will continue to make comparisons between S-Corporations and ROBS C-Corporations.
ROBS C-Corp or an S-Corp?
In Part 1 of this current blog topic (ROBS C-Corporations vs. S-Corporations [Part 1]), we compared a S-Corporation and a C-Corporation business of equivalent size and came to conclude that S-Corporations tend to pay less tax each year — but when it comes to tax strategy, that’s only a small piece of a bigger puzzle. It is important to consider the total taxes paid over the life of the business.
Taxation of a business and of the business owner happens at different points and at different rates — triggered by various transactions and milestones, and directed by the underlying legally registered business structure. What we want to share with you here is a bigger picture of the total tax impact respective of each business entity type, C-Corporation vs. S-Corporation.
Hitting a Home Run
While the S-Corporation usually has a lower tax bill, this can come back to haunt the entrepreneur if they hit a homerun and sell their S-Corporation for a sizeable gain. This is because the gain on the sale of their company is allocated 100% to the entrepreneur — so with hitting a homerun, the owners wind up getting hit with a huge tax bill on their personal income taxes.
But alternatively, who owns a ROBS C-Corporation? The entrepreneur’s retirement plan! The sale of the business is allocated pro-ratably among the shareholders, with the lion’s share getting socked away as pre-tax increased dollars in the ROBS retirement plan. For businesses sold with 7 or 8 figure price tags, the amount of taxes saved can be staggering!
Selling off the ROBS C-Corporation
In Part 1, our example ROBS C-Corporation was capitalized using $400,000 in exchange for 400,000 shares of stock (initial capital value is $1 per share in this scenario). The entrepreneur received 10% of the shares, and their retirement account received the remaining 90%.
Let’s assume that the business grows 15% year over year, and after 5 years the entrepreneur is looking to sell their business. Starting from the same basis that we used in Part 1, with Year 1 sales revenues = $500,000, five years later the company now has a $1,005,679 in annual revenues (using the simple formula $500,000 * 1.15%^5).
A prospective buyer is willing to pay about 2.5 times gross revenues for 100% of the stock, let’s say $2,516,000 — which translates to $6.29 per share. Remember that the initial investment was $1 per share.
Also recall that the retirement plan owns 360,000 shares — and at $6.29 per share, is now positioned to return $2,264,400 back to the retirement plan — tax-deferred.
The entrepreneur, holding 40,000 shares, receives $251,600 — of which $211,600 is subject to personal income taxes after accounting for their stock basis (their initial personal investment of $40,000 is not income).
From a ROBS Arrangement perspective, the retirement account is an investor that purchased $360,000 of stock, and sold it after five years for $2,264,400. These dollars are now free to invest in other publicly traded securities, just as they were prior to the original rollover. After all, this is what retirement investment accounts do. Someday the entrepreneur will draw down these funds in retirement, where they will pay personal income taxes on those retirement distributions (presuming these funds are in a traditional retirement plan).
Selling off the S-Corporation
So, what does the S-Corporations tax bill look like on disposal of this homerun business entity? Selling a business is a complex transaction, and tax rates vary based on the allocation of the purchase price between fixed and intangible assets.
However, if we assume the entrepreneur as individual taxpayer would receive the most favorable capital gains tax treatment on the entire sale, with an SBA loan balance remaining of $168,000 (per the blog Part 1 scenario), and depreciation recapture of $133,000 (about 1/3 of the total startup cost), and we assume there are no other sources of income in that tax year, we come up with a taxable income of $2,187,482 — from which pays $400,296 in income taxes, plus $74,578 of net investment income tax, for a total personal tax payment of $474,874.
Always remember: the proceeds from a S-Corporation flow through to the personal tax returns of the owner/stockholders.
How Selling the C-Corporation Impacts the Entrepreneur as Individual Taxpayer
What about the C-Corporation entrepreneur? They receive 10% of the sales price, which is $251,600, plus have a stock basis of $40,000. They pay long-term capital gains taxes on their stock sale. Assuming no other income sources that year, they are due to pay $15,855 in income taxes on the sale of the business on their personal tax return. The other 90% of the profit goes back to their retirement plan to live and reinvest — tax-deferred happily ever after (until drawn upon in retirement).
Total Tax Impact Respective of C-Corporation vs. S-Corporation
So, which entity paid more taxes over the 5-year lifespan of this business? Well, if we consider from Part 1 that a C-Corporation pays $11,839 more in taxes each year, that’s $59,196 more in corporate taxes over 5 years than the S-Corporation. But upon disposal, the S-Corporation entrepreneur incurred $459,019 more taxes in liquidation than the C-Corporation entrepreneur! That means that this entrepreneurial taxpayer saved $399,823 in taxes by operating their business as a ROBS Arrangement! Wow!
Now remember — this is an example where the entrepreneur hits a homerun and sells their business for a lucrative profit over a short period of time. We all wish we could be so lucky. But for the ROBS entrepreneur, they need to be thinking about their exit strategy from Day 1, because they have an inherent opportunity to shelter significant wealth from taxation that is unavailable to most other tax structures.
If you operate an existing ROBS Arrangement and would like to discuss tax planning and exit strategy, contact us by booking a free appointment — just click here.
I Need Cash Now!
In the above example, we see that the S-Corporation has greater exposure to taxation upon liquidation than the ROBS C-Corporation would have in the same scenario. How come?
Well, a big distinction here is that the S-Corporation entrepreneur puts 1.7 million in after-tax revenues directly into their personal bank account from the sale of their business. The C-Corporation entrepreneur, however, only puts about $195,745 in their personal bank account — but also deposits $2,264,400 into their retirement account.
“But I need cash now!” laments our clients. It’s true — if you want the cash, you’ve got to pay the tax. Therefore, it is important to do proper exit planning prior to selling a business. At 59½ years old, the entrepreneur can draw from their retirement balance without early withdrawal penalty — that same penalty they successfully avoid by using a ROBS to finance their business. So, if the entrepreneur is starting their business in their 30s, 40s, or 50s, it is important to map out an exit with age 59 ½ in mind.
Let’s say the entrepreneur in the previous example sells their business at age 58. They take their ~$195,000 profit and go on vacation for 18 months. They return home after traveling the world — sun kissed, and broke — and thus begin drawing upon their retirement account.
Their retirement balance of $2.2 million earns and average of 8-10% annually on the open market ($181,000-$220,000). They decide to live off $150,000 per year, paying a 22% tax rate annually. They’ve succeeded in creating a retirement account that generates more wealth than they need — thanks to the tax-sheltering attributes of a ROBS Arrangement.
Maybe I Don’t Need Cash After All!
What about the S-Corporation entrepreneur who now holds $1.7 million in post-tax profits? Is their money protected from bankruptcy? Unexpected medical expenses? Lawsuits? Back taxes? What about divorce? Having more funds available than necessary to one’s budget is dangerous, as there is inherent exposure to losing those funds in the event of untimely problems that inevitably pop up in life.
Most retirement money is safe from greedy debt collectors — depending upon state and federal laws — whereas your checking account is not.
Because entrepreneurs might want to increase the cash they have upon the sale of their business, it is important to discuss the composition of shareholders, as the owner may want to buy back stock from the retirement plan so the owner can appreciate a larger slice of the profit when they sell the business. Regardless — it all comes down to planning, and that is what we are here to help with at Baum CPA. Want to make an appointment for an initial consultation? Just click here. Your first appointment is absolutely free!
This blog and its authors provide this content strictly for informational purposes. No content herein should be misconstrued as financial advice. Everyone’s specific circumstances vary — Always consult with a qualified, licensed financial advisor, legal counsel, and tax professional before venturing into any investment or business activities.