When creating a new business entity, part of the consideration is what type of entity to choose is based on the tax consequences. If selling the company later is a possibility, the tax consequences of an exit strategy are important and could make a large impact upon an ultimate sale price. Two major considerations are double taxation and whether a tax-free stock swap deal is a possibility.
Double taxation is one consequence of creating a company taxed as a C-Corporation. If you are to sell the company, the C-Corporation pays tax on that initial income from the sale. See generally 26 USC §11. Afterwards, the shareholders are taxed again when they receive the amounts as dividends or distributions, resulting in double taxation. See e.g. Byron F. Egan, Choice of Entity Alternatives, 39 Tex. J. Bus. L. 379, 415 (2004). S-Corporations, however, do not have double taxation issues, as only the shareholders are taxed on whatever amount is greater than the basis of the stock is taxable as capital gains. Id. at 416; see also 26 U.S.C. §1363. LLCs may also avoid double taxation when the LLC is formed and chosen to be treated like a partnership. See 26 CFR 301.7701; see also Egan, Choice of Entity Alternatives at 453.
An alternative exit strategy is a stock swap, where some of the stock of the purchasing company is traded for the stock of the company being bought. C and S Corporations can make a stock swap transaction tax-free for the company if it follows the IRS rules. 26 U.S.C. § 1045; 26 U.S.C. § 368. By doing this, a C-Corporation can avoid the double taxation issue, and instead only shareholders will have to pay taxes if they decide to sell the newly swapped stock. An LLC, however, if taxed as a partnership, cannot have a tax-free stock swap since partnerships are exempted in the IRS Code. 26 U.S.C. §368.
Although the sale of a company may seem far off when forming it, choosing the right entity can have a large impact on taxes paid on the sale. There are other tax considerations when creating a company, including other sections of the federal tax code, and each state’s specific tax treatment of companies. It is important to know the rules in your jurisdiction before creating a business entity to minimize taxes if the company is sold in the future.
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