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Should Your Practice Be a C Corp?
Determining the right structure for you and your business
By Mark C. Tibergien, Principal, Moss Adams LLP, Seattle, WA

It’s not uncommon for investment advisory practices to elect to do business as regular ("C") corporations due to the benefits associated with this structure. These include lower corporate tax rates, deductible medical insurance fringe benefits and the perception that a C corporation represents a more substantive business entity. While these may be valid reasons to establish your practice as a C corporation, you may be unpleasantly surprised if you decide to sell your practice. Why? Because selling your practice as a C corporation could result in an income tax liability that diminishes your net realized value by as much as 30%. The good news is that there are strategies and alternative business structures that can prevent or substantially reduce this tax liability.

Table 1

Types of Sales

Currently, the vast majority of investment advisory practices are sold as "asset sales," meaning the sale of goodwill, a book of business and other tangible and intangible assets. In contrast, in a "stock sale" a corporate entity is sold as a unit or through transferring common stock. From the buyer’s perspective, a stock sale is generally less attractive because it doesn’t allow for a step-up in basis of the assets when stock is acquired. This eliminates the opportunity to receive future tax deductions based on the "premium" price paid.

Tax Implications

If an investment advisory practice operating as a C corporation is sold on an "asset basis," the corporation must first pay corporate income tax on the sale of those assets. The remainder is then distributed to the shareholder(s), who pay an additional capital gains tax on the proceeds. The same transaction in an originally elected S corporation results in only one tax—a capital gains tax at the shareholder level. The table above provides a comparison of the sale of a hypothetical C corporation and an S corporation.

The potential disadvantages the seller of a C corporation faces don’t end there. While asset sales are typically completed on an installment basis in which the buyer pays the seller over time, the structure of most deals requires that the corporate-level tax be paid immediately, meaning that the seller must be prepared to cover this tax bill at the time of sale.

Unfortunately, it may be difficult to mitigate the consequences of this tax problem by simply converting from a
C corporation to an S corporation. A newly elected S corporation must wait 10 years to avoid imposition of
the corporate-level tax on the sale of its assets. Electing S corporation status today will ensure that all future growth from the date of the election is excluded from the corporate-level tax if a sale takes place before 10 years elapse. If you decide to pursue this option, you’ll need an independent valuation of your practice to establish its baseline value at the time of the election.

Other Strategies

If you choose to retain C corporation status, you may have alternative means of mitigating the tax impact on its sale. A buyer purchasing assets typically prefers to allocate as much of the purchase price as possible to currently deductible expenses or short-lived assets, namely furniture and equipment. However, the portion of the purchase price that is allocated to goodwill (the book of business) must be amortized and the deduction spread over 15 years. As a result, many buyers prefer to allocate a portion of the purchase to a deductible Consulting Agreement rather than goodwill.

With a Consulting Agreement:

• The seller will owe ordinary income tax on the Consulting Agreement and incur additional expenses such as self-employment taxes

• The seller’s eligibility for Social Security benefits may be affected while receiving payments

• The buyer may have to recognize certain employee-related expenses that would not have occurred in a pure asset sale

Another alternative is to allocate the purchase price to "personal goodwill." Personal goodwill characterizes the goodwill associated with the practice as a personal asset of the individual shareholder, rather than something that belongs to the business.*

Personal Goodwill:

• For the seller, this allocation of the sale price bypasses the corporate-level tax by shifting the transaction to the seller’s personal tax return, thus netting more to the seller

• The goodwill is amortized and deducted over a 15-year period

Table 2 below demonstrates that by shifting the purchase price outside the business to personal goodwill, the seller nets $196,000 more from the sale.

Table 2

Reaching a Decision

In order to make the most advantageous election for your practice, work with an accounting firm experienced in business transactions and tax laws. For some practitioners, the income tax difference between personal and corporate rates is significant enough to retain C corporation status, particularly if they are no longer building value in their practice. However, evaluating the present value of tax savings of operating (and then selling) in an alternative entity structure may provide motivation to consider other options.

To determine the best approach for you and your business, your tax and legal advisors will need to understand the nuances of what you are trying to accomplish—requiring an investment of time and money on your part. By making this effort sooner rather than later, you stand to maximize the net return you can realize from your practice.

*Be advised that the IRS is closely scrutinizing transactions purporting to attribute goodwill to the shareholder rather than the corporation. Although several recent court cases were decided in favor of the taxpayer, this strategy seems to work only where the corporation really has no economic claim to goodwill and all of the goodwill is a result of the personal efforts of the shareholder.

Mark C. Tibergien is a principal at Moss Adams LLP, Seattle, WA. Moss Adams is the 13th largest CPA firm in the U.S. and specializes in valuation, ownership transition, practice management and accounting issues for a variety of businesses, including financial planning firms, broker-dealers and investment advisors.

The services and opinions or Mr. Tibergien are independent of Charles Schwab & Co., Inc. This article and opinions contained therein are for general information only, and are not intended to provide specific advice or recommendations for any individual or situation.

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