Build It So They Will Come

It’s relatively easy to sell a C corporation, Rummel says, but shareholders will most likely pay two levels of taxes on the proceeds. If the purchaser buys just the company stock, she says, the proceeds may be taxed once, and often at capital gains rates.

But stock brings liability for past company activities, so buyers often prefer to purchase C corporation assets. “In that case, the corporation pays income tax on the difference between the basis and the purchase price, and then the dividend is taxable to the seller,” Rummel says. “Buyers like to buy assets, and sellers like to sell stock.”

Sellers sometimes avoid double taxation by structuring a sale as a tax-deferred reorganization. “The selling owner can defer the payment of taxes until the shareholder sells the new stocks that were received in the reorganization,” Rummel says.

LLCs: New But Gaining Acceptance

Business owners who want to combine limited liability, pass-through profits and losses, and flexibility of-ten prefer limited liability corporations (LLCs).

This relatively new business structure has been around for about eight years and offers limited liability and a single taxation layer. LLCs divide company equity into membership units, an ownership form that resembles stock. There’s no limit to the number of shareholders, or, in this case, membership-unit owners, and they can be individuals or corporations.

Membership units can be even more flexible than preferred stock, Schley says. A company can separate financial rights and voting rights, for instance, or offer preferential liquidation, distribution, or management rights. You might arrange it so that one group of investors gets the majority of the money until they’re paid back, and then a second group will   get paid back in the same way. “You could do that with a corporation with preferred stock,” Schley says, “but it’s often much more difficult.”

Companies that make money by licensing their patents may get better tax treatment under an LLC than they would under an S corporation, Rummel says. “I saw a situation where a company was licensing out a patent,” she recalls. “Had they structured as an LLC rather than as an S corporation, the royalties would have qualified for long-term capital-gains rate, rather than the ordinary income rate.”

Industry professionals say that LLCs are gaining acceptance. “We are seeing venture capitalists and private equity firms getting comfortable with LLCs, because they’re able to take advantage of the tax treatment and still have the flexibility to structure rights and preferences to protect their investment,” Rummel says.

Even so, LLCs aren’t yet universally beloved. “An LLC’s flexibility also makes it more complicated and difficult for the investor to assess,” Schley says.