No, I don’t mean the yellow-brick road, or any train, or anything like that. I am referring, of course, to the Protecting Americans from Tax Hikes Act of 2015 (the “PATH” or the “Act”). The recently enacted legislation provides a number of tax benefits, a few of which will be of particular interest to the owners of certain closely-held corporations who may be considering the sale of their business. 
First, Some Basics
Most business owners who operate their closely-held business through a corporation know that the deal structure by which the business is sold may have a significant impact on their tax liability and, thus, on the net economic result of the sale.
A sale of stock will generate long-term capital gain for the selling shareholders, taxable at a federal rate of 20%, provided they have held the shares for more than 12 months. If the target corporation is a C corporation, an additional 3.8% surtax (on net investment income) may be imposed on the gain realized. If the target is an S corporation and the selling shareholder has been active in its business, this surtax may not apply.
A sale of assets may yield very different results, depending upon the composition of the corporation’s assets and the corporation’s tax status.
A sale of assets by a C corporation will generate gain that will be subject to corporate level tax, at a maximum federal rate of 35% (regardless of the nature of the assets sold); the distribution of the remaining proceeds to the shareholders in liquidation of the corporation will generate a second level of tax – to the shareholders – at the federal long-term capital gain rate of 20% and, perhaps, the 3.8% surtax.
A sale of assets by an S corporation is generally not taxable at the corporate level; rather, the gain realized will flow through and be taxed to the shareholders. The nature of the gain, as ordinary or capital, will depend upon the nature of the assets being sold (e.g., inventory, depreciation recapture property like equipment, real estate, goodwill, etc.); this will determine the rate of tax imposed upon the shareholders, with ordinary income items being taxed at a maximum federal rate of 39.6% and capital gain items at 20%. If the business was “passive” as to a particular shareholder, these rates would be increased to include the 3.8% surtax.
If the S corporation was previously a C corporation, and its assets were appreciated (had built-in gain, or “BIG”) at the effective date of the “S” election, then the sale of such assets within the corporation’s “recognition period” will generate a corporate level tax liability (at the maximum corporate rate), based upon the amount of the built-in gain.
Planning for the Sale?
Oh, to have a crystal ball.
Business owners have many things to think about when they start, or acquire, a business, and I daresay that taxes and the ultimate disposition of that business may not be at the forefront of their concerns.
Moreover, business realities may force certain tax “decisions” upon the owners. For example, the need for an infusion of capital from an unrelated investor group (an “angel” investor in the form of a partnership), whether as equity or convertible debt, may preclude an S corporation election for the business.
However, business owners who do not consider taxes at the inception of the business, and throughout their ownership of the business, do so at their peril.
Insofar as the PATH in concerned, business owners should familiarize themselves with the changes affecting the sale of small business stock and the recognition period for S corporations that were formerly taxable as C corporations.
Small Business Stock Exclusion
In general, a taxpayer other than a corporation may exclude 50% of the gain from the sale of certain “small business stock.” This is stock in a domestic C corporation that was acquired at original issue from the corporation (in exchange for cash, services, or property other than stock) and held for at least five years.
The amount of gain eligible for the exclusion by an individual with respect to the stock of any corporation is the greater of (1) ten times the taxpayer’s basis in the stock or (2) $10 million (reduced by the amount of gain eligible for exclusion in prior years).
To qualify as a “small business,” when the stock is issued, the aggregate gross assets (i.e., cash plus aggregate adjusted basis of other property) held by the corporation may not exceed $50 million, and the corporation must satisfy certain active trade or business requirements. The portion of the gain that is not excluded from taxable income under this rule is taxed at a maximum rate of 28% under the regular tax (not the 20% usually applicable to capital gain); 7% of the excluded gain is an alternative minimum tax preference.
Pre-PATH History and the PATH
Prior to the passage of the Act, for stock acquired after February 17, 2009 and before September 28, 2010, the percentage exclusion for qualified small business stock sold by an individual was increased from 50% to 75%. For stock acquired after September 27, 2010 and before January 1, 2015, the percentage exclusion was increased to 100% and the minimum tax preference does not apply.
The Act made both the post-September 27, 2010, 100% exclusion and the exception from minimum tax preference treatment permanent effective for stock acquired after December 31, 2014.
S Corporation Recognition Period
For taxable years beginning in 2009 and 2010, no tax was imposed on the net recognized BIG of an S corporation under section 1374 if the seventh taxable year in the corporation’s recognition period preceded such taxable year. Thus, with respect to gain that arose prior to the conversion of a C corporation to an S corporation (the “BIG”), no corporate-level tax was imposed if the seventh taxable year that the S corporation election was in effect preceded the taxable year beginning in 2009 or 2010.
For any taxable year beginning in 2011, no tax was imposed on the net recognized BIG of an S corporation if the fifth year in the corporation’s recognition period preceded such taxable year. Thus, with respect to the BIG, no corporate tax was imposed if the fifth taxable year that the S corporation election was in effect preceded the taxable year beginning in 2011.
For taxable years beginning in 2012, 2013, and 2014, the term “recognition period” was also the five-year period beginning with the first day of the first taxable year for which the corporation was an S corporation (or beginning with the date of acquisition of assets if the rules applicable to assets acquired from a C corporation applied). If an S corporation with assets subject to the BIG tax disposed of such assets in a taxable year beginning in 2012, 2013, or 2014 and the disposition occurred more than five years after the first day of the relevant recognition period, gain or loss on the disposition was not taken into account in determining the net recognized built-in gain.
The PATH
The Act made the rules applicable to taxable years beginning in 2012, 2013, and 2014 permanent, effective for taxable years beginning after December 31, 2014.
Thus, if the fifth year of an S corporation’s recognition period ended in 2015, the gain from an asset sale (or a deemed asset sale under IRC Sec. 338(h)(10) or Sec. 336(e)) in 2016 will not be subject to the BIG tax.
Planning for the Sale
With apologies to The Godfather, business owners never know when a potential buyer will make an offer that cannot be refused. Nor do they know when they will find themselves in circumstances under which the sale of their business, though not ideal, will make the most economic sense.
Preparing for the sale of the business is an ongoing process, not a matter of just a few months. For this reason, business owners should stay abreast of changes in the tax laws, such as the PATH provisions described above, and should keep their tax advisers informed of changes in the business and its ownership. This will afford business owners the opportunity to avoid costly mistakes and to tailor the structure of the business so as to reduce their tax liabilities on its disposition.