Beyond the ‘C’: Use S corporation to buy or transfer a business.

A reader of this site — let’s call him Joe — asked his CPA to call me to get a second opinion.

Here’s the story the CPA told me:

Joe was about to buy the stock of a C corporation for $2.2 million payable over eight years plus interest at prime, all evidenced by a note. In addition, another $600,000 was to be paid by the C corporation to be divided between a covenant not to compete (for three years starting immediately) and a consulting contract (the CPA was not sure that the seller was really going to consult) to the seller for three years. The idea was to make the $600,000 deductible as paid.

Joe intended to get the money to pay the principal and interest on the $1.2 million note by taking a bonus twice a year when the note payments became due.

Fortunately, the CPA called before any papers were signed. Without getting into every nook and cranny of the proposed transaction, here is a list of the most obvious tax blunders that would have befallen Joe and his C corporation.

– The bonuses to Joe almost certainly would have been attacked by the IRS as unreasonable compensation (Joe intended to take $250,000 to $275,000 as regular compensation, plus the bonuses).

– The interest to be paid by Joe is considered investment interest, which is deductible only to offset investment income (Joe had none). In effect, all of that beautiful interest would have been nondeductible.

– An employee or consultant already has a duty not to compete. Paying the seller for consulting is OK (assuming the amount is reasonable). So if the seller actually worked and got reasonable compensation, it would be deductible. On the other hand, if the seller really did not consult, none of the consulting payments is deductible. In any event, the amount of the covenant is not deductible over the three-year payment or not-to-compete period; instead, it can be written off only over 15 years.

Again, without attempting to cover every detail, here is how the transaction will be done:

– Joe will elect S corporation status. Now Joe can take tax-free S corporation dividends to pay the note. The interest, because of the S corporation status, is now deductible on Joe’s personal tax return as a business expense. The unreasonable-compensation problem is eliminated.

– The interest rate will be raised to two points over prime and reduce the covenant amount dollar for dollar. The consulting contract will run for only the period of time that the seller actually consults, and that will be paid for same. After the consulting period is over, the covenant not to compete will kick in.

One warning: Whether you’re buying or selling a business, work only with experienced and knowledgeable professionals. Pretend you’re having a heart transplant, and seek out the best professional help you can find. If you are selling your S corporation to one of your kids, he or she can deduct the interest (see Letter Ruling 9215013).

An S corporation is almost always the best route when you are transferring — by sale or otherwise — your business to your kids.

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