November 6th, 2024

Business Succession Planning for C-Corps: What Every Shareholder Should Know

Today’s publication of our succession planning series will dive into the nuts and bolts of business succession planning for C-Corps, building upon last week's discussion of partnerships. We'll focus on the tax issues that shareholders should consider when planning to gift or bequeath stock to their heirs.

Understanding C-Corp Taxation Structure

A C-corporation is a business entity legally distinct from its owners and shareholders. Unlike general partnerships, where stakeholders are liable for the business, C-Corp shareholders are not personally liable for the company's debts or obligations.

This corporate structure is the most common form of business incorporation in the United States due to its ability to attract investors. Here are key C-Corporation tax issues that business owners should keep in mind:

  • Income tax: In addition to state taxes, C-Corps are subject to a federal income tax of 21% on their profits.
  • Double taxation: Profits of C-Corps are taxed at the corporate and individual levels when profits are distributed to shareholders as dividends.

Given these taxation nuances, business owners should consider several factors when devising a corporate ownership transfer strategy for their C-Corp shares.

Key Tax Considerations in C-Corp Succession Planning

Your business succession plan determines the tax implications of transferring your C-Corp shares to heirs. If you gift your C-Corp shares to your children during your lifetime, stock redemption rules apply. However, if you bequeath your shares to heirs after death as part of your business succession plan, it’s important to understand the step-up in basis.

Stock-Redemption and Its Tax Implications

Here's how stock redemption works for C-Corps:

  • The corporation may buy back shares from the shareholder at their fair market value, providing immediate liquidity for retirement savings and other investment options.
  • The company may then decide to reissue these shares to the heirs set to take over the business, depending on its shareholder agreement and other considerations.

Regarding tax implications for the exiting shareholder:

  • According to the IRS, the shareholder recognizes a capital gain or loss if the stock redemption is treated as a sale or exchange. The gain is usually the difference between the redemption price and the shareholder's basis in the redeemed stock. To qualify for capital gains tax treatment, the stock redemption must significantly reduce the shareholder's ownership percentage in the company.
  • If the transaction does not qualify as a sale or exchange, the stock redemption may be treated as a dividend, depending on the C-Corp's earnings and profits.

Step-Up in Basis Adjustment and Its Tax Implications

A step-up in basis adjustment applies when a shareholder bequeaths their C-Corp shares to heirs after death. In simple terms, the value of the inherited shares is stepped up to the current fair market value at the date of the decedent's death. This adjustment can reduce the capital gains tax for the heirs if they decide to sell the shares later.

Stock-Redemption and Step-Up in Basis Adjustment: A Practical Example

Let's consider a practical example: Michelle is a founder of a burgeoning start-up. She owns 500 shares in the C-Corp with an original basis of $100 per share.

Scenario 1: Redemption of Shares by the C-Corpnbsp;

  • The start-up redeems the shares at $1,000 per share
  • Capital Gains Tax Calculation:
  • Tax Treatment: Michelle will pay capital gains tax on the $450,000 gain

Scenario 2: Inheritance and Redemption Post-Inheritance (Step-Up Basis Adjustment)

  • Michelle dies and bequeaths her 500 shares to her son, Mark
  • Fair Market Value (FMV) at the time of death: $1,000 per share
  • Step-Up in Basis: Mark receives 500 shares with a new basis of $1,000 per share

If the corporation redeems these shares from Mark at the same price as the FMV at the time of Michelle’s death, Mark will not incur any capital gains tax. Here's why:

  • Redemption amount: 500 shares for $1,000 = $500,000
  • Stepped-up basis: 500 shares × $1,000 = $500,000
  • Capital Gain: $500,000 - $500,000 = $0

Conclusion

This marks the end of our exploration into a few of the tax implications of transferring C-corp stock to heirs as gifts or inheritance. Join us next time to understand how to implement trusts for succession planning.

Are you wondering about any of the issues mentioned above? Please email us at info@wilkinsonlawllc.com or call (732) 410-7595 for assistance.

At Wilkinson Law, we give business owners the clarity they need to fund, grow, protect, and sell their businesses. We are trustworthy business advisors keeping your business on TRACK: Trustworthy. Reliable. Available. Caring. Knowledgeable.®

Categories: Succession Planning