Friends don’t let friends form C-corporations

May 1, 2002 By    

This is a story about two companies very much alike in all major respects but one.

Carlson’s Gas Service

Stan Carlson was 52 years old and had invested his career – or rather his life – into building Carlson’s Gas Service, a retail propane company that he founded 20 years earlier.

His only son had chosen not to continue in the business. Although disappointed in not being able to pass the business on, Stan was happy to continue his active ownership since he had a very solid manager who was running the office and administrative functions of the business. His drivers and service people were experienced and offered great customer service.

With a strong reputation and good marketing, the company steadily added customers each year. Stan regularly invested in new customer tanks and kept the rolling stock in above average condition. Over the years he was able to pay off all of his bank debt, except for seasonal working capital needs. He believed that he would continue to run the business for another 10 years.

But in the spring of 2000, Stan’s health took a turn for the worse. Although not terminal, his health would prevent him from continuing to operate the company. The situation dictated that he sell the business.

Fortunately, he had a standing offer from a friendly competitor that was favorable to both parties. Terms were agreed upon and assets of the company were sold for 100 percent cash. The operations, employees and customers were successfully transitioned.

In the transaction, Carlson’s shareholders received $4 million in cash for the assets. The sole shareholders were Stan and his wife, Linda.

In addition, Stan dissolved the corporation thereby withdrawing the proceeds of the sale. The sale transaction triggered tax liabilities that were ultimately paid out of the proceeds. The net amount after taxes that Stan and Linda received from the sale and liquidation of the company was $1.92 million or about 48 percent of the sale amount.

Lancaster Propane Company

Lancaster Propane Company was founded in 1980 by four investors, two of whom were active in the daily operations of the business. The company was originally capitalized with founder equity and bank debt.

In the early years, internally generated cash was used to fund growth and service debt. The company steadily purchased new tanks and kept the equipment in above average working condition. Lancaster Propane was eventually able to retire all of the bank debt. The business was successful in meeting the founders’ original growth plans and, in the last 10 years had made good distributions to its shareholders.

Lancaster Propane Company was, in fact, very similar in characteristics to Carlson’s Gas Service in the number and type of customers, the regional growth characteristics, and the income generated in a normal year.

During the last shareholder meeting, the two managing partners indicated that they were interested in retirement. They all agreed that, when the 1999/2000 winter season was over, the company would be put up for sale.

A local financial advisor familiar with the owners and the business was retained to solicit qualified proposals and manage the sale process. The successful bidder was awarded the transaction. The operating assets of Lancaster Propane were sold for $4 million in cash. As planned, the business entity was liquidated and the cash was distributed to the four original founders.

As with the Carlson’s Gas Service transaction, the Lancaster sale triggered federal income tax liabilities. The total proceeds after the dissolution of the company distributed to the Lancaster shareholders after taxes were $3.12 million, or 78 percent of the sale amount! That is a staggering $1.2 million more than Stan and Linda Carlson received.

The $1.2 million difference

If we assume these two companies were created about the same time, possessed a similar customer base and growth pattern, and were valued about the same when they were sold, it is also fair to assume that their tax basis and asset values were nearly identical. The question is, what single distinction created the dramatic $1.2 million difference in net proceeds to their shareholders?

The answer lies in the business structure of the entities themselves. Carlson’s Gas Service was a traditional C Corporation. This structure is the most common legal structure for businesses in America. It separates the liability of the company from its shareholders, to the extent of the equity invested.

As a C Corporation, Carlson’s pays a corporate tax on net income. Distributions or dividends paid to shareholders were also taxed to the shareholders on their individual returns. This creates the double taxation of earnings aspect of the C Corporation. Every dollar of net income first receives a corporation level tax, then is taxed as income, if distributed to the individual shareholder.

In addition, the two-step process of the sale transaction and dissolution of the C Corporation also created a similar significant “double tax” liability in the Carlson case. Combined, these tax liabilities can be as much as 55 percent to 60 percent of the proceeds of the sale.

On the other hand, Lancaster was established as a Subchapter S Corporation under the IRS guidelines. Like the C Corporation, the Sub S Corporation limits the liability of the shareholders.

However, the Sub S Corporation is not a taxable entity. Taxable gains and losses are treated at the shareholder level, so a single tax structure to the shareholder is in place. Likewise, at the dissolution of an S Corporation, the single tax treatment is also significantly more favorable to the shareholders.

In Conclusion

Are there ways to minimize the dramatic differences demonstrated above? Absolutely. We did not go into the detailed accounting and tax calculation process that occurs during a transaction, and we also chose in our examples for both companies to sell assets for cash. We chose to focus on very simplistic transactions with straightforward outcomes.

The final question is why did Carlson’s Gas elect a C Corporation structure and Lancaster Propane choose to set up a Subchapter S Corporation? Who knows? I have yet to learn a single advantage of a C corporation over a Sub S corporation for entities in our industry.

Is this important to you if you are not contemplating a sale? Yes, because you may not be contemplating a sale right now, but your plans could change – as in the case of Stan Carlson. And if they do, you might wish you had looked into this issue further.

It is possible to convert from a C Corporation to an S Corporation. Contact your legal counsel or financial advisor for more detailed information about the best legal structure for your business.

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