When selling your MSP, one of the most critical factors to consider is how the sale will be taxed. The tax implications can significantly impact your net proceeds from the sale, and much of this depends on your company’s structure.
Regardless of structure, there will be significant taxes to pay. Understanding the balance between buyer and seller tax preferences is key during negotiations. So while you may chose a structure to reduce your personal tax burden, you can expect a reduction in your valuation when the buyer will gets stuck with the tax bill.
C Corporation: The Double Tax Dilemma
If your MSP is structured as a C corporation, you’ll need to be aware of what’s commonly known as “double taxation.” This means the company pays taxes at the corporate level when it sells assets, and then shareholders pay taxes again when they receive distributions.
- Corporate-Level Tax: A C corp must pay taxes on the profits from selling assets—currently taxed at a federal rate of 21%.
- Shareholder-Level Tax: After corporate taxes, when the remaining funds are distributed to shareholders, they’re taxed again at capital gains rates (typically 20%).
Stock vs. Asset Sales: Buyers prefer asset sales, where they can “step up” the basis of the assets for tax purposes. Sellers often lean toward stock sales to avoid double taxation. However, many buyers are completely unwilling to to do stock deals with C corps.
S Corporation: Pass-Through Taxation
An S corporation avoids the double taxation issue, as profits and losses “pass through” directly to the shareholders and are taxed only once at the individual level. Here’s how that plays out during a sale:
- No Corporate Tax: Unlike C corps, an S corp doesn’t pay corporate-level taxes on the sale of assets. The income passes through to the shareholders, who report it on their personal tax returns.
- Capital Gains: Shareholders pay taxes at the long-term capital gains rate (15% or 20%) on profits if they’ve held the stock for more than a year.
However, if your MSP recently converted from a C corp to an S corp, you could be subject to the built-in gains tax—a special tax on appreciated assets from the C corp years. This applies if the sale happens within five years of the conversion.
Qualified Small Business Stock (QSBS): A Hidden Tax Advantage for C Corps
For C corp owners, the QSBS exemption under Section 1202 of the Internal Revenue Code can be a game-changer. It allows shareholders to exclude up to 100% of the capital gains from the sale of their stock, provided certain conditions are met.
- C Corp Requirement: QSBS only applies to C corporation stock, so if you’re operating as an S corp, this isn’t an option.
- Holding Period: You must hold the stock for at least five years before you’re eligible for the full tax exclusion.
- Gain Exclusion: If your stock qualifies, you can exclude up to the greater of $10 million or 10 times your original investment in the company from federal capital gains taxes.
Why It Matters: If your MSP qualifies as a small business under QSBS guidelines (with less than $50 million in assets when the stock was issued), you could potentially sell your company and pay little to no federal capital gains tax on the sale. That’s a huge advantage, especially for those who’ve held their stock long-term.
Choosing the Right Path
Deciding between a C corp or an S corp isn’t just about how you’ll be taxed today—it’s about your long-term strategy for selling your MSP. If you’re a C corp, the QSBS exemption might make it worth sticking with that structure. However, if avoiding double taxation is your priority, an S corp offers more immediate relief, even if it doesn’t provide the QSBS benefits.
