By: Philip J. Clements and Cassie Glynn. October 2011

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1 C TO S TAX CONVERSION By: Philip J. Clements and Cassie Glynn Fundamental Tax Planning Principles: October 2011 General Principles: When everything is done, you should find that income or gains are taxed only once. If it sounds too good to be true, it is too good to be true. Good tax planning does 3 things: 1. Defers tax payments. 2. Changes tax rates, such as: a. Ordinary income to capital gains. b. Compensation to non-compensation. 3. Avoids double tax, by converting from C to S corp. Disclaimer: Tax avoidance is never part of our discussion in tax planning. --- Notice and Disclaimer IRS Circular 230 requires us to give you the following notice: Any tax advice contained in this communication (including any attachments) is not intended to be used, and cannot be used, for purposes of avoiding penalties imposed under the United States Internal Revenue Code. More specifically, Cathedral Consulting Group, LLC is in the operation and strategy consulting practice and does not hold itself out as tax experts, but provides tax insights when such observations may be relevant to operation evaluation. Therefore Cathedral recommends that all tax comments be taken to your tax professional for full consultation and evaluation, before any action is taken.cathedral Consulting Group, LLC is in the operation and strategy consulting practice. Clients request that we record discussions and decisions. Such records are not intended to be operative legal documents and legal counsel should be utilized to create all necessary legal instruments.

2 Background: A corporation is an entity chartered by a state. It is treated as a separate entity from its owners, the shareholders. The shareholders do not have liabilities for the activities of the corporation. Such is the legal framework for a company founded as a corporation. For tax purposes, a corporation can have one of two statuses: 1) a C Corporation often referred to as a C corp., or 2) a S Corporation, often referred to as an S corp. or SubS corp. The C and the S refer to parts of the Internal Revenue Code (IRC) under which each is taxed. The C corp. is taxed under subsection C of the IRC and the S corp is taxed under subsection S of the IRC. A C corp. is treated as a separate taxpaying entity from its shareholders. As an entity, a C corp is responsible for the taxes on its earnings. The shareholders do not pay tax on the operating earnings until they are distributed in the form of dividends. The dividends from the C corp. are then taxed at special rates, currently 15%. The taxation of the same earnings at both the company level and the shareholder level is referred to as double taxation. So a C corp. is said to have double tax on its earnings. A S corp is treated as a pass-through entity. A pass-through entity does not pay tax on its earnings. Instead, the earnings are passed through to the owners, in this case the shareholders, and the shareholders report the earnings on their tax returns, as if they had earned the amount directly. As a result, the S corp has only one level of tax, at the shareholder level. Earnings can be withdrawn without further taxes at any time. Other pass-through entities are Partnerships and Limited Liability Companies (LLC). Both the C corp. and the S corp. have significant rules which are beyond the scope of this paper. The Problem: The problem we are concerned with is that the C corp. creates loss in value in a sale transaction, because of double taxation. The double taxation and loss of value arises as follows: C corp. XYZ s shareholders decide to sell, and ABC corp. decides to buy. XYZ has machinery of value, but no tax basis for future depreciation. The price is $100,000. XYZ shareholders want to sell their stock to get capital gain. However, if ABC buys the XYZ stock, ABC gets a basis of $100,000 in the stock, but the machinery basis does not change. Therefore ABC gets no depreciation on the purchase price. So ABC wants to buy assets to get $100,000 depreciable basis in the machinery, which would result in about $35,000 in tax savings. At this point we can see that a stock sale is $35,000 inefficient to ABC, so it would offer $65,000 for the stock and $100,000 for the assets. XYZ shareholders do not want to sell the assets because the tax would be $35,000 at XYZ level and then a tax of about $9750 on the distribution of the remaining $65,000. At a minimum the loss in value to the seller, XYZ shareholders, is about 10%, but often it is closer to 35%. This assumes that the machinery would not qualify for capital gains treatment. By contrast, if C corp. were a S corp., the assets could be sold for only one tax of $35,000. No further taxes would be required. Therefore, the double tax is avoided.

3 Sale of Stock Sale of Asset The problem then is the double tax on transactions of C corps which can be avoided if the entity is a S corp. XYZ Shareholders Sell Asset ABC Asset Purchase Gain Tax Rate Tax Basis Tax Rate Tax Savings Value of Assets $ 100,000 35% $ 35,000 Depreciable Basis in Asset $ 100,000 35% $ 35,000 Dividend to Shareholders $ 65,000 15% $ 9,750 Total Depreciable Basis: $ 35,000 Total Tax: $ 44,750 XYZ Shareholders Sell Stock ABC Stock Purchase Gain Tax Rate Tax Basis Tax Rate Tax Savings Value of Stock $ 100,000 15% $ 15,000 Depreciable Basis in Stock $ - 0% $ - Total Tax: $ 15,000 Total Depreciable Basis: $ - Tax from Sale of Assets: Tax From Sale of Stock: XYZ Sharoholder Tax Difference (Stock Sale Tax Savings): $ 44,750 Asset Purchase Total Tax Savings from Depreciable Basis: $ 35,000 $ 15,000 Stock Purchase Total Tax Savings from Depreciable Basis: $ - $ 29,750 ABC Tax Difference (Asset Sale Tax Savings): $ 35,000 XYZ Asset Desired Purchase Price $ 100,000 ABC Asset Offer Purchase Price $ 100,000 XYZ Stock Desired Purchase Price $ 100,000 ABC Stock Offer Purchase Price $ 65,000 The Solution: Conversion The solution is to convert a C corp. to a S corp. A conversion can be done by the shareholders of the C corp. electing to be a S corp. The election must be filed by the 15 th day of the third month following the start of the tax year. For calendar year companies, this filing must occur by March 15 th. All shareholders must agree to the S corp. election. The Problems with the Solution Several problems arise with a conversion of a C corp. to a S corp.: 1. The shareholder limitations: S corp. is designed for individual shareholders of a limited number. Therefore the law allows for only 100 shareholders. The shareholders need to be individuals, not other C corporations. Some trusts and estates can qualify and there are some family grouping to make this more effective. 2. Net operating losses: Net operating losses (NOLs) belong to a particular entity. Because the new S corp. is viewed as a new entity, the C corp. s NOL cannot transfer to the S corp. Therefore, the unused C corp. NOL is effectively lost. But see the factors of accrual conversion and built in gains below. a. A key factor to watch in NOL planning is the alternative minimum tax (AMT) and the state and local impact. b. The alternative minimum tax is effectively a 28% minimum tax, so the NOL is not freely useable to avoid taxes. c. An exemption from AMT applies to Small Business Corporations corporations with gross receipts of less than $7.5 million average for the past three years. d. In order to gain tax basis in the S Corp stock to use NOL s, the shareholder needs capital contribution to the company. 3. Accrual conversion: Because the conversion is viewed as a transfer of assets and liabilities from one company to another, the built in income and expenses of a cash basis C corp. have to be recognized in the C corp. s final tax return. This is referred to as an accrual adjustment at the end of the C corp. s last year.

4 a. Generally, the accrual adjustment will mean some pickup in income, because the accounts receivable (unrecognized income) will exceed the accounts payable (unrecognized expenses). Sometimes a bit of planning can reduce the impact of the accrual adjustment at the time of conversion. b. From a planning perspective, the accrual adjustment will reverse in the following months in the S corp. The S corp. can go back on the cash basis, which allows for the accounts receivable and accounts payables to not be recognized. Generally the reversal will occur in the first quarter. As a result, the impact of the accrual adjustment is a onetime acceleration of taxes, which are then recouped. 4. Built-in gains: Because S corps avoid two layers of tax, a sale transaction is much more efficient when done by a S corp. as compared to a C corp. Congress recognized that when a transaction was imminent a conversion of a C corp. to a S corp. would be desirable. a. Therefore, Congress provided that the value gain in the net assets in the company at the time of conversion, called Built-in Gains, would have to be treated as income of the C corp when a transaction occurs. b. Any additional gain would be treated as S corp income. c. Therefore, any sale of the company or assets within 10 years of the conversion will trigger this built-in gain. Recently, the length of time has been shortened to 7 years and even 5 years. Therefore, the length of time from conversion to a sale must be carefully checked for the status of this timing. d. NOLs of the C corp at the time of conversion can offset any built-in gain. However, there are carryover rules for NOLs which can limit those available when the built-in gain is recognized. Alternative minimum tax will also be a factor in the utilization. e. To document the amount of the built-in gain at the time of conversion, a valuation of the assets/business should be performed at the time of conversion. Benefits of the S corp. After Conversion: There are a number of benefits of a S corp. The following is a list of the benefits with some highlighting of the structural limitations of S corp. rules. Care in planning and a current review of tax rules is critical. 1. Single tax on income: The income of a S corp. is taxed at the shareholder level. a. Shareholders have to pay quarterly estimated taxes on the income of the S corp. b. A detriment is that Shareholders have to file individual returns in all states that the S corp. does business. c. Generally, S corp. will distribute enough funds to pay the income tax. i. However, there is no requirement that such a distribution be made. Therefore, a minority shareholder should have an agreement for the distribution of funds to pay the taxes. 2. Single tax on income allows for easy flow of funds: Once the income is taxed to the shareholders, the income can be paid out or retained without additional taxes. a. Any retained income increases the shareholders tax basis in their stock. Therefore, any gain on the sale of the company is reduced by the amount of the retained income.

5 b. After conversion, pre-conversion retained earnings can be a factor in distribution plan. 3. NOL pass through of a S corp. is passed through to the shareholders and can be used on their return, subject to a number of limitations. a. The pass through is limited to the basis the shareholder has in the S corp stock. i. The basis is a technical tax concept generally calculated by the price paid for the stock, plus any contributed capital, plus any loans to the S corp, plus any taxable income reported, less any distributions, less any NOLs used. [Basis=(Stock Principal+Contributed Capital+Loans to S corp+taxable Income-NOL)] 1. A key rule is that guarantees of debt by shareholders does not create basis in the stock for NOL purposes. 2. The shareholder has to loan the money to the S corp, even if the shareholder has borrowed the money lent. ii. When the shareholder does not have sufficient basis in the shares of the S corp, the NOL cannot be used and is suspended until there is sufficient basis. 4. Limits on benefit rules: S corp. has a variety of special rules for tax treatment of benefits such as health insurance, retirement plans and other items. Compensation: Key Principles: 1. Compensation should be reasonable based on given market rates. 2. Minimum compensation reduces payroll taxes. A1. C Corp Dividends and NOL as C Corp.: a. Use NOL, which created incremental NOL, which creates double tax. Example: Compensation Paid Out as Dividend Tax Year 1 Year 2 Total Rate Tax $ Tax $ Tax $ Compensation: Salary $ 150,000 39% $ 58,500 $ - $ 58,500 Free Cash Flow After Expenses (Before Dividend) $ 250,000 NOL $ (1,000,000) Dividend (Rather than Bonus) $ 250,000 15% $ 37,500 $ - $ 37,500 Eventually NOL Tax of 35% on the same 250K $ 250,000 35% $ - $ 87,500 $ 87,500 Total Annual Tax: $ 96,000 $ 87,500 $ 183,500 Compensation Paid Out as Bonus Tax Year 1 Year 2 Total Rate Tax $ Tax $ Tax $ Compensation: Salary $ 150,000 39% $ 58,500 $ - $ 58,500 Free Cash Flow After Expenses (Before Bonus) $ 250,000 NOL $ (1,000,000) Bonus (Rather than Dividend) $ 250,000 39% $ 97,500 $ - $ 97,500 Total Annual Tax: $ 156,000 $ - $ 156,000 Total Tax on Dividend Compensation: $ 183,500 Total Tax on Bonus Compensation: $ 156,000 Total Tax Difference (Bonus offers Tax Savings of $27.5K): $ 27,500 **THIS ANALYSIS IS ILLUSTRATIVE ONLY. All tax rates are estimates using a maximum concept. Rates change year to year and include federal non-income and state.

6 B1. NOL as S Corp: a. Guarantee: No tax basis in S corp shares. b.shareholder borrows $1 million in loan to S corp. which gives basis in S Corp shares allowing NOL to offset other passive income at shareholder level. S Corp. Tax Without Basis Tax Tax Amount Rate Compensation 39% $ 150,000 $ 58,500 Free Cash Flow After Expenses $ 250,000 NOL $ (350,000) Basis in Shares $ - Shareholders use of NOL $ - $ - C1. Benefits of LLC opposed to C corp. is not covered in this document. Examples of Leasing Company Transactions: Total Taxes After Basis: $ 58,500 S Corp. Tax With Basis Tax Tax Amount Rate Compensation 39% $ 150,000 $ 58,500 Free Cash Flow After Expenses $ 250,000 NOL $ (350,000) Basis in Shares $ 100,000 Shareholders use of NOL 35% $ (350,000) $ (122,500) Total Taxes After Basis: $ (64,000) Total Tax Without Basis: $ 58,500 Total Tax With Basis: $ (64,000) Total Tax Difference (Basis offers Tax Savings of $122.5K): $ 122, Cars added per year 500 Cars in Portfolio YTD $ 30,000 Value of each car $ 3,000 Upgrade Value $ 3,000 Markup Value Fact Pattern $ 36,000 Total Value of Vehicle after Upgrade & Markup 20% Residual Percentage of Value $ 7,200 Residual Value of Vehicle 5% Interest Rate on Bank Note 7% Rate of interest to calculate Lease Payment 40% Tax $ (2,000,000) NOL $ - Remaining Basis **Definition: Small Business exemption from AMT **5 year wind down, Sell vehicles at Residual. No Gain ** This Analysis is Illustrative Only. Each situation requires a review of the specific acts and all Tax Rates are estimates using a maximum concept. Rates change year to year and include federal non-income and state. **

7 A. Wind Down NewCo: a. Assumptions: i. Q decides to withdraw from the fleet leasing business. ii. R decides to enter the fleet leasing business. iii. Q Sells cars as they come off-lease. iv. R sets up new S corp. and gets many of Q s former customers. v. R does not pay Q. vi. Q gives no support to R. b. Goal is to collect all funds at minimum cost, pay all taxes and have the cash out of the corporation. B. Sale of assets, assuming an S corp: a. What is the value of the lease or vehicles? b. This may be a premium C. LLC vs. S Corp not covered in this document. Technical Issues: If Q and R are related, then it creates a potential argument of a Sale-Gift. If C sale then it would be a sale of stock at present value. i. Book value of vehicles. (unamortized depreciation) ii. Value of customers is $500 per car. iii. Then subtract the value of the debt. The calculation: Business Value=(Book value + Value of customers Value of debt ) This does not reflect any going concern or good will with customers though the calculation of $500 per customer is a proxy calculation. Options for Tax Planning: 1. As a C Corporation, wind down the operations and sell all the vehicles. 2. As a C Corporation, two options to distribute cash: Option 1: Bonus. i. Bonus tax calculation with Social Security Tax and without. Option 2: Dividend. 3. As an S Corporation, wind down the operations and sell all the vehicles. 4. As an S corporation, sell assets. Example 1: C Corp Wind Down. C Corporation: Wind Down Net Cash in Company after Payment of Debt and Tax: 2,764,672

8 Example 2: Cash distribution options for C Corporation. Distribution of Cash from C Corp. Net Cash in C Corp is $2.8 Million Option 1: Option 2: Bonus Distribution Bonus (Includes the Tax Avoided at the C Corp Level) 4,250,000 Bonus (Includes the Tax Avoided at the C Corp Level) 4,250,000 Ordinary Income Tax 1,657,500 39% Ordinary Income Tax 1,657,500 39% Without Social Security Tax - 14% With Social Security Tax 595,000 14% Net Proceed to Shareholder 2,592,500 Net Proceed to Shareholder 1,997,500 Dividend Distribution Dividend 2,764,672 Tax on Dividend 414,701 15% Net Proceed to Shareholder 2,349,971 Dividend or Bonus Without Social Security Dividend or Bonus With Social Security Net Bonus Distribribution 2,592,500 Net Bonus Distribribution 1,997,500 Net Dividend Distribution 2,349,971 Net Dividend Distribution 2,349,971 Difference in Net Distribution: 242,529 Difference in Net Distribution: (352,471) Example 3: S Corp. Wind Down. S Corporation: Wind Down Cash to Shareholder 2,764,672 No Tax on Shareholder Level - 0% Net Proceed to Shareholder 2,764,672 Example 4: Sale of Assets as S Corp. Conclusion: Net Asset Value Value of Good Will Value of Cars Under Lease $500 per Car $ 500 Total Income from Rent $ 6,244,506 Number of Cars 500 Total Income from Sale of Vehicle $ 3,600,000 Good Will Value $ 250,000 Value of Cars Under Lease $ 9,844,506 Gross Asset Value $ 10,094,506 Total Interest Expense $ 494,590 Total Principle Pay Down $ 6,299,054 Total Debt $ 6,793,644 Net Asset Value Before Taxes: $ 3,300,862 Overall, business conversions are not to be taken lightly. Planning is crucial to ensure all legal and financial steps are taken properly. Changing the business structure of an entity can reap many financial benefits due to tax savings attached to such a formation or conversion. It is important to note that tax rates and regulations are continually changing. It is encourage that before making any change or conversion to a business entity, seeking assistance and/or aid in the process is a recommended step from the beginning.

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