A costly mistake: How one business owner triggered double taxation

Tyler Kert
Tamarack Wealth Management

Sometimes, learning from others' mistakes is the most powerful and memorable way to learn. This article will outline a real-life case study that took place in the Wenatchee Valley in hopes of helping business owners avoid similar mistakes. All names are fictional for confidentiality reasons.

Mark Ellison was a successful Wenatchee business owner who learned a very expensive lesson about mixing personal finances with corporate structures. Mark built Ellison Mechanical, Inc., a thriving business he started in the mid-1980s. He had humble beginnings, but with time and perseverance grew his business into a successful and profitable family venture. He liked routine and organization, and maybe most of all, he liked efficiency. Unfortunately, though, he sought little guidance when it came to structuring his business.

Early on, Mark opened a brokerage account to invest the profits of his growing business. He invested in a combination of stocks and bonds. Nothing crazy. But instead of putting the account in his own name, he titled it under Ellison Mechanical, Inc. His reasoning was simple: “It’ll be cleaner if everything is under the business.”

Fast-forward to last year. Mark turned 73 and finally got serious about estate planning. He had recently finished wrapping up his late mom’s estate and after going through what seemed like a marathon of a process, wanted to make the process easier for his kids when his time came. His attorney recommended transferring his investment assets into a revocable trust to streamline future inheritance issues. This is when Mark discovered his mistake.

Because the brokerage account was inside his C-corporation, the only way to move the assets into his trust was for the corporation to distribute them out to him. This distribution caused the entire portfolio to be treated as if it had been sold at fair market value. The investment account had grown from Mark’s original deposits totaling about $1 million to over $1.2 million. The corporation now owed tax on $200,000 in gains. And because it was a C-corporation, those gains were taxed at the corporate level.

Mark didn’t love that news, but he thought he could handle it. Unfortunately, though, the worst was yet to come. Once the corporation distributed the account to Mark personally, it was treated as a dividend to him, meaning he owed tax on the entire $1.2 million value, even though he didn’t receive cash, just the investments themselves.

When it was all said and done, Mark owed corporate tax on the gain and personal tax on the full value of the distribution. He experienced the definition of double taxation: two layers of tax on the same assets. Suddenly, Mark’s well-intentioned move years ago had turned into a six-figure tax bill.

When Mark realized his mistake, he tried all the options. Could he re-title it without recognizing gain? No. Could he convert the C-Corp to an S-Corp and avoid the issue? Not without triggering built-in gains tax. Could he “loan” the assets to himself? No. Corporations and shareholders must follow strict distribution rules.

By the time everything was settled, Mark paid over $300,000 between corporate and personal taxes just to move investments from his business account to his personal account. He was forced to liquidate some of his investments just to pay the tax bill. This was all money that would have stayed in his family if the account had simply been in his own name from the start.

Mark learned his lesson the hard way, but he’s used the experience to change the way he approaches tax planning. He now keeps his business and personal assets separate. His story is a powerful reminder that just because something seems efficient doesn’t mean it is efficient. And when it comes to C-corporations, the wrong move can create a double-tax trap that’s painful to unwind.

It’s been said that cheap accountants are the most expensive. When you’re setting up your business structure, take the time to speak with a trusted advisor and make sure that you are structuring your business correctly. What seems like a minor difference in the short-term could have major repercussions down the road. The IRS received $300,000 from Mark that with better planning could have benefitted his family. Remember, the IRS loves people that don’t plan.

This material is for informational purposes only and does not constitute financial, investment, or tax advice. Please consult your tax advisor or financial planner to discuss your specific circumstances before making any decisions. Securities offered through Cetera Wealth Services LLC, Member FINRA/SIPC. Advisory services offered through Cetera Investment Advisers LLC, a registered investment adviser. Cetera is under separate ownership from any other named entity.

Tyler Kert, a licensed financial advisor and CPA, provides financial planning and tax consulting services at Tamarack Wealth Management in Cashmere, WA.