The intersection of entity choice and tax reform
The promise of tax reform carries with it the obligation to consider realigning a business entity with strategies that might benefit it under a new tax regime. Choosing the right type of entity is a crucial decision that has to be made, whether at the outset of the entity life cycle, or in response to changes in the tax law or economic factors affecting the business.
Although taxes are a significant driver in determining which business structure to select, they are not the only factor to consider in the process, according to Barbara Weltman, author of J.K. Lasser’s Small Business Taxes. “There’s also access to capital, liability, the nature and the number of owners, Social Security and Medicare taxes, restrictions on accounting methods, the owner’s payment of company expenses, filing deadlines and extensions, multistate operations and exit strategy,” she explained.
And with a growing number of reasons why an S corporation structure may no longer be desirable, now might be a good time to consider terminating an S election, she observed.
Among the reasons are proposed tax rate changes, flexibility in seeking investors, and health coverage, she noted.
Tax reform proposals that call for a dramatic cut in the corporate tax rate and the elimination of double taxation on C corporations are among the changes that might favor C corporation status. If the expected tax reform produces rates that favor C corporations, “Existing S corporations that expect to be profitable may want to revoke their elections,” Weltman explained.
C corporations make it easier to raise cash through outside investors, Weltman noted. “Equity crowdfunding currently is not suitable for S corporations because such entities have a 100-shareholder limit,” she explained. “There has been a proposal to waive the shareholder limit on S corporations for equity crowdfunding purposes, but this has not yet become law.”
“Likewise, if the corporation wants to do an [initial public offering], it cannot do so as an S corporation because of the 100-shareholder limit,” she added.
And while S corporations must report company-paid health care coverage as taxable compensation for any owner-employees with more than a 2 percent ownership interest, C corporations can provide health coverage tax-free to owner-employees, she observed. Moreover, S corporations are limited in the types of shareholders they can have. Individuals who are nonresident aliens, partnerships, and corporations are not allowed as shareholders.
LOOKING BEYOND THE LLC
Scott Kaplowitch, managing partner at Edelstein & Co., is also starting to reconsider entity choice. “I’ve always been an LLC guy because there’s a single level of taxation,” he said. “But I’m starting to rethink that.”
Limited liability companies, formed under state statutes, have been popular alternatives to C corporations, since they insulate owners from personal liability and are typically treated as a partnership for federal tax purposes.
“If you exit an LLC, there are more benefits to the buyer, so potentially you may receive more for the business when you sell,” he said. “But under a potential new tax regime, a C corporation may be more beneficial. There would still be the double tax, but with the lower rates and the possibility of using the Section 1202 exclusion if you’re a qualified small business, the C corporation becomes more attractive.”
Under Code Section 1202, qualified small-business stock held for more than five years is eligible for exclusion from gross income upon its sale.
Timothy Jessell, CPA, Esq., a partner at law firm Greenberg Traurig, agreed that the availability of the Section 1202 deduction can be a major factor. “If I could get zero tax on a sale of the business, I would accept a lower sale price,” he said. “That makes sense for tech start-up companies.”
There are also additional deductions available to a C corp that are not available to an S corp or an LLC, such as the deduction for health insurance, Kaplowitch observed.
And even if tax reform doesn’t “fix” the double taxation of C corporations, with tax rates being potentially much lower it might not matter, according to Kaplowitch. That, plus the small-business exemption on sale proceeds, and the additional tax advantage of deductions that are not available under an S corporation or an LLC, may tip the scales in favor of a C corp.
But Kaplowitch isn’t in a rush to change entity choice for his clients, at least not yet. “Right now, we’re in a holding pattern,” he said. “We’re not doing anything as far as changing entity choice until we really know what’s going on.”
READING THE TEA LEAVES
While the exact outline of tax reform is not firm, there have been some hints along the way, according to Chip Wry, a partner at law firm Morse Brown Pendleton: “It will be similar to the GOP Blueprint. Both the Trump plan and the Blueprint call for lower corporate and individual rates. And the pass-through rate may be an intermediate rate between the corporate and individual rates.”
“The way to look at it when you approach entity choice is how you think you will make money,” he said. “Will you retain earnings, or will they be distributed? Even today, the top corporate rate is lower than the individual rate. If you retain earnings you can actually get a lower effective rate under a C corporation than an S corporation or an LLC, but if earnings are distributed to the owners periodically, you can get a lower effective rate with a pass-through entity, since a C corporation’s earnings are taxed twice.”
Under both the Trump plan and the GOP plan, the rate relativity remains as it is today, with the corporate rate under each plan lower than the individual rate, Wry observed. “So if you retain earnings, it might point to a C corporation as the better choice, but if you distribute earnings, the combination of the two rates will result in a higher rate than on a pass-through, the same as it is today,” he said. “If there is a need to be a C corporation for other reasons, the lower rates will make it more palatable under tax reform.”
A venture capital fund, for example, may include tax-exempt and foreign investors, Wry noted: “They have certain sensitivities they can avoid by investing in a C corp.”
“Under the Trump proposal, a C corporation will have a significantly lower rate than the individual rate applied to pass-throughs,” said Jessell.
“The question is whether or not entities should start converting to C corporations,” he said. “The answer is ‘Not yet,’ and probably ‘No’ in most situations. Under the House and Trump proposals there’s also a lower rate for a pass-through entity, so it gets the benefit of the lower rates as well.”
THE LONG-TERM EFFECT
Entity choice may have a huge impact on succession planning, particularly in smaller businesses, according to Jeff Call, partner at Top 100 Firm Bennett Thrasher. “I see succession planning as probably more focused on smaller businesses, because they have a greater challenge,” he said. “More often than not, the issue is passing a firm down to generation two or three. The key is finding a way to do this effectively from an estate tax standpoint. Many times the owner wants financial remuneration. They may give a discount if they’re selling to a family member, or may be passing the business to an estate planning trust and getting compensation out in the form of a continuous pension as an obligation of the company to pay.”
If the estate tax goes away, the necessity of using a trust is less of an issue, Call indicated. “The business owners may make direct gifts to the children without a trust structure unless they are concerned about asset protection and other benefits of a trust. It may be less costly to transition the business if there is no estate tax. In addition, if income tax rates go down significantly, it could make it potentially easier to transition to entities subject to a lower corporate tax rate.”
For a company already in existence, the choice is probably to “wait and see,” concluded Daniel Zucker, a partner at law firm McDermott Will & Emery. “The situation is very fluid.”
“If it turns out that there are reductions in the corporate tax rate but no or very little reduction in the individual rates, it would favor a company being taxed as a C corporation,” Zucker noted. “With an S corporation or an LLC you have one level of tax — earnings can be distributed without incurring a second level of tax. But a lot of corporations don’t pay dividends. If they re-invest earnings in the business, they would pay less tax than a flow-through entity. The real point is to wait and see. Behavior shouldn’t change based on what people are anticipating the law will be.”