Choice of Entity Under the Tax Cuts and Jobs Act

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1 Choice of Entity Under the Tax Cuts and Jobs Act By S. Kyle Agee The recent enactment of the Tax Cuts and Jobs Act (the TCJA ) resulted in two significant changes for business entities: the corporate tax rate was lowered to 21 percent and a deduction was established for pass-through entities. In light of these significant changes, business owners and their trusted advisors must now view the choice-of-entity decision in a substantially different context. Although pass-through entities (such as S corporations or partnerships) were the overwhelming choice of entity prior to the TCJA, the newly enacted legislation, relating to both C corporations and pass-through entities, and their interaction with existing Internal Revenue Code (the Code ) sections may help swing the choice-of-entity pendulum toward a more equal balance of C corporations and pass-through entities. The chart below highlights the dominance of pass-through entities as the preferred choice of entity prior to promulgation of the TCJA: Return Type 2016 (actual) s (Form 1120) 1,807,102 1,780,800 1,632,400 1,604,200 1,576,600 S Corporations (Form 1120-S) 4,831,588 4,909,700 5,312,400 5,370,600 5,423,100 Partnerships (Form 1065) 4,005,907 4,077,200 4,480,900 4,541,400 4,596,500 See Internal Revenue Service, Publication 6292: Fiscal Year Return Projections for the United States (Rev ), available at The taxation first on the income of a business and then on its distributions to shareholders historically has been a disincentive for business owners to choose a C corporation as a business model (i.e. a double-taxed entity). In contrast, pass-through entities typically have been preferred for federal income tax purposes because, with such an election, income, gain, and loss are taken into account on the owners individual tax returns (i.e. a single-layer tax). Although other federal tax rules may encourage or discourage selection of a particular type of business entity, the following example demonstrates the tax advantages favoring pass-through entities prior to the TCJA: Pre-TCJA double tax vs. single layer Distributing All Net Income Retaining All Net Income Entity Income $100,000 $100,000 $100,000 Corporate Federal Income Tax (35%) $35,000 $35,000 N/A Net After Income Taxes $65,000 $65,000 $100,000 Individual Federal Income Tax (20% for ordinary dividends / 39.6%) + NIIT (3.8%) = 23.8% or 43.4% $15,470 $0 $43,400 Net Cash to Shareholders/Owners $49,530 $0 $56,600 Effective Tax Rate 50.47% 35% 43.4% The choice of entity preferences noted above are directly correlated with the tax delta between corporate and personal income tax rates. It is noteworthy that pre-1986, corporate tax rates were lower than individual rates. However, this tax paradigm has shifted over the past three decades and the choice-of-entity pendulum has tracked in favor of lower tax rates provided by the single-layer tax regime. As we will see, the 7 The Will & The Way Published by the Estate Planning & Fiduciary Law Section of the North Carolina Bar Association May 2018

2 provisions of the TCJA significantly affect the post-1986 tax arbitrage favoring pass-through entities. A closer look reveals that, in certain instances, C corporations may now be preferential to pass-through entities for tax purposes. Taxation Under the TCJA As noted above, the double tax regime of the C corporation framework subjects corporate earnings to taxation at both the entity and shareholder level. Additionally, unlike pass-through entities, shareholders of C corporations do not see their stock basis increase (or decrease) as the corporate entity increases its retained earnings. Under prior law, C corporations were subject to a maximum corporate income tax rate of 35 percent. Under the TCJA, however, the corporate income tax rate currently is a flat 21 percent. Additionally, the corporate alternative minimum tax was repealed by the TCJA. double tax regime Distributing All Net Income Retaining All Net Income Income $100,000 $100,000 Federal Corporate Tax (21%) $21,000 $21,000 Net After Income Taxes $79,000 $79,000 Federal Income Tax (20% for ordinary dividends) + NIIT (3.8%) = 23.8% $18,802 $0 Net Cash to Shareholders $60,198 $0 Effective Tax Rate 39.6% 21% Accordingly, following the TCJA, the maximum income tax rate applicable to C corporations that distribute all net income to shareholders is 39.6 percent. As we shall see later, this effective tax rate is strikingly close to that on certain pass-through entities. For a C corporation that retains all of its earnings, the effective tax rate is now 21 percent, substantially below the maximum individual tax rate of 37 percent. Federal Tax Disincentives for s As noted above, prior to 1986, individual income tax rates generally were markedly higher than corporate tax rates. As such, shareholders of corporations often utilized tax planning in an effort to take advantage of lower corporate tax rates by deferring the second level of taxation on corporate dividends. In an effort to curtail such tax planning, Congress implemented certain shareholder level taxes, in addition to the corporate level income tax, on the accumulated earnings in excess of reasonable business needs or excessive passive income of certain corporations. Although the reduction in the corporate tax rate under the TCJA nearly returns us to the pre-1986 spread between individual and corporate tax rates, we must continue to be mindful of certain federal tax disincentives for C corporations that are in place to prevent income shifting or, at worst, deferral from higher individual rates to lower corporate rates. The Accumulated Earnings Tax In previous decades, when personal rates were higher than corporate rates, C corporations were often used to allow corporate income to accumulate and compound at the lower corporate rate. This tax strategy often had the added benefit of deferring the second tax on dividends to shareholders. In an effort to curb this practice, the Tariff Act of 1913 created the first iteration of the accumulated earnings tax. As currently enacted, the accumulated earnings tax ( AET ) generally applies to a C corporation with impermissible accumulated earnings and imposes an additional tax on the corporation s accumulated taxable income at a rate of 20 percent. Thus, the AET can be seen as a penalty tax that is intended to abate the accumulation of earnings at the corporate level for the purpose of avoiding shareholder tax on dividends. Although for the AET to apply, the Internal Revenue Service ( IRS ) must prove that the C corporation has allowed the earnings to accumulate for the purpose of tax avoidance, that need not be the primary or dominant purpose for such accumulation. Evidence of tax avoidance may include: (i) the corporation is a mere holding or investment company; (ii) earnings are permitted to accumulate beyond the reasonable needs of the business; (iii) loans to officers or shareholders; and (iv) a poor dividend record. It is important to note that any legitimate, rea- 8 The Will & The Way Published by the Estate Planning & Fiduciary Law Section of the North Carolina Bar Association May 2018

3 sonable need will justify a corporation s retention of earnings and profits. Reasonable business needs include replacement of plant and other assets, finance expansion, retirement of indebtedness, reserves for pending litigation, anticipated product liability losses and working capital requirements. The need for working capital (i.e., current assets less current liabilities) is a legitimate reason to retain earnings in a business. However, corporations should document contemporaneously such reasonable business needs (e.g. corporate minutes, written proposals, blueprints, progress payments, contracts, etc.). While the AET statutory framework may enable the IRS to impose a shareholder level of tax on corporate earnings, it nonetheless rarely has been imposed on most C corporations. As the AET is not self-assessing, the tax is only applicable upon the issuance of a notice of deficiency by the IRS. Going forward, it is unclear as to whether the AET will serve as a bar to the retention of corporate earnings in light of the lowered corporate tax rates under the TCJA. The Personal Holding Company Tax Originally enacted in 1934, the personal holding company tax ( PHCT ) is also intended to impede tax shifting in an environment where corporate tax rates are lower than individual rates. The PHCT is designed to discourage the transfer of individually owned investment properties to a corporation in order to take advantage of lower corporate tax rates. The PHCT is assessed at a rate of 20 percent on undistributed personal holding company income. Unlike the AET, the PHCT is self-assessing and a company must report it on its Form 1120 on Schedule PH. However, like the AET, the PHCT has affected only a small number of taxpayers and provided minimal income revenue to the IRS. Federal Tax Incentives for s Three provisions in the Code give preferential treatment to equity investments in small business corporations: (i) Section 1045 allows the tax-deferral of gain realized on the sale of stock of one or more qualified small business corporations into stock of another small business corporation; (ii) Section 1244 allows ordinary loss treatment with respect to the stock of small business corporations; and (iii) Section 1202 allows a significant, if not full, exclusion for gains recognized with respect to stock of qualified business corporations. Taxpayers to whom all three of these provisions apply enjoy the best of both worlds with respect to their equity investments. On one hand, they can rollover gain without recognizing it. If they do recognize gain, it is subject to a favorable tax rate that is effectively lower, in most cases, than the normal tax rate. On the other hand, if their investments decline, they enjoy ordinary treatment for their losses, which is generally preferable to capital loss treatment. Of these three favorable federal tax incentives, Section 1202 is the section most likely to be an important consideration in making a choice of entity. Section 1202: Small Business Stock Capital Gains Exclusion Section 1202 excludes from gross income a specified percentage of a taxpayer s gain upon the sale of qualified small business stock ( QSBS ) if certain conditions are met. The applicable exemption percentage may be 50 percent, 75 percent or 100 percent depending on the taxpayer s stock acquisition. In order for stock in a corporation to qualify for the exemption in Section 1202(a), the following requirements must be satisfied: Five year holding period the taxpayer must have held the QSBS for at least five years. Shareholder other than a corporation the taxpayer must not be a corporation. Acquisition at original issuance for cash or services the taxpayer must have acquired the QSBS at its original issuance either (i) in exchange for money or other property (not including stock), or (ii) as compensation for services provided to the corporation (other than services as an underwriter). Domestic the QSBS must be in a domestic corporation taxed under subchapter C of the Code. Gross Asset Test The aggregate gross assets of the corporation prior to and immediately after the taxpayer acquires the stock must not exceed $50,000,000. For this purpose, aggregate gross assets includes the amount of cash and the combined adjusted bases of other property held by the corporation. However, the adjusted basis of any property contributed to the corporation is determined as if the basis of such contributed property were equal to its fair market value at the time of the contribution. Qualified Active Business The corporation must have conducted a qualified trade or business, which is defined in the negative to exclude the following types of businesses: o Any business involving performing services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or any business where the principal asset of the business is the reputation or skill of its employee(s); o Any banking, insurance, financing, leasing, investing or similar business; o Any farming business (including the business of raising or harvesting trees); o Any business involving the production or extraction of products of a character with respect to which a deduction is allowable under Sections 613 or 613A; and o Any business of operating a hotel, motel, restaurant, or similar business. 80 percent of assets by value used in qualified active business At least 80 percent of the corporation s assets must have been used in the active conduct of one or more qualified trades or businesses during substantially all of the taxpayer s holding period for the shares. For this purpose, the following rules apply: o Assets used for research and experimental expenditures under Section 174 in conjunction with a future qualified business are treated as used in the active conduct of a qualified business without regard to whether the corporation had any gross income from such activities at the time of the determination; o Any assets either (i) held as part of the reasonably required working capital needs of a qualified trade or business of the corporation, or (ii) held for investment but reasonably expected to be used in qualified trade or business by the corporation 9 The Will & The Way Published by the Estate Planning & Fiduciary Law Section of the North Carolina Bar Association May 2018

4 within two years to finance research and experimentation or increases in the corporation s working capital needs, are treated as used in the active conduct of a trade or business. However, after the corporation has been in existence for two years, no more than 50 percent of its assets may qualify as eligible working capital or investment assets under this rule; o The corporation may not have held real estate assets in excess of 10 percent of the value of the corporation s total assets if such real estate was not used in the active conduct of the corporation s trade or business. For this purpose, owning, dealing in, or renting rental property is not a qualified, active trade or business; and o The corporation may not have held portfolio stocks or securities in excess of 10 percent of the value of the corporation s total assets (in excess of liabilities) if such portfolio stocks or securities were not used in the active conduct of the corporation s trade or business. With that said, it is important to note that there is a per-corporation exclusion ceiling on each taxpayer s eligible Section 1202 gain. If a taxpayer s gain from sales of QSBS of a particular corporation exceeds the ceiling amount, none of the excess is excluded from gross income. In each taxable year, the ceiling is the greater of (i) $10 million, reduced by the taxpayer s Section 1202 eligible gain used in prior years and (ii) 10 times the taxpayer s original basis in the stock of the corporation that was sold during the taxable year. Additionally, there is a limitation on the Section 1202 exclusion for partners in partnerships holding QSBS. The partner must have held his interest in the partnership both (i) at the time the partnership acquired the QSBS and (ii) at the time the partnership sold the QSBS. For purposes of determining the $10 million or 10 times adjusted basis ceiling, the partner s basis is determined to be his proportionate share of the partnership s basis in the stock. Additionally, even if a partner increases his ownership interest in the partnership between the time that the partnership acquires QSBS and the time it sells the QSBS, the partner s Section 1202 gain exclusion is limited based on the partner s original proportionate interest in the partnership at the time the partnership acquired the QSBS. Lastly, the corporation must be an eligible corporation, which is also defined in the negative to exclude the following types of corporations: (i) a domestic international sales corporation, (ii) a corporation that has a Section 936 election in effect or one of its shareholders has a Section 936 election in effect, (iii) a regulated investment company, real estate investment trust, or real estate mortgage investment conduit, or (iv) a cooperative. Taxation of Entities Under the TJCA In contrast to a C corporation s double taxation framework, passthrough entities are subjected only to a single layer of taxation imposed at the shareholder/owner level. As owners increase their tax basis in the entity as income and gain flow through to the owner, pass-through entities generally can distribute earnings to owners on a tax-free basis. Under prior law, shareholders /owners pass-through income was subject to a maximum individual tax rate of 39.6 percent plus the 3.8 percent net investment income tax ( NIIT ), where applicable. Now, the highest individual income tax rate is 37 percent and the NIIT remains applicable to passive income earned by individuals in higher tax brackets. Further, the Code has retained the alternative minimum tax but phases it in at a higher level, which will now be adjusted for inflation, and it has maintained the maximum qualified dividend income and long-term capital gain rate at 20 percent. In addition to the individual rate changes, the TCJA introduced a new deduction that owners of pass-through entities may be able to claim so as to further reduce their effective tax rate. For certain pass-through entities, individuals may now deduct up to 20 percent of net qualified business income allocable to them through a passthrough entity or sole proprietorship (the QBI deduction ). The QBI deduction is discussed in detail in the Vol. 37, No. 3 edition of The Will and The Way in Thomas Cooper s article entitled Business Tax Planning and Fiduciary Income Tax After Tax Reform. single layer tax regime with full QBI deduction with no QBI deduction Income $100,000 $100,000 QBI Deduction = 20% $20,000 $0 Taxable Income $80,000 $100,000 Federal Income Tax (37%) + NIIT (3.8%) = 40.8% Net Cash Available (distributed or not) To Shareholders/Owners $32,640 $40,800 $67,360 $59,200 Effective Tax Rate 32.64% 40.8% For pass-through entities that fully qualify for the 20 percent QBI deduction, the favorable tax arbitrage that existed prior to the TCJA in favor of single layer tax entities remains intact. Specifically, the approximately 7 percent tax delta that existed pre-tcja (formerly percent vs percent) remains intact post-tcja (currently 39.6 percent vs percent). However, for pass-through entities that either partially or fully fail to qualify for the 20 percent QBI deduction, the effective tax rate for such pass-through entities is now slightly higher than the effective tax rate of a C corporation that distributes all net income to its shareholders (i.e percent vs percent). Passive Income Limitations for S Corporations Under current law, S corporations cannot produce earnings and profits ( E&P ); only C corporations can. However, if the S corporation was previously a C corporation, it may have accumulated E&P from years when it was a C corporation. Similarly, if an S corporation was a party to a tax-free reorganization with another corporation that had accumulated E&P, the S corporation may have inherited the other corporation s accumulated E&P. S corporations that 10 The Will & The Way Published by the Estate Planning & Fiduciary Law Section of the North Carolina Bar Association May 2018

5 have accumulated C corporation E&P can have both problems and opportunities. S corporations that do not have any accumulated E&P from before their C corporation elections are not subject to passive income limitations; however, corporations with accumulated E&P that elect S status are subject to passive income limitations. Accordingly, S corporations with accumulated E&P need to monitor their passive income for two reasons: (1) if passive income for a taxable year exceeds 25 percent of gross receipts for the year, a corporate level tax on excess net passive income may be imposed under Section 1375(a); and (2) if the 25 percent limit is exceeded for three consecutive years, the corporation s S status will terminate at the beginning of the next tax year under Section 1362(d)(3). Tax Considerations for Entity Conversions Although new business owners have the benefit of a clean slate when making the choice of entity decisions, existing businesses may want to reconsider their choice of entity following tax reform. Some changes in entity election may come with a tax cost, which should always be taken into consideration. For the reasons described above, many pass-through entities now have a bona fide tax reason to consider converting into a C corporation. Additionally, such a conversion generally can be done without a tax cost. For a partnership converting to a corporation (whether a C corporation or an S corporation) the transaction is generally tax-free (except where the partnership has liabilities in excess of basis) and the conversion can be done at any time during the taxable year. An S corporation can also generally elect, on a tax-free basis, to terminate its S election and convert to a C corporation. Conversely, a corporate conversion to partnership generally has a tax cost in that the conversion generally is treated as a taxable liquidation of the corporation, which triggers taxation at both the corporate and shareholder levels. Finally, a conversion of a C corporation into an S corporation generally does not trigger an immediate tax liability. Considerations With the corporate income tax rate now being significantly lower than the individual income tax rate, the double tax regime of C corporations is no longer the steep penalty that it once was. For a business that plans to distribute most of its earnings, C corporation rates are now comparable to pass-through entities, and, in certain situations, even have a slight rate advantage. For businesses that plan to retain their earnings and reinvest them in the business, C corporations now have a clear rate advantage: a 21 percent tax rate on retained earnings, while passive owners of pass-through entities pay tax at a rate of percent if the QBI deduction fully applies or at 40.8 percent if it is inapplicable. While the QBI deduction helps make the pass-through tax rate more competitive, its application varies from business to business and depends in part on the owner s income level. Additionally, the QBI deduction is generally inapplicable to service-oriented businesses in which the owners income exceeds certain thresholds for claiming the deduction. Choice of Entity Exit Considerations Pass-through entities historically have had a tax advantage over C corporations upon a sale of a business. For tax and other reasons, purchasers generally prefer to acquire the assets of the business rather than equity from the owners. For C corporations, selling assets typically triggers the problem of double taxation at the corporate and shareholder levels. Conversely, a pass-through entity can typically sell its assets or its equity without producing significantly different tax results. While these fundamental principles remain unchanged under the TJCA, asset purchases no longer provide as large of a tax benefit to the purchaser given the low tax rates and selling assets out of a C corporation is no longer as cost-prohibitive as it once was. However, C corporation shareholders will still prefer a stock sale if feasible, since tax applies only at the shareholder level and, as discussed above, the shareholders of C corporations also may avoid tax on all or a significant portion of their gain from the sale of stock. For a business that does not plan to distribute earnings to owners during operations and where the potential for its shareholders to claim the Section 1202 exclusion exists, C corporations should be given serious consideration. With lowered tax rates during operations combined with the ability to avoid tax altogether on an equity sale, C corporations may now be advantageous for many newlyformed startup or high-growth businesses. Choice of Entity Final Thoughts This article attempts to highlight some of the tax factors that play a role in the choice of entity decision and how those factors are affected under the TCJA. Whereas pass-through entities dominated the choice of entity decision under prior law, there now exists, at least in certain circumstances, legitimate reasons to consider C corporations for either startups or existing entities through conversions. S. Kyle Agee (KAgee@jahlaw.com) is a partner at Johnston Allison & Hord in Charlotte. His principal areas of practice are Estate Planning and Administration, Taxation, Corporate, Business Succession Planning, Charitable Planning, Nonprofit Entities & Tax-Exempt Organizations and Motorsports. Follow the NCBA on 11 The Will & The Way Published by the Estate Planning & Fiduciary Law Section of the North Carolina Bar Association May 2018