DALLAS CPA SOCIETY CONTINUING EDUCATION CORPORATION MEMBER APPRECIATION CPE SERIES. February 9, Do Corporations Trump Passthroughs?

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1 DALLAS CPA SOCIETY CONTINUING EDUCATION CORPORATION MEMBER APPRECIATION CPE SERIES February 9, 2017 Do Corporations Trump Passthroughs? Daniel G. Baucum Shareholder, Munsch Hardt Kopf & Harr PC Course Description: A fresh look at how your choice of business entity selection for your client s business may be affected by recent case law and proposed tax regulations and possible federal tax reform. Learning Objectives: Participants will be able to identify the business and tax law benefits and disadvantages encountered for each of the most popular business entities currently in use, and how recent judicial and regulatory changes and possible tax reform may affect your choice. Course Level: Prerequisites: Technical None

2 Do Corporations Trump Passthroughs? Business Entities and Taxes Dallas CPA Society February 9, 2017 Presented By Daniel Baucum Shareholder

3 Closely Held Businesses Partnerships Limited Partnerships Registered Limited Liability Partnerships Limited Liability Companies Manager Managed Member Managed S Corporations C Corporations

4 Federal Tax Classification Limited Liability Companies Number of Owners Controls Federal Tax Classification S Corporations Number and Types of Owners/One Class of Stock/Passthroughs C Corporations Double Tax/Current Tax Rates/Tax Upon Contributing Appreciated Property

5 Federal Tax Classification : LLCs One owner LLC default classification is as a disregarded entity or a division of another entity Spouses in community property state (i.e. Texas) = 2 owners LLC with Multiple Owners default classification is a partnership. Federal Classification Elections S corp. (Form 2553) C corp. (Form 8832)

6 LLC advantages vs. disadvantages LLC Advantages 1. One level of federal income tax 2. State law charging rule creates asset protection advantage 3. Manager managed (corp. analogy) or member managed (p'ship analogy) 4. Elect S Corp status LLC Disadvantages 1. Members subject to federal SE tax on service income 2. Partnership tax rules byzantine Regulatory vs. Target Allocations 3. Partnership audit rules default to partnership level tax

7 Federal Tax Classification: S Corps Formed as a state law corporation Elect to be treated as an S corp for Federal tax purposes by filing IRS Form 2553 Must meet eligibility requirements 100 or fewer shareholders (spouses count as one) U.S. citizen or resident alien (green card) Certain trusts and nonprofits No partnerships or C Corps as owners Disregarded LLC ok if owned by eligible owner One class of stock (voting and nonvoting common ok)

8 S Corp advantages vs. disadvantages Advantages 1. Passthrough taxation if always an S corp 2. Tax calculations much easier than partnership tax 3. Pay Federal employment tax on smaller amount not SE tax on total amount (?) Disadvantages 1. If prior C corp, passive income can cause "stinger" tax or disqualification 2. Must watch tax triggered upon contributions (e.g., formation) 3. S election blown then C corp (double tax)

9 Federal Tax Classification: C corp. Formed as a state law corporation. Automatically taxed as a C corporation if no S corp election made. Corporate level tax at 15% for first $50,000, 25% for next $25,000, 34% up to $100,000, 39% up to $335,000, then 34% up to $10,000,000, 35% up to $15,000,000, 38% up to $18,333,333, then 35%

10 C Corp advantages vs. disadvantages Advantages 1. Lowering corporate tax rates hot legislative topic 2. Salary tax deductible, if reasonable. High salaries are disguised dividends. 3. Stock sale subject to capital gains tax 4. Tax exclusion on stock sale (IRC Sec 1202) Disadvantages 1. Current corp tax rates highest in World 2. Salary subject to employment tax 12.4% to $127,200 SS 2.9% Medicare 3. Distributions of cash taxed as dividends subject to double tax

11 S Corp SE Taxes: Who earned the income? Financial Consultant Fails to Avoid Self- Employment Tax with S Corp Structure Fleischer v. Comm'r, T.C. Memo Case involves common S corp. structure used by small business service-providing taxpayers wishing to minimize self-employment tax liability by funneling service income to those corporations. The Tax Court reallocated income to T/P who earned it. S corp. structure based on advice from his CPA and lawyer. Employment Agreement between T/P and S corp. Received salary of $35,000. (Too low?) Financial consultant entered into contracts with Mass Mutual & LPL in individual capacity; received 1099s personally from these financial service companies. This was T/P's undoing.

12 Fleischer v. Comm'r First Principles of Tax A first principle of income tax, is that income must be taxed to him who earned it. The opinion states that for almost as long as this first principle of income taxation has been in place, the principle that a corporation is a separate taxable entity has been, too. The opinion then discusses the key to reconciling these principles: Because it is impractical to apply a simplistic who earned the income test when the Court s choices are a corporation and its service-provider employee, the question has evolved to one of who controls the earning of the income. To determine if the corporation and not the shareholder controls the earning the opinion notes that the case law looks to two requirements: (1) the individual providing the services must be an employee of the corporation whom the corporation can direct and control in a meaningful sense, and (2) there must exist between the corporation and the person or entity using the services a contract or similar indicium recognizing the corporation s controlling position.

13 If you're going to do it... In McAlary v. Comm'r IRS expert cited Risk Management Association Annual Financial Statement Studies as a reference to determine reasonable compensation by coming up with a reasonable percentage of profit to take as salary. Come up with reasonable percentage of earnings to state as salary.

14 Service Corp Bonuses Deductible? Brinks Gilson & Lione PC v. Comm'r, T.C. Memo Professional services firm (C corp) denied deduction for portion of bonuses paid to shareholder attorneys as compensation; recharacterized as dividend. Pediatric Surgical Associates v. Commissioner, TC Memo C Corporation employed both shareholder and nonshareholder surgeons. Shareholders received a fixed monthly compensation plus a monthly bonus. Non-shareholder only received fixed monthly compensation. The bonuses were deducted as officers compensation. The Tax Court ruled that a portion of the bonuses constituted a nondeductible, disguised dividend.

15 Corporate Tax Reform Principles of tax reform are clear: Congress should improve efficiency by levying lower rates on a broader base (i.e., close loopholes) Encourage economic growth and meet public needs without adding to the national debt. Trump Lower tax rate from 35% to 15% One time repatriation of offshore profits at 10% tax Eliminate tax credits except R & D Don't depreciate, manufacturers expense capital investment and not deduct interest expense.

16 House Ways & Means and Speaker Ryan House Republicans Repeal corporate income tax and replace with a "destination-based cash-flow tax (DBCFT)" No tax on goods and services sold overseas. No deduction for imported goods. Taxed on where goods are sold. Products sold in the US would be subject to US tax. Essentially a VAT with a deduction for wages. Discourages tax-motivated corporate inversions. Taxes consumption from holding capital instead of paying wages. Border adjustment may create very big, very profitable exporters that get full tax rebates (political "hot potato") Could require rate of 30 percent or more to eliminate revenue shortfall.

17 Bye Bye Tax Reform, Hello Tax Relief No tax cuts or even tax reform. TAX RELIEF!!! Reframing the debate- The estate tax became the death tax Eliminating popular tax subsidies became eliminating "loopholes" A professor at Columbia recruited test subjects who self-identified as Democrats, Republicans, or independents. Then he presented them with a choice: They could buy a roundtrip airline ticket from New York to Los Angeles for $345 or they could pay $352 for the identical flight. And he told them the higher-priced ticket included a surcharge to help fund efforts to reduce carbon emissions. For half the participants, the extra price was described as a tax. For the other half, it was described as an offset (whatever that is). Regardless of political affiliation, about half the respondents said they d be willing to pay the higher price when it was described as an offset. But it was a very different story when the extra fee was called a tax.

18 Sound Familiar? "People want to know that they're going to get tax relief and [President Trump] has promised that. We just hope the Democratic Senate will support his tax relief package the way the Democratic Senate in 2001 did for President [George W.] Bush. They passed tax relief for all Americans by June of that year. We hope the same happens here. Kellyanne Conway, on ABC's This Week, Jan. 22, Here's my take- Expect reduced marginal tax rates, increase standard deduction amounts, repeal of personal exemptions, cap on itemized deductions, and businesses allowed to elect to expense new investment and not deduct interest expense.

19 Daniel G. Baucum Munsch Hardt Kopf & Harr, P.C. Shareholder 500 N. Akard Street, Suite 3800 Dallas, TX O: D: Daniel Baucum is a Shareholder in the Corporate & Securities section of the Dallas office. He represents entrepreneurs and their families in tax and business planning, as well as estate and succession planning. In addition, Dan regularly counsels clients on tax matters regarding the acquisition or sale of businesses and real estate, cross border transactions, and forming charitable organizations. Utilizing his experience as a tax planner and litigator, Dan also represents clients and their advisors in high-stakes audits, IRS Appeals and in court proceedings. Dan s legal career spans more than 35 years as an attorney in Dallas and Washington, D.C. He speaks often regarding the tax and business aspects of pass-through entities, such as partnerships and limited liability companies, and has testified in court as an expert witness on pass-through taxation, estate and gift taxation, and IRS practice matters. For more than a decade Dan worked in Washington, D.C., first as a Special Assistant to the IRS Chief Counsel and then as Director of IRS Practice for a Big Six accounting firm. His years working in government and private practice in Washington give Dan unique insight into the inner workings of the Internal Revenue Service and the Treasury Department that sharpens his ability to represent clients in court and before the government. Dan teaches business and tax law at the Southern Methodist University s Dedman School of Law. While in Washington, Dan taught IRS Practice and Procedure in the Graduate Tax Law Program at Georgetown University s Law Center. He also speaks regularly before legal and accounting professionals.