SESSION 3: NAVIGATING CHOICE OF ENTITY IN THE WAKE OF TCJA 10:30 12:30 p.m. Jamie Harnish, CPA McSoley & McCoy Steve Trenholm, CPA, MST Gallagher, Flynn & Company, LLP, Esq. DINSE P.C. DISCLAIMER: This outline is intended for general educational purposes only and is not substitute for personalized legal or tax advice. Nothing contained in this outline is to be considered as the rendering of legal or tax advice in specific cases, and individuals are responsible for obtaining such advice from their own legal and tax advisors. Information in this outline may become outdated or inaccurate based on subsequent legislative, regulatory, or judicial developments. Any liability for errors or omissions contained in this outline is hereby disclaimed.
2018 VERMONT TAX SEMINAR SESSION 3: NAVIGATING CHOICE OF ENTITY IN THE WAKE OF TCJA A. INTRODUCTION: CHOICE OF ENTITY AFTER TJCA 1. Tax Rate Cuts. The Tax Cuts and Jobs Act ( TCJA ) made huge cuts in tax rates, including the following reductions: Individual tax rate reduced from a maximum of 39.6% to 37%. Corporate tax rate reduced from 35% to as low as 21%. Tax rates on pass through entity may be reduced by 20%. The highest current individual tax rate is now 37%, but with the 20% deduction on qualified business income (QBI) from pass thru entities, this rate is effectively reduced to 29.6% [37% (100% 20%)]. An individual taxpayer now has two different rates after the TCJA, one is the regular tax rate on wages and other compensatory income (with maximum rate of 37%) and the other is QBI from pass through entities at 29.6%. These rate cuts will have a major impact on choice of entity analysis (to the extent choice of entity is driven by tax considerations) and tax planning generally. 2. Impact on Tax Professionals: Deeper Analysis/More Time Required. Given the possibility of a 20% deduction on pass thru income, the choice of entity analysis has become more complicated. In order to undertake a full analysis of the choice of entity tax consequences, tax professionals will need to gather more information from their clients (e.g., wage base information, capital expenditure information, etc.), confirm a set of assumptions with the client, and 2
perform detailed calculations (with software tools being helpful if not necessary). Back of the envelope calculations should be eschewed, and clients should be educated that a comprehensive choice of entity analysis will require more time and professional expense than before. 3. Non Tax Considerations. While tax considerations loom large in many cases, there are a host of nontax considerations that can impact choice of entity analysis. A discussion of nontax choice of entity considerations follows. B. NON TAX CONSIDERATIONS IN CHOICE OF ENTITY 1. Angel and Venture Capital/Private Equity Financing. If the company s business plan contemplates accepting equity or debt investments from venture capital or private equity firms, it should expect that the investors will request/demand that the company be organized as (or converted to) a C corporation. Venture capital firms and other institutional investors typically avoid ownership in pass thru entities (since, among other things, a passthru entity can pass through debt financed unrelated business income to a taxexempt partner). Most venture capital investments take the form of preferred stock (or debt convertible into preferred stock) and as such the corporate form is generally desirable. Because an S corporation cannot issue preferred stock (without forfeiting its S election), the corporation will need to be a C corporation at the time of investment. Additionally, the choice of entity analysis will more frequently favor C corporations when QSBS treatment is likely to apply (discussed below). 3
2. Qualified Small Business Stock ( QSBS ) under IRC 1202. Section 1202 allows a taxpayer to exclude 100% of the eligible gain realized from the sale or exchange of QSBS issued after September 27, 2010, and held for more than five years. ( 1202(a)(1), 1202(a)(4)). This is a BIG deal and is another reason venture capital firms and private equity firms often prefer to make investments in C corporations. A qualified small business is a domestic C corporation that (i) had gross assets not exceeding $50 million at all times on or after August 10, 1993, and prior to issuance of the stock, (ii) had gross assets immediately after issuance that did not exceed $50 million, and (iii) for which reports required by the Secretary of Treasury are submitted. Additionally, the corporation must satisfy the active business test, which requires that the corporate use at least 80% of its assets in the active conduct of a qualified trade or business. 1 The QSBS exclusion, however, is not without limit. IRC 1202(b)(1) limits the amount that can be excluded per issuer to the amount of eligible gain, which is the greater of (i) $10 million reduced by any amount the taxpayer excluded from sales or exchanges of QSBS from the same issuer in prior years or (ii) 10 times the aggregate adjusted basis of the QSBS issued by the corporation disposed of by the taxpayer during the taxable year. 1 The definition of qualified trade or business in section 1202(e)(3) has gained significant attention since the TCJA borrowed the definition (with slight modifications) in defining those businesses eligible to take the 20% QBI deduction under IRC 199A. 4
3. Multi State Operations (with multiple owners). The tax compliance required for a pass thru entity with multiple owners can be burdensome and potentially unwieldy, particularly if the business operates in jurisdictions which do not allow composite filing for non resident owners. Awards. 4. Availability of Equity Based Compensation: Stock Options and Stock The Internal Revenue Code provides preferential tax treatment for incentive stock options (which, even though issued as a form of compensation, may be taxed at capital gains rates if the stock is held for at least two years from the date of grant and at least one year from the date of option exercise). Many employees in the tech sector are familiar with stock options and request/demand compensation in the form of stock options. Offering stock options or stock awards to key employees may be an important compensation strategy for a company. The preferential tax treatment for incentive stock options ( ISO s ) does not extend to interests in partnerships and LLCs. Additionally, equity based compensation agreements (while possible for a pass thru entity) are more complicated and less understood by employees. 5. Entities Holding Real Estate or Other Appreciating Property. Since the repeal of the General Utilities doctrine in the Tax Reform Act of 1986, 2 it has been a standard tax planning strategy to not put appreciating property (typically real estate but also intellectual property) in a corporation since 2 The General Utilities doctrine, derived from the Supreme Court's decision in General Utilities & Operating Co. v. Helvering, 296 U.S. 200 (1935), permitted a corporation to distribute appreciated property to its shareholders without recognition of gain. 5
the property gets trapped there (i.e., it may not be distributed to shareholders without triggering gain on the appreciation). For this reason, it is not uncommon to see tandem structures in which an operating company is formed as a corporation (either C corp or S corp), and the real estate (or IP) used by the corporation is held in a separate pass thru entity and leased/licensed to the corporation. Contractor. 6. Work Force Management Issues: Employee v. Independent One of the tax planning strategies discussed below is to maximize the 20% QBI deduction by converting one or more independent contractors to employees in order to increase the 50% wage base limitation. But converting an independent contractor to an employee involves considerations beyond tax, including the requirement that an employer pay into the unemployment compensation system administered by the Vermont Department of Labor (or its equivalent in other states), the requirement to pay employment taxes, and the requirement to secure workers compensation insurance in order to secure the company s obligation to compensate employees who injured in the course of employment. Additionally, the decision to convert an independent contractor to employee status may impact employee benefit considerations (both welfare benefit plans and retirement benefit plans). 6
C. NEW IRC 199A: 20% QUALIFIED BUSINESS INCOME DEDUCTION 1. The Big Picture. Up to 20% deduction (emphasize up to ) for noncorporate taxpayers for qualified business income. Deduction also referred to as the pass thru deduction (although it is available to self employed individuals filing Schedule C). Effective rate on pass thru income is lower than normal ordinary income tax rate for salaries or portfolio income. Will result in significant tax savings for many self employed taxpayers. Deduction is taken below the line (i.e., reduces taxable income but not adjusted gross income) and available regardless of whether you claim itemized deductions. Described by one tax commentator as a perfect mess. 2. Some Conceptual Points to Thing About (to Simplify the Analysis). PRIMARY DRIVER is taxable income of taxpayer. The threshold amounts are $315,000 for joint filers and $157,500 for single filers. If taxable income is below these thresholds, the various limitations do not come into play. SECONDARY DRIVERS (for taxpayers over income thresholds) are (i) W 2 wages paid, (ii) the company s capital investment, and (iii) the type of business ( specified service trade or business are not eligible for QBI deduction). Consider IGNORING all limitations relating to specified service businesses, the 50% wage base, and the 25% wage base/2.5% capital base EXCEPT 7
FOR high income taxpayers (i.e., those with incomes exceeding $315,000 for joint filers or $157,500 for single filers). 3. Qualified Business Income. Qualified business income ( QBI ) does not include dividends, interest, capital gains/losses. Guaranteed payments to partners are also excluded. Also excluded is reasonable compensation paid to the taxpayer by any qualified trade or business of the taxpayer for services rendered with respect to the trade or business (IRC 199A(c)(4)). QBI does not include income from a specified service trade or business ( SSTB ) (i.e., any "trade or business" involving the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, consulting, athletics, financial services (i.e., investing and investment management, trading, dealing in securities or commodities), brokerage services, or any trade or business where the principal asset of such trade or business is the reputation or skill of 1 or more of its employees or owners). BUT DON T BE FOOLED, SSTB taxpayers will be eligible for the 20% QBI deduction if their income falls below the threshold amounts of $157,500 (for single) or $315,000 (for joint returns). QBI excludes reasonable compensation paid to the taxpayer by the QTB for services rendered with respect to the trade or business. IRC 199A(c)(4)(A). QBI excludes any guaranteed payments paid to the taxpayer as a partner for services rendered to the trade or business. IRC 199A(c)(4)(B). 8
For pass thru entities, expect Schedule K 1 to change to reflect wages paid at the entity level since partner/shareholder computes 199A deduction at partner/shareholder level and thus will need to know amount of wages allocated to partner/shareholder. NOTE: It appears that partnerships may specially allocate wages to specific partners. 4. The Limitations (50% Wage Base Limitation, 25%Wage Base 2.5% Capex Base Limitation, SSTB Limitation). There are a number of limitations that serve to reduce or eliminate the 20% QBI deduction if the taxpayer s taxable income exceeds the threshold amount, namely as follows: (a) 50% W 2 wage base limitation; 3 (b) 25% W 2 wage base +2.5% of unadjusted basis of tangible depreciable property (which taxpayer can use if GREATER THAN the 50% W 2 wage base limitation); 4 and (c) the SSTB limitation (which provides that the QBI deduction is lost for taxpayers engaged in a specified service trade or business (e.g., health, law, engineering, architecture, accounting, actuarial science, etc.). 5 [REMAINDER OF PAGE INTENTIONALLY BLANK] 3 Note that statute does NOT exclude wage paid to employee owners from wage base calculation. In certain situations, increasing the wages paid to an S corporation shareholder could yield tax savings by increasing the wage base. 4 Capital base is not depreciated down. Use unadjusted base for 10 years or full life, whichever is longer. 5 In case of partners or S corporation shareholders, various limitations are applied at the partner/shareholder level. Wages and capital base are allocated among the partners/shareholders. 9
In table format, the limitations operate as follows: BELOW PHASE IN ABOVE LIMITATION THRESHOLDS (from $157,500 to THRESHOLDS (below $157,500 single $207,500 single; (above /below $315,000 joint) (from $315,000 to $207,500 single; above $415,000 joint) $415,000 joint) 50% Wage Base NO LIMITATION LIMITATION APPLIES. FULL LIMITATION Limitation APPLIES. FULL 20% QBI DEDUCTION WILL BE APPLIES BUT QBI DEDUCTION ALLOWED. REDUCED (NLESS 50% DEDUCTION ALLOWED WAGE BASE TEST PASSED. IF WAGE BASE TEST PASSED. 25% Wage Base + NO LIMITATION LIMITATION APPLIES. FULL LIMITATION 2.5% Capex Base APPLIES. FULL 20% QBI DEDUCTION WILL BE APPLIES BUT QBI Limitation (use if DEDUCTION ALLOWED. REDUCED UNLESS 25% DEDUCTION ALLOWED greater than 50% WAGE BASE + 2.5% CAPEX IF WAGE BASE/CAPEX wage base) TEST PASSED. TEST PASSED. SSTB Limitation NO LIMITATION LIMITATION APPLIES. GET FULL LIMITATION APPLIES. FULL 20% QBI PARTIAL QBI DEDUCTION. APPLIES. NO QBI DEDUCTION ALLOWED. DEDUCTION for SSTB 5. Tax Planning Opportunities. Planning Tip #1: Consider converting independent contractor relationships to employee relationships in order to increase 50% wage base limitation. Planning Tip #2: For S corporations, consider reducing the amount of wages paid to employee shareholders (which will increase the amount of qualified business income ). But be aware of IRS requirement that shareholders providing substantial services be paid reasonable compensation (see David E. 10
Watson, P.C., 714 F. Supp. 2d 954 (S.D. Iowa 2010) and JD & Assocs., Ltd., 3:04 cv 59 (D.N.D. 2006); Rev. Rul. 74 44). Planning Tip #3: For partnerships/llcs, consider restructuring any guaranteed payments to provide the service partner with a priority allocation of profits in lieu of a guaranteed payment (e.g., Partner A receives 100% of LLC profits, if any, to the extent of the first $100,000 of profits). Guaranteed payments are not eligible for an IRC 199A deduction and also reduce partnership income that otherwise would generate a 199A deduction. Planning Tip #4: Moderately compensated employees might consider recasting themselves as independent contractors to avail themselves of the 20% QBI deduction (since services as an employee are not eligible for the 20% deduction). Planning Tip #5: For C corporations, consider converting entity to a passthru entity (i.e., partnership, LLC, S corporation). Planning Tip #6: Many specified service businesses are examining themselves to see if there are one or more qualified trade or business embedded within the business that if separated from the primary trade or business would produce the 199A deduction in sufficient amount to make the restructuring worthwhile. D. CONVERSION ISSUES WHEN CONVERTING TO ANOTHER FORM OF ENTITY. 1. Conveyance of Assets; Assignment of Contracts and Other Issues. When considering the conversion of one entity type to another (e.g., converting from a corporation to an LLC), it is important to bear in mind that 11
assets of the existing entity will be need to transferred to the new entity (excluding cases where the tax classification is simply changed by electing or terminating S corp status). In some cases, this may be relatively easy. In other cases, there may be significant challenges in terms of the number of conveyances and potential recording fees. The transfer of assets to the new entity must be documented and separate filings or recordings may be necessary to effect all of the transfers. This may involve separate real property deeds, lease assignments, patent and trademark assignments, motor vehicle registrations, and other evidences of transfer that cannot be covered by a general bill of sale. Moreover, if the assets are located in a number of jurisdictions, the transfer documents will likely have different forms and other requirements for filing and recording. Also, the entity s contracts with customers/clients will need to be transferred to the new entity. The general rule is that contracts are freely assignable unless the contract itself (or sometimes a statute) dictates otherwise, but it is not uncommon for contracts to include anti assignment clauses, which require that the transferor get the permission of customer/client before assigning the contract to the new entity. Even in the case where assignment is not prohibited, there may be challenges in effecting transfers dealing with notifying the customers/clients of the assignment. 2. Converting from C Corp to S Corp: Beware That Accounts Receivable of Cash Basis C Corp Subject to IRC 1374 Built In Gains Tax. If a C corporation is considering making an S election to avail itself of the 20% QBI deduction, it should be aware if the corporation is a cash basis taxpayer that the built in gains tax of IRC 1374 will apply to its accounts receivable. That is, when a cash basis C corporation elects to be an S corporation and has receivables at the beginning of its first S corp tax year, the receivables, when received, are built in gain items. 12
Example: ABC is a calendar year cash method C corporation that elects to become an S corporation on January 1, 2019. On that date, ABC has $50,000 of accounts receivable for services performed before January 1, 2019. In 2019, ABC then collects $50,000 of accounts receivable. The entire $50,000 will be treated as recognized built in gain. Accordingly, when receivables are collected by the S corporation in the above example, double tax is incurred. A cash method corporation with substantial receivables that is preparing to make an S election should consider collecting as many receivables as possible prior to the effective date of the effective date of the S election. E. C CORP CONSIDERATIONS: ACCUMULATED EARNINGS TAX AND PERSONAL HOLDING COMPANY TAX. With corporate tax rates far below that of individuals, some taxpayers may be motivated to retain earnings inside of a C corporation. But that strategy is not without its risks. Taxpayers and tax professionals need to consider the potential impact of the accumulated earnings tax (IRC 531) and the personal holding company tax (IRC 541), which Congress enacted as penalty taxes. 1. Accumulated Earnings Tax (IRC 531). The accumulated earnings tax ( AET ) is a 20% tax on "accumulated taxable income," which may apply when the earnings and profits of a corporation are permitted to accumulate beyond the reasonable needs of the business. The AET applies to every corporation, excluding personal holding companies, tax exempt corporations, and passive foreign investment companies. The determination of an "excessive" accumulation is subjective as any amount of accumulated E&P can 13
be justified if the taxpayer can substantiate that the accumulation is tied to reasonable business needs. Good tax planning involves identifying and documenting the reasonable business needs for which earnings are being accumulated, including, for example, expansion of facilities, acquisitions of other businesses, establishing reserves to withstand competition, and establishing reserves to protect against the loss of a key customer or customers. 2. Personal Holding Company Tax (IRC 541). A personal holding company is a C corporation in which more than 50 percent of the value of its outstanding stock is owned (directly or indirectly) by 5 or fewer individuals and which receives at least 60% of its adjusted ordinary gross income from passive sources. The personal holding company tax is imposed on the undistributed income of those C corporations that serve as vehicles to shelter passive income. Dividends to shareholder (and dividends can be paid 2½ months after year end if a special election is made) can be made to reduce or eliminate the amount of undistributed income. * * * 14