Corporate Update

A copy of Corporate Update can be found HERE.

 

On behalf of FisherBroyles’ corporate group partners, I’m pleased to introduce this tax update. We plan to release Updates several times each year containing substantive legal developments we hope you will find beneficial to your business. You may learn more about our broad and diverse corporate practice here: https:// fisherbroyles.com/areas-of-practice/. If you have questions, please feel free to contact your relationship partner or me.

Thank you. Jess Bahs, Managing Partner – Corporate.

 

RECENT TAX BILL CHANGES TO 1202 AND 199A AND THEIR IMPACT ON CHOICE OF ENTITY ISSUES

 

There were two changes in the recent tax bill that will often affect choice of entity issues going forward.

 

199A REDUCED TAX RATES FAVOR PASS-THROUGH ENTITIES

The first change is that Internal Revenue Code (IRC) §199A reductions in tax rates for pass-through entities were made permanent.  This is not much of a change, but the fact 199A survived and is made permanent will have a lasting impact.  There were concerns that deficits would require the §199A discounted tax rates to be allowed to expire.

For pass-through entities (partnerships and S-corps), owners effectively qualify for having their top federal income tax rate of 37% dropped to approximately 30%.  This change effect in tax rates was from the prior 2018 tax bill, but the rate reduction was previously set to expire in 2026.

The §199A rate reduction basically applies when owners either have income below certain thresholds, or when the company has a sufficiently high enough employment cost.   Owners can also qualify when their operations are capital intensive; however, employment cost is generally the main factor.

The income limit for phasing out the deduction for a married couple filing jointly is now $394,600 to $544,600 (whereas the upper part of this range before was $494,600).  Above this limit, the company must have sufficient employee costs to qualify—the reduction in rates is allowed against owner income not in excess of (i) 50% of W-2 wage expense for the company; or (ii) 25% of W-2 wage expense PLUS 2.5% of unadjusted basis in tangible depreciable property, such as equipment, machinery, fixtures and furniture, buildings and building improvements.   (Note that employment and capital costs do not help for high incomes from specialized services such as health, law, consulting, and other service businesses where reputation or skill of employees is critical).

Policy and political debates aside, the rate reduction serves as an implicit incentive for a taxpayer to leave W-2 employment status with their employer and form their own company, if able.   For taking the risk and expanding employment for others, the government is indirectly subsidizing the activity with the §199A rate reduction.

 

S CORPORATIONS vs PARTNERSHIPS

By making the §199A rate reduction permanent, there are many reasons to prefer pass-through entities such as S-corps and partnerships.   As for the preference between S-corps and partnerships, the details of that debate are beyond this article.   However, in overly basic terms– small service companies without many owners and without much capital will continue to prefer S-corps, while capital intensive companies with multiple owners, multiple sharing arrangements, and more investors will prefer partnerships.  Companies with real estate and appreciating intangible assets will generally prefer partnership status over S-corp status.  Even still, the desire for Medicare tax cost savings with S-corps will remain the dominating factor.  The main counterbalancing factors against S-corps will be their lack of flexibility and the limits on the types of owners who can be shareholders.

 

THE REVENGE OF THE C CORPORATION

What about IRC §1202 qualified small business company status and its preference for C-corp status?

Many investors now want to hold Qualified Small Business Stock (QSBS) pursuant to IRC §1202.  Some still prefer to deduct losses with partnership status if able, but a growing number want the opportunity to wait five years and sell shares TAX-FREE.

Policy and political debates aside, §1202 is an indirect implicit government subsidy encouraging relatively wealthy investors to start and grow small companies.   Most owners can benefit from §1202 status but it generally favors wealthy investors (otherwise, one has to be particularly frugal with their living expenses).  The reason for this is that the rewards from §1202 come with an indirect cost: the economics do not work as well unless profits are annually reinvested to grow the company in a way that tax on operating income is minimized and the company does not make taxable dividend distributions (more on this below).  Stated differently, owners who do not need to live off the company income are better able to leverage the tax-free benefits from §1202.

IRC §1202 benefits were improved in the recent tax bill.  Previously, an owner of qualified small business stock needed to wait five years to be able to sell the stock tax-free.  Now, for a sale after three years, 50% of the gain is not taxable, and for a sale after four years, 75% of the gain is not taxable.  The investment period is shortened if a taxpayer is willing to take a partial benefit instead of an entire benefit.

Another important change is that the “small company” status need not be as small anymore.  Previously, the company had to have less than $50 million in assets to qualify.  That threshold was recently increased to $75 million.

Also new is that the gain amount eligible to be tax-free is the greater of $15 million per shareholder or 10x the shareholder’s basis in the stock.   This prior gain exclusion amount was $10 million (or 10x basis).

These recent tax bill changes should make many owners consider whether it makes sense to convert their existing pass-through entity into a §1202 C-corporation (if able).  Since the size limit has increased from $50 million to $75 million, more companies will now find it easier to qualify today.  Professional service companies will not qualify.   Also, leisure and hospitality businesses (among others) will not qualify.

Although the value of the company prior to §1202 conversion will not qualify to be tax-free, the future growth in value can avoid tax.   Converting an existing company may have particular unexpected benefits— since prior value growth is not eligible for 1202 benefits, the owners are entitled to have additional basis for 1202 purposes.  If the 1202 basis is increased to a high number for value as of conversion, say perhaps $5 million for example, the 10x basis multiplier will allow significant tax savings— it means $50 million of growth could be tax free in this example (the 10x basis exclusion limit).

 

SO, WHAT IS ONE TO DO WITH THESE COMPETING CHOICES TODAY?

In many cases, the conclusion will be that clients who form companies to live off their income will still prefer pass-through entities (not §1202 QSBS C-corporations).  Owners who do not need distributions will prefer §1202 QSBS C-corporations. If money is distributed by the C-corporation, it will incur two levels of tax, which is a higher tax cost than the rates that apply with potential §199A reduction benefits.   (Although profits could also be paid out as W-2 income, this will not qualify for §199A reduction benefits).

If an owner is relatively wealthy, or lives modestly, and does not need distributions to live, the C-corporation will often be preferred (assuming the company can qualify for §1202 status).   Profits can be reinvested to minimize tax on operating income, the company can grow in value, and then a later sale at a higher value will be tax-free.

There is an important downside factor to consider with §1202 status.   For §1202 tax savings to occur, a purchasing company must acquire stock; not assets.  A corporate asset sale instead results in two levels of tax on gain.   This will be more expensive than compared to a sale of assets by a pass-through entity.   A capital-intensive manufacturing company in the Midwest may find it hard to find a buyer of stock (compared to its assets).   However, a tech company on the west coast will often find a buyer that prefers to acquire stock (and not assets).  The type of entity and the location of the company will likely be factors.  Either way, with a company stock sale, the buyer cannot amortize and deduct any of the purchase price cost (much of which is commonly goodwill deducted over a 15-year period).  For this reason, many buyers will demand a purchase price discount of 10% to 15% for a stock acquisition, as opposed to an asset acquisition.  This is an indirect tax.   (Comically, one client once said he would rather see the buyer get this indirect tax as opposed to paying the government).

Based on the above, if the company will make distributions of profit AND there is a significant risk a buyer will discount a stock acquisition price by 10% to 15%, the case for choosing pass-through entity status may win the day.   Modeling the differences in an Excel sheet is often enlightening.