Year End Tax Planning: Are You Considering Changes In The Tax Structure Of Your Business?
Toward the end of most calendar years, I am often asked such questions as “Why am I taxed as a partnership? I read an article that if I were taxed as an S corporation, I would pay less tax.” Or “My friend’s business just became a C corporation because it saved my friend a lot of taxes. Can I do the same thing?”
Choosing the best form of tax structure for your business is an extremely complicated and fact-specific problem. Changing the tax structure of your business after it is up and running introduces a new layer of complexity. A decision to convert the tax structure of your business requires the owners to focus not only on short-term tax savings, but also on the impact such change will have on the taxes payable in the long-term. This article will highlight certain of the factors that owners should take into consideration when making a decision to convert the tax structures of their businesses.
Most closely-held businesses, including family-owned businesses, are treated as “pass-through” entities for income tax purposes. Customary pass-through entities include S corporations and partnerships. In a pass-through entity, the entity itself does not pay any income tax. Instead, the entity’s taxable income is allocated among its owners and the owners reflect this taxable income on their individual income tax returns and pay tax on it. This arrangement should be contrasted with a C corporation, which is a separate taxpaying entity and pays its own income tax.
It is important to understand that the tax structure of a business is a separate question from how the business is organized under state law. For example, a limited liability company formed under Minnesota law may be taxed as a C corporation, a partnership or an S corporation. The form of business organization may preclude you from adopting certain tax structures. For example, if your entity is organized as a corporation with preferred stock outstanding, you will not be able to elect to be taxed as an S corporation. The first step in changing the tax structure of an entity is to ensure that the existing business organization does not preclude you from adopting a particular tax structure.
Recent changes in the tax law have made it more attractive to operate as a C corporation. The federal tax rate for C corporation income has been reduced to 21%. In addition, state income taxes paid by the C corporation are fully deductible to the corporation. In a pass-through entity, the state tax deduction is now limited since an individual can only deduct up to $10,000 of state income taxes. A pass-through entity can mitigate these C corporation advantages somewhat if the owner is eligible for the 20% deduction on qualified business income under Section 199A of the Internal Revenue Code. The overall rate of tax on business income will, however, typically be higher for a pass-through entity rather than a C corporation. Some states have tried to minimize the issue of non-deductibility of state income taxes by shifting the obligation to pay state income taxes to the entity and not the individual owner.
Given these advantages, what are these disadvantages? Although in the short term, the C corporation may pay less in income taxes, in the long-term, the use of a C corporation may result in significantly more taxes. Using a C corporation typically results in a lower “basis” in a shareholder’s stock. Basis refers to the original cost for the stock plus or minus any adjustments to the original cost permitted under the Internal Revenue Code. In a sale transaction, the difference between the sales price for the stock and the basis in the stock equals the amount of gain that is subject to tax. With a pass-through entity, the income that is passed through to an owner increases basis, while distributions from the entity decrease basis. The net effect is that with a pass-through entity, you are taxed only once on the entity’s income.
This does not happen with a C corporation. A C corporation is a separate taxpayer. It pays tax on the income that it generates. A shareholder does not receive any increase in the shareholder’s stock basis if the C corporation earns income. In addition, distributions from the C corporation are typically not deductible by the C corporation but are taxable income to the shareholder. Distributions are essentially double taxed — once to the C corporation and once to the shareholder. Since basis is not increased when the C corporation earns income, the gain recognized by a shareholder will be greater than that experienced by a pass-through entity.
A related problem occurs when the shareholders of the C corporation sell the entire business. Buyers of a closely-held business generally prefer to have the sale transaction structured as a purchase of the C corporation’s assets rather than purchase of the shareholders’ stock. If the buyer purchases the assets, the buyer acquires a basis in the assets equal to the purchase price which allows the buyer to depreciate or amortize the cost of the purchased assets. If, on the other hand, the buyer acquires the shareholders’ stock, the buyer’s basis in the assets of the C corporation stays the same. The buyer cannot amortize the basis in the stock it just purchased.
An asset sale, however, will usually be detrimental to the shareholders since there will be two levels of tax on the transaction — once at the C corporation’s level as the assets are sold and once as the shareholders distribute the sales proceeds from the C corporation. With a pass-through entity, a buyer can purchase the entity’s assets and any gain from the transaction will be passed through to the owners who will pay only one level of tax on the transaction. In general, a pass-through entity gives the owners more flexibility in structuring a sale transaction with a lower tax cost.
It is not easy to undo a conversion into a C corporation. If the original entity was taxed as a partnership, converting back into a partnership will be treated as if the assets of the C corporation had been sold, which leads into the double tax problem described above. If instead the original entity was taxed as an S corporation, it will be necessary to wait for five years after the conversion date before the C corporation can make a new election to be taxed as an S corporation. In addition, once the new election to be taxed as an S corporation has been made, it will take another five years before the double-tax issue goes away completely. In summary, if there is an intent to sell the business or to purchase a significant amount of stock from one of the shareholders or owners, it may not make sense to give up pass-through treatment and be taxed as a C corporation.
Another transaction frequently discussed is the conversion of a partnership into an S corporation. While flow-through treatment is retained in this type of transaction, there are various limitations on the operation of an S corporation that may make the conversion unattractive. Why would the owners of a partnership want to be taxed as an S corporation?
Unlike a partnership, in an S corporation, the shareholders can receive a salary. A partner in a partnership is subject to self-employment tax on all earnings of the partnership allocated to the partner unless the partner is a limited partner who is not actively involved in the business. The shareholder in an S corporation, however, is only liable for employment taxes on the salary the shareholder receives from the S corporation. Amounts allocated to the shareholder that are not salary are not subject to employment taxes. Since there is no cap on the amount of income subject to Medicare taxes, depending upon the amount of S corporation income allocated to a shareholder excluding salary, there may be significant tax savings. In addition, the calculation of qualified business income under Section 199A of the Internal Revenue Code is generally more favorable if the shareholder receives a salary from the S corporation rather than distributions from a partnership. Thus, the 20% deduction on qualified business income will likely be greater if the entity is an S corporation rather than a partnership.
There are some disadvantages. The ability to increase basis in an S corporation is more limited than in a partnership. If a person purchases stock in an S corporation, that person will acquire a basis in the stock equal to the purchase price. The basis in the S corporation’s assets will, however, remain unchanged. If, a person purchases a partnership interest, that person will not only acquire a basis in the partnership interest equal to the purchase price for the partnership interest, but, assuming a special election is made, the person’s basis in their share of the partnership’s assets can also be increased. This obviously minimizes any gain in the event of a later sale.
An S corporation also has significant limitations on who can be a shareholder. A partnership does not have similar limitations. For example, a corporation or a partnership cannot be a shareholder in an S corporation. Similarly, an S corporation cannot issue preferred stock. A partnership is permitted to have preferred interests.
It is not easy to convert an S corporation back into a partnership. If an S corporation is converted back into a partnership, the transaction will be treated as if the S corporation had sold all of its assets. While this results in only one level of tax, it still accelerates any gain that will be recognized to the S corporation’s shareholders.
If an individual had perfect foresight, it would be easy to decide on an optimal tax structure for a business. Unfortunately, perfect foresight is a rare attribute. It is necessary to analyze the most likely scenarios and to make certain assumptions about future events. Another factor that must be taken into consideration is that tax laws are changing more regularly and often in dramatic ways. Changes in the tax laws can often upset the most careful planning. For example, there is no guarantee that C corporation rates will stay at 21% indefinitely. If C corporation rates increase, how high would rates have to go to make a C corporation conversion uneconomic. Similarly, there is no guarantee that allocations of S corporation income will not become subject to self-employment tax. And, unplanned and often uncontrollable life events also can affect the best laid tax planning – what if the owners plan to sell the business in 10 years, but the principal owner of the business falls ill and the business needs to be sold more quickly?
As you can see, changing the tax structure of a business may result in the owners becoming locked into a particular position that is not tax favorable. Business owners need to balance short-term tax savings against the potential for greater taxes in the future. Some value needs to be placed on maintaining flexibility for the business. Business owners are well advised to spend time talking to their tax advisor about the advantages and disadvantages of changing their tax structure before they do so.
Fredrikson & Byron is a 300-attorney law firm based in Minneapolis, with offices in Bismarck, Des Moines, Fargo, Mankato, St. Paul, Saltillo, Mexico, and Shanghai, China. Fredrikson & Byron has a reputation as the firm “where law and business meet.” Our attorneys bring business acumen and entrepreneurial thinking to work with clients, and operate as business advisors and strategic partners, as well as legal counselors. More information about the firm is available at www.fredlaw.com. Follow us on LinkedIn and on Twitter @FredriksonLaw.