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Business Law Section Partnerships and LLCs Committee

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Roger Royse's presentation on the choice of entity under the Tax Reform Act of 2017 (presented by the Partnerships and Limited Liability Companies). This is part 1 of 1.

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Business Law Section Partnerships and LLCs Committee

  1. 1. Business Law Section Partnerships and LLCs Committee Choice of Entity under the Tax Reform Act of 2017 (presented by the Partnerships and Limited Liability Companies) November 15, 2018
  2. 2. LLC (not taxed as corp) S Corporation C Corporation Entity Level Federal Income Taxes No federal tax at LLC level. Generally no tax at S corporation level; some excise taxes, and built in gains taxes may apply. Income tax on earnings at corporate level. Eligibility Requirements of Owners and Equity No restrictions. US citizens or resident individuals, certain trusts, and certain tax exempt entities. 100 max (generally). One class of stock limitation. No restrictions. Entity Level California Taxes Gross receipts fee, unlike state law partnerships. $800 minimum. Minimum franchise tax of $800 or 1.5% taxable income. 8.84% corporate rate applies, or $800 minimum franchise tax. Option Plans, NSOs, ISOs Employees & consultants can be given options to acquire LLC interests, but such options are generally more complex, and cause §704(b) challenges. ISOs not available, but profits interests generally superior to ISO. ISOs commonly granted to employees. NSOs may be granted to employees, consultants, and advisors. ISOs commonly granted to employees. NSOs may be granted to employees, consultants, and advisors. 1. Choice of Entity (Assuming Domestic Entity) 2
  3. 3. LLC (not taxed as corp) S Corporation C Corporation Status Change on Transfer of Interests If taxed as partnership, LLC terminates for tax purposes on transfer of 50% or more of capital and profits in 12 months. Can convert between DRE and partnership on transfer No termination of entity on transfer of interests, except for election termination on transfer to ineligible shareholder. No termination of entity on transfer of interests. Treatment of Foreign Owners Foreign members subject to US tax on their share of effectively connected income of LLC; branch profits tax may apply. Foreigners cannot be shareholders of S corporation. Foreigners are subject to withholding tax on dividends from US corporation, subject to treaty rate or exemption. Foreign Individual Owners - Transfer Taxes Unclear. N/A. Foreigners cannot be shareholders of S corporation. Corporate stock may be gifted tax free. U.S. corporate stock will be part of taxable estate, however. Conversion to Another Entity May generally be incorporated tax free, but see discussion herein. Conversion between partnership and DRE can cause tax (e.g., investment company rules). Can convert tax-free to C corporation by revoking election; likely to be taxed on converting to LLC. Can convert to S corporation by making election (built in gains tax may apply to later dispositions of appreciated property). Conversion to LLC likely taxable. Taxes on Sale or Liquidation One level of tax, generally capital gain except for amount allocable to certain assets. “Flowthrough” of international tax characteristics to foreign seller (including ECI). One level of tax on sale of stock or assets, generally capital gain on stock sale. No 754 election, decreasing desirability of stock sale to buyer. Potential double tax. Corporate tax on sale of assets. Shareholder level tax on sale of stock or liquidation. Sales by foreign shareholder likely not U.S. taxed. 1. Choice of Entity (Assuming Domestic Entity) 3
  4. 4. 199A Deduction • 20% deduction for certain income of pass-through entities including sole proprietorships through 2025. • Maximum deduction is 20% of the “qualified business income” (QBI”). • The 199A deduction amount is equal to the lesser of the following: – (1) the taxpayer’s “combined qualified business income amount,” or – (2) 20% of the excess of (i) the taxpayer’s taxable income for the taxable year, over (ii) the taxpayer’s net capital gain for such taxable year. • This calculation is subject to a number of exclusions and limitations, which has added a great deal of complexity to this provision.
  5. 5. Qualified Small Business Income • QBI is the net amount of qualified income, gain deduction and loss with regards to a qualified trade or business. – Must be effectively connected to US trade or business – Included or allowed in determining taxable income. Qualified Business Income does not include the following: • Investments-dividends, interest capital gains. • Compensation paid to an owner for services rendered with respect to the trade or business. – Guaranteed payments – Reasonable Compensation – Payment to a partner for services rendered – W-2 Income
  6. 6. Limitations to 20% Deductions • The 20% deduction is limited to a cap equal to the greater of: – 50% of W-2 wages paid, or – 25% of W-2 wages paid plus 2.5% of the original basis of “Qualified Property” • W-2 wages could have a larger effect on S-Corps as opposed to partnerships. – Partnerships do not pay W-2 Wages to partners. – Guaranteed payments under IRC Section 707(c), if paid, are not included (until otherwise stated by IRS) as W-2 wages, but also not included in QBI. Payments for services covered by IRC Section 707(a) are also not included as W-2 wages or QBI. • Taxpayers whose taxable income is less than the “threshold amount” do not have to follow the wage limits. • Threshold amount is defined in Section 199A(e)(2) as $157,500 or 200% of such amount ($315,000) in the case of a joint return. • For taxpayers with QBI falling in between $207,500 and $415,000, there is a phase out of the wage limits which must be calculated in order to determine the proper deduction.
  7. 7. Reasonable Compensation S-Corporation must pay shareholders who provide services to the company as an employee, in a reasonable amount. Concern that reasonable compensation could have been applied to partnerships. Regulations provide that reasonable compensation will continue to only be applied, in the context of Section 199A to entities taxed as S- Corporations. If the S-Corporation fails to pay its shareholder employees a salary, the amount of reasonable compensation that would be applicable will still be deducted from QBI.
  8. 8. 8 Specified Services Section 199A(d) excludes “specified service trade or businesses” from the definition of “qualified trade or business” for purposes of Section 199A. That includes the following industries: • Health Providers • Legal • Accounting-includes services provided by enrolled agents. • Actuarial Science • Performing Arts • Financial Services • Brokerage Services • Other service professionals where the business is based upon a specialized skill of one or more of the owners.
  9. 9. Specified Services Business • For owners of excluded businesses with income less than $157,500 for single taxpayers, or $315,000 for taxpayers filing joint returns, the specified services exclusion does not apply and they are entitled to full 20% deduction. • There is a phase out for owners with income between $157,000 and $207,500 for single taxpayers, and $315,000 and $415,000 for married taxpayers filing jointly. • Owners in excess of $207,500 for single taxpayer and $415,000 for joint taxpayers are not entitled to claim the 20% deduction. 9
  10. 10. 10 What Qualifies as a Law Firm • Law firms are included within the definition of “specified service business.” • What is included in the actual trade or business of a law practice? — Performance of the services of the field of law — Includes not just services from lawyers, but also paralegals, legal arbitrators, mediators and other similar professions. — Exclusions from regulations “printers, delivery services or stenography services.”
  11. 11. 11 What is a Legal Service • Real estate attorney who do not just practice real estate law, but also offer title insurance etc. • Tax lawyers who provide services that can also be offered by other professionals cannot escape because of the accounting services exemption. • Attorney who provide collection services-look to the service provided.
  12. 12. 12 Financial Comparison of C-Corp and Pass Through C Corp. C Corp. (No distribution) Pass Through (Active) Pass-thru (No 199A) Taxable income $1000.00 $1000.00 $1000.00 $1000.00 Entity level tax ($210.00) ($210.00) ($0.00) ($0.00) Net distribution $790.00 $790.00 $1000.00 $1000.00 20% deduction ($200.00) Individual tax ($180.80) ($0.00) ($290.60) ($370.00) After-tax cash $609.20 $790.00 $709.40 $630.00 Effective tax rate 39.8% 21.0% 29.6% 37.0%
  13. 13. TEN TAX ADVANTAGES OF A C CORPORATION 13 1. Operating Agreements 2. S Elections 3. Suspended Losses 4. 704(c) Allocations 5. Venture Capital 6. QSB Stock 7. Stock Option Plans 8. LLC Debt 9. Reorganizations 10. Fringe Benefits 11. Audits and Liabilities 12. Contingent Allocations
  14. 14. C Corporation (If Qualifying for QSB Stock) • 21% corporate income tax • 0% on shareholders if qualifies for QSB stock treatment • Subject to limitations ($10 million or 10 times the taxpayer’s adjusted basis) • Exit: QSB stock treatment not available in asset sale S Corporation • Not subject to corporate income tax • Up to 37% on shareholders • Exit: can choose between stock vs. asset sale • Possible capital gains rates 2. Qualified Small Business Stock GENERAL REQUIREMENTS  Original issue  Five-year holding period  100% post- Sept. 27, 2010  $50 million Gross Assets Test  Active Business Test  No significant redemptions Note: California does not follow federal income tax treatment of QSB stock under I.R.C. § 1202. 14
  15. 15. 2. Qualified Small Business Stock – Better than S Corp? Qualified C-Corp S-Corp Assets Assets VS. (From seller’s view) Answer: Depends! Compare qualified tax savings to S-corp asset sale’s higher pre-tax FMV Tax Savings Favor QSB Stock •0% rate for QSB stock sold (unless gain exceeds threshold) •20% rate for capital assets from S corp (likely no SECA, NIIT) •37% rate on OI assets from S corp Pre-Tax FMV Favors S corp •Buyer should pay extra to buy S corp assets; get value of cost recovery •Value of cost recovery can be high, if fast rate, low future value discount •S corporations generally have only one layer of tax in asset sale, unless there are ordinary income or BIG-tax assets Note: California does not follow federal income tax treatment of QSB stock under I.R.C. § 1202. 15

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