Category Archives: S Corporations

Tax Savings Estimator: Qualified Business Income Deduction

If you own a business taxed as a sole proprietorship, partnership, or S corporation, the new Section 199A Qualified Business Income Deduction offers one of the biggest potential tax benefits under the recently-enacted Tax Cuts and Jobs Act. It allows you to deduct up to twenty percent of your business income. If your income exceeds $157,500 ($315,000 for a married joint filer), the deduction is limited by filters tied to your company’s employee payroll and depreciable property ownership. There are other restrictions, but for most business owners our calculator offers a useful, simplified estimate of tax savings from the new deduction.

Curious whether you should change the tax status of your company? Read our analysis here: Should You Reform Your Business for Tax Reform?

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

Welcome the New Year With Our Updated Tax Reform Review

On December 22, 2017, President Trump signed into law the most important rewrite of the US tax code in decades. The federal law, which is entitled “An Act to provide for reconciliation pursuant to titles II and V of the concurrent resolution of the budget for the fiscal year 2018” (the Act), has no other name, as its short title, the Tax Cuts and Jobs Act, was stricken from the bill shortly before being signed.

We have prepared a summary of the Act as a non-exhaustive discussion of key changes to the tax code. We will continue to analyze the Act and will post updates and recommend planning strategies on this blog.

For more information regarding the Act, please see our previous related blog posts linked below:

On behalf of everyone at Williams Parker, we hope you and your family have a healthy and happy 2018.

Please note this post was co-authored by Elizabeth Diaz, Colton Castro, and Nicholas Gard. 

Elizabeth P. Diaz
ediaz@williamsparker.com
941-329-6631

Colton F. Castro
ccastro@williamsparker.com
(941) 329-6608

Nicholas A. Gard
ngard@williamsparker.com
(941) 552-2563

Should You Reform Your Business for Tax Reform?

If you own a closely-held business, it likely utilizes a “pass-through” S corporation or partnership tax classification.  The owners pay income tax individually on pass-through entity income, whether or not the business distributes the income.

C corporations are different.  C corporations pay tax on their own income.  The shareholders pay an additional dividend tax only when the C corporation distributes dividends.

Under the Tax Cuts and Jobs Act that Congress likely will pass Tuesday, the federal tax rate on retained C corporation income will drop from 35% to 21%.  The top individual tax rate, which also applies to pass-through entities, will equal 37%.  The Act makes C corporation tax status more attractive than in the past.

Should you convert your pass-through business to a C corporation?  

Should you change the tax classification of your business?

The short-answer: Probably not, unless you plan to own the business a long time and indefinitely reinvest profits.

A longer answer:

Under the Act, converting your business into a C corporation creates a trade-off between:

  1. a lower tax rate on operating income, leaving more cash to reinvest in the business; and
  2. paying more tax (or getting a lower purchase price) when you sell the company, and having less flexibility taking profits out of the business in the meantime.

If you convert your Florida-based pass-through business to a C corporation, the business will pay state income taxes that pass-through entities avoid. The C corporation’s combined federal and state tax rate will reach just over 25% on reinvested income.

The problems? You will pay a higher or equivalent tax rate, as compared to the pass-through tax rate, if you take the profits out of the corporation.  If you sell the business as a C corporation you will (1) pay about a 43% combined corporate-level and shareholder-level tax rate on the sale gain (versus a likely 20% or 23.8% rate as a pass-through), or (2) receive a lower purchase price to compensate a buyer willing to purchase the corporation stock for forgoing a tax basis step up in the corporate assets.  And if laws or circumstances change, you cannot always readily convert back to pass-through status without negative tax consequences.

What’s in the Act for Pass-Through S Corporations and Partnerships?

The Act includes a new deduction of up-to-20% of income for pass-through businesses.  If your business earns $10 million of income, you might qualify to deduct $2 million.  The deduction would save $740,000 in federal income tax and reduce the business’ effective income tax rate from about 36% to approximately 29%.

The catch?  For taxpayers with income over about $400,000 (or a lower threshold for persons other than married, joint filers), the Act limits the deduction to (1) 50% of the wages paid to employees, or (2) the sum of 25% of wages, plus 2.5% of the value of owned depreciable property.  If the business earns a $10 million profit, but its payroll is $3 million, you may only qualify to deduct $1.5 million, not $2 million. Unless the business has a lot of payroll or owns substantial depreciable property, its tax rate may remain in the mid-to-high 30% range.

Despite the new deduction, the Act leaves most pass-through entity owners paying a higher tax rate than C corporations pay on reinvested business profits.  But most pass-through entities retain the advantages of a lower tax rate on profits distributed to owners and on the sale of the business.

What to Do?

If you can predict future payroll and equipment purchases, the price and timing of a business sale, and Congress’ whims, you can perform a present value calculation to decide whether pass-through or C corporation tax status is best for your business.  The calculation would compare the pre-business-sale tax savings from the reduced C corporation tax rate on reinvested profits, against the increased tax on distributed profits and from a future business sale.

The math is more complicated for businesses qualifying for other tax breaks, such as the Section 1202 small business stock gain exclusion.  It grows even more complicated if the model considers the tax effects of an owner’s death.

If your crystal ball isn’t clear, you are stuck making best guesses about the future of politics and your business.  But if you frequently take profits out of your business or imagine selling it in the foreseeable future, you probably will stick with the pass-through  tax status your business already uses.

For more comprehensive information regarding the Tax Cuts and Jobs Act, follow this link to our previous post.

E. John Wagner, II
jwagner@williamsparker.com
941-536-2037

The S Corporation Inversion – How to Convert an S Corporation into a Tax Partnership Tax-Free

Tax inversions have been in the news for several years now, but almost always in the context of a public US company reincorporating in a foreign country to achieve lower tax rates on non-US source income. However, there is another type of inversion, the S corporation inversion, that does not involve any foreign countries but can be an elegant solution to a problem faced my many small and medium-sized businesses operated as S corporations.

Many businesses start as S corporations for good tax reasons, but later in their lifecycle want to convert to a tax partnership (such as an LLC taxed as a partnership) for a variety of business and tax reasons. For example, perhaps a private equity fund or foreign investor (which are both impermissible S corporation shareholders) want to invest in the business and become owners. Another example is where an S corporation wants to grant an equity interest to a key employee in exchange for their past and future services. Oftentimes, the best approach in this case is to grant the employee a “profits interest” in the business, but S corporations cannot grant such interests, while tax partnerships can. Simply converting or merging the S corporation into an LLC taxed as a partnership is not satisfactory, because that transaction would trigger the taxable liquidation of the S corporation.

One method to convert to a tax partnership tax-free, without undergoing an inversion, is the “LLC drop-down,” which entails the S corporation forming a wholly-owned LLC, that is initially a disregarded entity for tax purposes, and transferring all of the S corporation’s assets and business to the new LLC. Once this is accomplished, the new investors can invest in the business by investing into the new LLC, which will become a tax partnership. However, this restructuring is deceptively simple, because migrating the S corporation’s business to the new LLC can create many issues, including (1) migrating employees, payroll, and benefit plans to the new LLC; (2) opening new operating and payroll bank accounts for the new LLC; (3) consulting with insurance agents to obtain coverage for the new LLC; (4) assigning customer, lease, vendor, and other key agreements to the new LLC, which oftentimes requires the counterparty’s consent; (5) transferring or obtaining new licenses and permits for the new LLC to operate the business; and (6) obtaining lender consent.

These headaches can oftentimes be avoided by utilizing an S corporation inversion. The S corporation inversion is accomplished by having the shareholders of the S corporation (“Old S”) transfer their stock to a newly formed S corporation (“New S”) in exchange for all the stock of New S. Old S immediately makes an election to be a qualified subchapter S subsidiary, and so Old S will be disregarded for tax purposes. New S then forms a wholly-owned LLC, which is initially disregarded for tax purposes, and then merges Old S into the new LLC, with new LLC as the survivor of the merger. The merger is without tax consequences, because it’s a merger of two entities, Old S and LLC, that are disregarded for tax purposes. Furthermore, by operation of the Florida merger statute, all of the assets, liabilities, contracts, and legal relationships of Old S transfer to LLC and in most circumstances no third party consents are required. Now the old business is in a new LLC that can take on new investors in a tax partnership format and without many of the headaches of migrating a business to a new legal entity. For guidance on this structure, see Treasury Regulation Section 1.1361-5(b)(c), Example 2.

Michael J. Wilson
mwilson@williamsparker.com
941-536-2043