Anticipated tax reform is expected to significantly reduce the tax rates imposed on C corporations' taxable income. Such a reduction in rates would give closely held businesses a significant reason to consider converting their passthrough-entity structures (S corporations and partnership-type entities), which are taxed at the owner level, to C corporations.
Changing from a passthrough to a C corporation is typically uncomplicated, generally requiring revocation of an S election or, for a limited liability company (LLC) or other entity taxed as a partnership, filing Form 8832, Entity Classification Election. In most cases, this transformation is also tax-free, although care must be taken when converting an entity taxed as a partnership under Subchapter K. In these situations, the relief of liabilities upon conversion may exceed the owners' adjusted tax basis in the entity, which would result in a taxable event under Sec. 357(c). In many cases, however, this tax-free transition door swings just one way, so taxpayers should fully analyze both the potential benefits and pitfalls of changing the form of entity taxation, because conversion back to a passthrough structure could carry a significant tax cost.
Taxing a company as a C corporation has traditionally offered a short-term benefit where the entity earns a modest amount of income and the low C corporation tax brackets save significant tax over the marginal cost of including the income on the owner's personal tax return.
Example: A company has taxable income before owner's compensation of $300,000 and pays the owner a $200,000 salary. The $100,000 of company income remaining after owner's compensation would be taxed at a blended rate of roughly 22% to the C corporation. In the passthrough-entity regime the same $100,000 would most likely be taxed at the owner's individual marginal rate of 33%, depending on the owner's filing status and other tax attributes.
Further costs could include self-employment tax on partners and accelerated phaseouts from the increase in the owner's adjusted gross income. Beyond that, there may be an added state tax benefit if the company is doing business in a state such as Ohio that does not impose an income tax on C corporations. Some states, such as Florida, tax C corporations but not the income of passthrough entities. In either case, there may also be a significant compliance benefit when using a C corporation instead of a passthrough entity in cases where the company has nexus in several states and has several owners.
This is especially true where the passthrough entity's circumstances will not allow composite filing. Additional tax filings multiply quickly in the passthrough-entity environment, versus the "one and done" filing for C corporations. A simple example would be a family-owned business that has taxable operations in 15 states and, due to its specific circumstances, cannot file composite returns in 10 of the 15 states. Assume the business has multiple generations of owners, totaling 30 individual taxpayers. Under these circumstances, the state filing requirements could entail 305 or more separate returns (five state composite returns, plus 10 separate individual returns for each of 30 owners). In the C corporation environment, this is most likely reduced to 15 separate filings.
The downside of converting to a C corporation is primarily the double tax that ultimately will be paid on a liquidation of the C corporation or sale of its assets followed by a distribution of the net sales proceeds to its owner. Sec. 1202 (which allows a partial exclusion of gain from the sale of certain small business stock), if applicable, can mitigate this added expense. Additionally, it is not uncommon for businesses to be bifurcated, i.e., split into components, to use several types of entities to get favored tax treatment both currently and at sale or liquidation.
For example, "value assets" such as real estate, machinery, intellectual property, or business goodwill and other intangibles may be housed in a passthrough entity to provide for a single tax on their sale. Income assets such as receivables or inventory could be owned by a C corporation that conducts the actual business and pays rents and royalties to the passthrough entity as a cost of operations. There may be very little taxable gain on the sale of full-basis receivables and inventories in disposition, but the business can benefit from lower tax rates and more deductible fringes while in operation. In these situations, where a business is operated through multiple commonly owned entities, the taxpayer should be wary of the provisions of Sec. 482 and the need to have arm's-length pricing of goods and services transmitted between the related entities.
An interesting form of bifurcation arises when a business operating as a passthrough entity decides to form a wholly owned C corporation subsidiary with its income assets. Owners should take care to meet the rules of Sec. 351 and, specifically, the aforementioned Sec. 357(c) to ensure tax-free incorporation. They should also take care to properly create leases and licensing agreements between the parent and subsidiary as well as to properly assign any third-party contracts. Payroll tax filings may need to be shifted to the subsidiary, or the group may qualify for common paymaster status, depending on the underlying facts.
The taxpayer should also consider other non—income-tax-related issues in the split of the business, such as worker's compensation and unemployment tax experience ratings, product liability exposure, insurance coverage, qualification to do business in various states, etc. Once established, however, the business could benefit from the current income tax treatment of C corporations with the long-term benefit of a passthrough entity, because the value assets remain in the passthrough entity holding company.
One scenario that warrants extra attention occurs when the subsidiary had previously been a C corporation but later made a qualified Subchapter S subsidiary (QSub) election and is currently a disregarded entity with an S corporation parent. This, of course, could not have been the case had the parent been an LLC, as the corporation would be deemed to have been liquidated in order to achieve status as disregarded (presumably, a single-member LLC).
With the QSub election, the subsidiary is deemed to be liquidated into the S corporation parent tax-free under Secs. 332 and 337. If the former C corporation subsidiary had accumulated earnings and profits (E&P) at the time of the QSub election, that E&P would have transferred to the parent by virtue of Sec. 381(a)(1). This should make the company more mindful of the distribution rules under Sec. 1368 as well as the passive investment income rules under Sec. 1375.
Now suppose, consistent with the thinking above, the owner desires to bifurcate the business to return the subsidiary to C corporation status. How is the E&P to now be split between the S corporation parent and the new C corporation subsidiary?
The Sec. 312 regulations govern the split. Regs. Sec. 1.312-11(a) provides:
In a transfer described in [Sec.] 381(a), the acquiring corporation, as defined in [Regs. Sec.] 1.381(a)-1(b)(2), and only that corporation, succeeds to the earnings and profits of the distributor or transferor corporation (within the meaning of [Regs. Sec.] 1.381(a)-1(a)).
The regulation adds:
Except as provided in [Regs. Sec.] 1.312-10, in all other cases in which property is transferred from one corporation to another, no allocation of the earnings and profits of the transferor is made to the transferee.
A QSub revocation is not treated as a reorganization under Sec. 368(a)(1)(A), (C), (D), (F), or (G), and the stock is not being distributed to the shareholders. Therefore, the transaction does not qualify under Sec. 381(a) or meet the requirements of Regs. Sec. 1.312-10; and none of the parent's E&P will be allocated to the subsidiary, even if the source of the E&P was clearly attributable to the subsidiary for the period prior to the revocation of the QSub election.
This unexpected consequence of this transaction has the odd effect of leaving E&P with the S corporation parent, and Sec. 1368 and 1375 concerns will continue. The Sec. 1375 concerns are particularly troubling if the combined balance sheet split left the value assets at the parent level. This could produce solely rental and royalty income to the parent S corporation, which could now be subject to the Sec. 1375 tax and could even jeopardize its S corporation status.
Tax reform, if enacted, could make C corporations far more attractive in closely held business settings than they have been in the past 30 years. However, as illustrated, many of the moves to consider are only tax-free in one direction or may have lingering unintended consequences.
EditorNotes
Anthony Bakale is with Cohen & Company Ltd. in Cleveland.
For additional information about these items, contact Mr. Bakale at 216-774-1147 or tbakale@cohencpa.com.
Unless otherwise noted, contributors are members of or associated with Cohen & Company Ltd.
