States of Matter: A Change in Form in a Post-Tax Reform Era - - PowerPoint PPT Presentation

States of Matter: A Change in Form in a Post-Tax Reform Era

Moderator: Janelle Darnell, KPMG LLP Speakers: William Alexander, Skadden, Arps, Slate, Meagher & Flom LLP Kyle Colonna, PwC LLP Brianne de Sellier, Crowe LLP Morgan Klinzing, Pepper Hamilton LLP

July 19, 2019

1

Agenda

• General Choice of Entity Considerations
• New Tax Reform Provisions - Impact on Choice of Entity Selection
• Consequences of Converting to a Corporation

2

General Choice

• f Entity Considerations

3

• Corporations:
• 2 layers of tax.
• Easy to form.
• Partnerships
• Single layer of tax.
• Complex rules regarding allocations of income.
• S Corporations
• Single layer of tax.
• Restrictions on ownership.
• LLCs
• Default to flow-through entities (disregarded or

partnership).

• Election available to treat as a corporation.
• Very flexible.

Entity Options

4

C Corporation P'Ship S Corporation LLC as P'Ship LLC as Corp LLC as DRE

Opco Tax 21% of $5MM Distribute After Tax ‘A’ Taxable Income ‘A’ Tax @23.8% ‘A’ After Tax Cash DON’T FORGET STATE TAXES

5

Using a C Corporation, with Distributions

$1,050,000 $3,950,000



Earns $5MM in Taxable Income



Distributes all After Tax Income

Opco A B 50% 50%

$1,975,000 $ 470,050 $1,504,950

6

Using a Pass Through, with Distributions



Opco earns $5MM, which is allocated pro rata to A & B

Opco A B

$2.5MM 50% 50% $5MM

Opco Tax Member Income QBI Deduction Tax, Income Tax 37% ETR After Tax Cash

• 0 -

$2.5MM $.5MM $2.0MM $740,000 29.6% $1,760,000



Case 1. Assume no 20% deduction Opco Tax Member Income Tax 37% After Tax Cash

• 0 -

$2.5MM $925,000 $1,575,000



Case 2. Assume each member can claim the 20% deduction for qualified business income

After-Tax Cash Comparisons

• C Corporation:

$1,504,950

• Pass Through (no deduction):

$1,575,000

• Pass Through (w/ deduction):

$1,760,000

• REMINDER: DON’T FORGET STATE TAXES

7

Choice of Entity Considerations

• Losses
• Ownership
• Tax Rates and Expectation of Distributions
• Flexibility of Distributions
• Tax Return Filings – Investors and Entity
• Flexibility to Restructure Through Tax-Free Corporate

Reorganizations

• Raising Capital
• Exit Planning

8

New Tax Reform Provisions - Impact on Choice-of-Entity Decision

TAX REFORM CHANGES THE MATH!

• 21% Corporate Tax Rate
• Section 199A – Qualified Business Income
• Section 163(j) – Limitation on Business Interest
• Other Domestic Considerations
• International Considerations

Tax Rate Considerations

• Tax reform lowered top marginal US income tax rates on ordinary income:

C Corporation Individual

35.0% 21.0% 39.6% 37.0%

Tax Rate Considerations

• But reduction in base tax rate is just the START of the analysis
• Additional taxation on corporate distributions may increase effective

corporate tax rate

• 20.0% rate on qualified “dividends”
• 3.8% NIIT on dividends received
• 199A passthrough deduction may further reduce maximum individual

income tax rate

• 37% rate reduced to 29.6% w/ maximum 199A deduction!
• Int’l Tax provisions may further reduce effective corporate level

income tax rate

• As low as 10.5% ETR for tax years before 2026!

Tax Rate Considerations

• Also need to consider type of income that business is deriving
• Capital Gain vs. Ordinary Income?
• All income is taxed at 21% rate for C corporations
• But long-term capital gains are taxed at preferential rates for individuals

(20%), which may change the math for passthroughs

Section 199A – QBI Deduction

• Deduct up to 20% of qualified business income (“QBI”), subject to

wage/investment limitation

• Qualified trades/businesses include all, EXCEPT:
• Performance of services as an employee
• “Specified service" businesses
• Could significantly reduce ETR on passthrough income

*Assumes maximum 20% 199A deduction for active passthrough entity

Without 20% 199A Deduction With 20% 199A Deduction 37.0% 29.6%*

163(j) – Limitation on Business Interest Expense

• Deduction for net interest expense limited to:
• Trade or business interest income plus
• 30% of adjusted taxable income plus
• Floor plan financing interest
• Limitation does not apply to certain small businesses
• Some partnerships and S corporations (which may be more likely to

be small) may be excluded

163(j) – Limitation on Business Interest Expense

• 163(j) applies differently to different entities

Corporations Partnerships 163(j) limitation determined & applied at entity level 163(j) limitation determined first at partnership level Disallowed excess business interest subject to carry forward at the CORPORATE level Any excess business interest disallowed at the partnership level is then allocated to partners Carried forward limitation may become subject to limitation under IRC Sec. 382. Excess business interest allocated to a partner is subject to carryforward and treated as business interest paid or accrued by the partner in a future tax year to the extent the partner is allocated “excess taxable income” from the partnership

Other Domestic Considerations

• Annual tax cost/benefit is only 1 factor!
• Tax Year
• C Corps have more flexibility
• 168(k) bonus depreciation –
• May further reduce ETR in corporate or passthrough context if applicable
• Dividends Received Deduction
• C corporation is entitled to DRD for dividends received from another corporation
• Partnerships and S corps are not entitled to DRD benefit

Other Domestic Considerations

• State & Local Tax Deduction – limited to $10,000/year for individuals
• Limitation does not apply to the same taxes paid by a C corporation
• But may apply to state & local taxes passed through from partnership or S corp
• Shareholders
• S corp shareholder eligibility may limit access to capital & investors
• Exit considerations  IRC Sec. 1202
• Passthrough entities are not eligible for IRC Sec. 1202 exclusion
• If sale of C corp stock qualifies for 1202 exclusion on exit, this could significantly

reduce the OVERALL tax over the life of the business, even if annual distributions are double taxed

Int’l Tax Considerations add Additional Complexity to Choice-of-Entity Decisions

Key International Considerations

• Global Intangible Low-Taxed Income (“GILTI”)
• Foreign Derived Intangible Income (“FDII”)
• Base Erosion Anti-Abuse Tax (“BEAT”)
• Other Considerations:
• Foreign Tax Credit
• Section 245A Dividends Received Deduction
• Section 965 Transition Tax

Global Intangible Low-Taxed Income

Foreign Derived Intangible Income

Base Erosion Anti-Abuse Tax

Other International Considerations

• Foreign Tax Credit
• Section 245A Dividends Received Deduction
• Section 956
• Section 965 Transition Tax

Consequences of Converting

25

Partnership to a C Corporation - Rev. Rul. 84-111 describes the Service’s position with respect to

partnership incorporations. Assume no other steps occurring as part of plan.

26

• Situation 1: P’ship transferred all its assets to C Corporation in exchange for all C Corporation stock and

the assumption by C Corporation of P’ship’s liabilities. P’ship then terminated by distributing all the stock

• f C Corporation to its partners.
• Step 1 generally qualifies as a tax-free contribution under section 351, provided the section 351

requirements are satisfied and limitations/restrictions are inapplicable, and subject to the application of section 367. Rev. Rul. 84-111 indicates that section 368(c) is not violated.

• Step 2 generally qualifies as a termination under section 708(b)(1). Consider sections 732, 733, 735, and

752.

C Corporation P’ship A B

50% 50%

C Corporation A B

50% 50%

1 1 2 2

Situation 1: “Assets Over” Situation 2: “Assets Up” Situation 3: “Interests Over”

C Corporation P’ship A B

50% 50%

2 2 1 1 1 1

P’ship

2 2

Section 351 Termination Section 351 Termination Section 351 Termination

Partnership to a C Corporation (Cont’d)

27

• Situation 2: P’ship distributed all its assets and liabilities to its partners, and the partners thereafter

transferred all the assets received to C Corporation in exchange for all the stock of C Corporation and the assumption by C Corporation of P’ship’s liabilities that had been assumed by the partners.

• Step 1 generally qualifies as a termination under section 708(b)(1). Consider sections 732, 733, 735, and

752.

• Step 2 generally qualifies as a tax-free contribution under section 351, provided the section 351

requirements are satisfied and limitations/restrictions are inapplicable, and subject to the application of section 367.

C Corporation P’ship A B

50% 50%

C Corporation A B

50% 50%

1 1 2 2

Situation 1: “Assets Over” Situation 2: “Assets Up” Situation 3: “Interests Over”

C Corporation P’ship A B

50% 50%

2 2 1 1 1 1

P’ship

2 2

Section 351 Termination Section 351 Termination Section 351 Termination

Partnership to a C Corporation (Cont’d)

28

• Situation 3: The partners of P’ship transferred their partnership interest to C Corporation in exchange for all
• f the stock of C Corporation.
• Step 1 generally qualifies as a tax-free contribution under section 351, provided the section 351

requirements are satisfied and limitations/restrictions are inapplicable, and subject to the application of section 367.

• Step 2 generally qualifies as a termination under section 708(b)(1). Consider sections 732, 733, 735, and

752.

C Corporation P’ship A B

50% 50%

C Corporation A B

50% 50%

1 1 2 2

Situation 1: “Assets Over” Situation 2: “Assets Up” Situation 3: “Interests Over”

C Corporation P’ship A B

50% 50%

2 2 1 1 1 1

P’ship

2 2

Section 351 Termination Section 351 Termination Section 351 Termination

Partnership to a C Corporation (Cont’d)

29

• 37% rate (highest marginal rate of individual partner) vs. corporate 21% rate.
• Query the effective tax rate if the partners are instead classified as corporations for U.S.

federal tax purposes.

• Flow-thru treatment vs. double taxation (e.g., corporate level tax and shareholder level tax on

distributions by the corporation with respect to its stock).

• Consider section 199A vs. section 245A (assuming corporate partners).
• Consider IP, financing structure, and other assets of transferor(s) and transferee regarding section

59A (the “BEAT”) and section 163(j).

• If the legal organizational structure has CFCs, consider: (i) impact of section 951A (“GILTI”) vs. the

BEAT; and (ii) subpart F.

• Consider application of section 269(a).
• Consider state/local tax rates and local regulatory issues.

Disregarded Entity to a C Corporation

30

• If an eligible entity that is a disregarded entity elects to be classified as an association taxable as

a corporation, the following is deemed to occur: The owner of the eligible entity contributes all of the assets and liabilities of the entity to the association in exchange for stock of the association.

• The tax treatment of a change in the classification of an entity for federal tax purposes by election

is determined under all relevant provisions of the Code and general principles of tax law, including the step transaction doctrine.

• Assume no other steps occurring as part of plan.

C Corporation LLC as DRE C Corporation C Corporation

Disregarded Entity to a C Corporation (Cont’d)

31

• Generally qualifies as a tax-free contribution under section 351, provided the section 351

requirements are satisfied and limitations/restrictions are inapplicable, and subject to the application of section 367.

• Newly formed C corporation is now potentially subject to taxation depending on, inter alia,

jurisdiction of incorporation and legal organizational structure.

• Consider section 254A vs. disregarded treatment.
• Similar to partnership, need to consider IP, financing structure, and other assets of transferor

and transferee regarding BEAT and section 163(j).

• If the legal organizational structure has CFCs, consider impact of: (i) GILTI vs. the BEAT; and

(ii) subpart F.

• Consider state/local tax rates and local regulatory issues.

Converting to a C Corporation: S Corporation Election

32

• C corporations generally are subject to tax at the corporate level at a 21% rate, and the

shareholders are subject to tax at a specific rate depending on whether the shareholder is, inter alia, an individual, corporation, or partnership on distributions of property by the C corporation with respect to its stock.

• If an S corporation election is made, there is generally only one level of tax at the shareholder level

at a 37% rate (highest marginal rate of individual S corporation shareholder).

• Section 199A vs. section 245A.
• Section 1202: Partial exclusion for gain from certain small business stock.
• There are significant limitations on qualifying as an S corporation and maintaining S corporation

status that do not apply to C corporations.

• Might make sense for a small privately held business with no significant growth plans to make an S

corporation election if they are already incorporated and otherwise satisfy the S corporation election requirements.

C Corporation to a Partnership

33

• If an eligible entity classified as an association taxable as a corporation elects to be classified as a

partnership, the following is deemed to occur: The association distributes all of its assets and liabilities to its shareholders in liquidation of the association, and immediately thereafter, the shareholders contribute all of the distributed assets and liabilities to a newly formed partnership.

• The tax treatment of a change in the classification of an entity for federal tax purposes by election is

determined under all relevant provisions of the Code and general principles of tax law, including the step transaction doctrine.

• Assume no other steps occurring as part of plan.

C Corporation A B

50% 50%

1 1

P’ship

2 2

A B

50% 50%

P’ship

C Corporation to a Partnership (Cont’d)

34

• Step 1 generally qualifies as a taxable liquidation under sections 331 and 336.
• Step 2 generally qualifies as a tax-free contribution under section 721.
• Query the result if the eligible entity was instead wholly owned by a corporation. See

section 332.

• The considerations discussed previously are equally applicable in this context (e.g.,

Section 199A vs. section 245A; disparate tax rates; double taxation vs. flow-thru treatment; section 163(j); GILTI; BEAT; subpart F; state/local taxes and regulatory issues).

C Corporation to a Disregarded Entity

35

• If an eligible entity classified as an association taxable as a corporation elects to be disregarded as an

entity separate from its owner, the following is deemed to occur: The association distributes all of its assets and liabilities to its single owner in liquidation of the association.

• The tax treatment of a change in the classification of an entity for federal tax purposes by election is

determined under all relevant provisions of the Code and general principles of tax law, including the step transaction doctrine.

• Assume no other steps occurring as part of plan.

C Corporation LLC as DRE C Corporation C Corporation

C Corporation to a Disregarded Entity (Cont’d)

36

• Generally qualifies as: A tax-free distribution section 332, provided the section 332

requirements are satisfied and limitations/restrictions are inapplicable, subject to the application of section 367 (i.e., Treas. Reg. § 1.367(b)-3).

• Query the result if the parent of the eligible entity was instead a partnership or
• individual. See sections 331 and 336.
• The considerations discussed previously are equally applicable in this context (e.g.,

Section 245A; taxable vs. disregarded treatment; section 163(j); GILTI; BEAT; subpart F; state/local taxes and regulatory issues).