|January 17, 2013|
Previously published on January 2013
The American Taxpayer Relief Act of 2012 was signed into law on January 2nd. Although the recent headlines suggest the “fiscal cliff” was averted with this legislation, for most business owners, dealing with significantly higher tax rates is now a reality. With few exceptions, the higher tax rates deemed problematic by congressional Republicans are now in effect for persons with taxable income in excess of $450,000. Of course, this threshold includes income allocated to owners by any business operated as a "pass-through" entity such as an S corporation or LLC. For the owners of these businesses, the $450,000 threshold will quickly be reached assuming the business is profitable.
With tax rates now set, one question many business owners are asking is what type of entity (C corporation, S corporation, LLC or partnership) is best suited to minimize exposure to income taxes. Should C corporation owners consider making an S election, or is a C corporation now more tax efficient, such that S corporations should revoke their S election and LLCs should consider a conversion to a C corporation? Several commentators, noting that the highest C corporation tax rates will in most cases be lower than the individual tax rates effectively paid by pass-through entities, have suggested that it may be time for businesses to consider operating as a C corporation.
The analysis necessary to make this determination is not straightforward. In addition to the new higher tax brackets, the additional 3.8 percent tax on certain passive investment income (the “Medicare Tax”) is imposed in different ways, depending on the type of entity, the income level of the owner and whether the owner is active in the business. While the analysis of this issue has become more complicated, there is a bright side to the new legislation. We now know what the tax rates for 2013 and the foreseeable future are, and tax planning can focus on specific actions based on actual tax rates instead of speculation.
The Choice of Entity Issue
As noted above, several commentators have suggested that under the current tax structure, tax rates on C corporation income are now favorable as compared to those of pass-through entities. If income is allocated to owners who are active in the business, the profits generated by pass-through entities will be taxed at a maximum rate of 39.6 percent. To the extent the owners of a pass-through entity are not active in the business, the Medicare Tax must be added. This makes for a total tax rate of 43.4 percent on pass-through income for these owners. In either case, these rates are significantly higher than the maximum effective tax rate of 35 percent for most C corporations. This disparity is an issue even with pass-through entities having some or even most owners in lower tax brackets, since tax distributions are usually (in the case of a LLC) and must be (in the case of a S corporation) made in proportion to ownership, not based on owners' individual tax rates. The chart below shows that if tax distributions are made proportionately, a hypothetical pass-through business can have a tax rate of 43.4 percent, even though some (or even most) of the owners are in the 25 percent tax bracket. An owner in the 43.4 percent tax bracket might feel like tax distributions are a windfall to the owners in the lower brackets.
In fact, the current rate structure makes operating as a pass-through much more complicated. Historically, owners of pass-through entities generally were subject to the same, or at least similar federal tax rates on allocations of income. Under the current rate structure, it is much more likely that owners will be subject to very different rates of tax depending on their income levels and whether they are active in the business. A single pass-through entity with five owners could easily be taxed effectively at five different rates, as follows:
Passive or Active
Taxable income less than $146,400
AGI more than $250,000 but taxable income of $398,450 to $450,000
Taxable income exceeding $450,000
AGI of more than $250,000 but taxable income of $398,450 to $450,000
Taxable income exceeding $450,000
Since there are actually five tax brackets for taxable income between $146,400 and $450,000, and the numbers above (and in this alert) reflect the thresholds for taxpayers filing jointly, the number of variations based on the owner’s Adjusted Gross Income (AGI), filing status and whether the owner is active in the business is much greater than set forth above.
It is fairly obvious that strictly from the standpoint of tax rates on business income, C corporation rates will generally be less than pass-through rates, and operation of a C corporation from a tax standpoint will be more straightforward. The issue with this analysis is that it does not take into account: (i) whether the corporation will be paying dividends year to year; and (ii) the taxation of the business and its owners upon an exit event with respect to the business. Adding these factors to the analysis will often change the conclusion regarding which type of entity is more tax efficient.
Dividends are a Key Consideration
A key issue in the choice of entity analysis relates to distributions of profits. Simply put, if the business is profitable and it is anticipated that a significant portion of these profits will be distributed to the owners, then pass-through entities will usually be a better choice than a C corporation. Businesses that put most or all of their profits back into the business and do not make (and do not plan to make) significant distributions will likely pay lower taxes overall if operated as a C corporation.
Dividend rates actually represent the one “bright spot” for higher income taxpayers because the tax rates on dividends only increased to 20 percent. If no deal had been reached in Congress, the dividend rate would have increased to 39.6 percent for these taxpayers, plus the 3.8 percent Medicare Tax for a total dividend tax rate of 43.4 percent. As enacted, those taxpayers subject to the Medicare Tax and the higher dividends rate (those with taxable income in excess of $450,000) will pay tax on corporate dividends at a 23.8 percent rate, which still represents a significant increase from the 15 percent rate.
It is interesting to note that although the 20 percent dividend rate only applies to taxpayers with more than $450,000 of taxable income, the Medicare Tax applies to most taxpayers with over $250,000. Thus, the income threshold for imposing the Medicare Tax did not change as a result of the new legislation. Taxpayers with AGI of more than $250,000, but with taxable income of $450,000 or less, will have an effective tax rate on dividends of 18.3 percent.
In any case, for business owners at higher income levels, the tax rate on dividends will be 23.8 percent. Although this is a significant improvement upon the scheduled rate change, when comparing the tax efficiency of a C corporation with a pass-through entity, the additional tax on the distribution of profits must be added to the basic C corporation tax rate if it is anticipated that dividends will be paid.
If dividends are being paid, the conclusion as to entity choice will usually shift; LLCs and S corporations will have an overall lower tax rate as compared to C corporations since the second level of tax on dividends is eliminated. Even passive pass-through investors paying the 43.4 percent tax on business income will be better off than investors in a C corporation paying a 35 percent corporate rate plus a 23.8 percent dividend rate.
Exit Event Considerations
Business owners must also consider the impact of entity choice on the tax results from the potential sale of the business. Although these considerations are more difficult to quantify since the exit event may be in the distant future, the tax differences are significant enough that they need to be taken account of in any choice of entity analysis.
Sale of Assets
When a business is sold, C corporations are still at a significant disadvantage if the sale is structured as an asset sale. Gain on the sale of assets will usually generate a single level of tax at capital gains rates for LLCs and S corporations. C corporations pay tax on asset sale gains at ordinary income rates, plus the tax on the distribution of the cash to the shareholders. As such, the C corporation will pay tax on the entire gain from the sale of the business at a rate of 35 percent; the after-tax proceeds from the sale that are distributed to the shareholders will be taxed in most cases at an additional 15 percent to 23.8 percent depending on income levels. This is in stark contrast to the sale of assets by a pass-through, which will primarily generate one level of gain to the owners at a rate of 15 percent to 23.8 percent, again depending on income levels and whether the owners are active or passive. This tax rate disparity cannot be dismissed by concluding that when the time comes, the business will require the transaction to be structured as a sale of stock rather than a sale of assets. Most buyers prefer to structure the acquisition as an asset sale, due to the ability to depreciate or amortize the purchase price for tax purposes, and avoid assuming all of the liabilities of the target company. Buyers willing to structure an acquisition as a stock acquisition will often demand a reduction to the purchase price to account for these two issues.
Sale of Equity
If the exit event is structured as a sale of equity, owners must take into account not only anticipated levels of taxable income but also the imposition of the Medicare Tax, which depends not only on the type of entity but whether the shareholders are active in the business. The Medicare Tax is imposed on gain from the sale of C corporation stock for all shareholders whose AGI exceeds $250,000. On the other hand, shareholders who are active in the business will generally not pay the Medicare Tax on the gain from the sale of their equity if the business is an S corporation or LLC, regardless of their AGI. So, while passive investors would be ambivalent about the choice of entity with respect to the Medicare Tax (since it is imposed in any case), shareholders who are also employees or otherwise meet one of the “active participation” tests will be better off if the business is structured as a pass-through entity.
Medicare Taxes and the Material Participation Test
As noted above, the Medicare Tax is imposed on allocations of LLC and S corporation income to owners who are not active in the business. Gain on the sale of equity in a S corporation and LLC is also subject to the Medicare Tax unless the owners are active. These rules may cause those owners who are able to qualify as active to consider becoming active. The test in this context is whether the owner “materially participates” in the activity, and this test is generally the same as the test under other provisions in the Internal Revenue Code. An owner can therefore qualify as active under any one of several different tests, including:
The owner works 500 hours or more during the year in the activity
The owner does substantially all the work in the activity
The owner works more than 100 hours during the year in the activity and no one else works more than the owner
Note that while this strategy could work with a S corporation, being characterized as active in the business of a LLC will generally subject the owner to self-employment taxes on allocated income. The hospital insurance portion of taxes on self-employment income (the portion that has no maximum) in excess of certain thresholds was also increased by the Affordable Care Act from 2.9 percent to 3.8 percent, which means the income allocated will in most cases be subject to the same additional taxes, whether in the form of the Medicare Tax or taxes on income from self-employment.
Control over Dividend Payments
As described above, the decision of whether to operate a business as a C corporation or a pass-through entity will, in many cases, come down to whether the business entity will pay dividends. Unfortunately, the question of whether to pay dividends is not always up to the business owners. The IRS has several tools to ensure that C corporations do not accumulate profits to avoid paying dividends. The IRS can also exert control over salaries paid to shareholder/employees, another mechanism for distributing profits of a company without paying dividends.
Excess Accumulated Earnings
In certain circumstances, the IRS is able to effectively force a corporation to pay a dividend by imposing a tax on excess accumulated earnings. This tax can be imposed on any corporation that retains cash that is beyond the “reasonable needs” of the business. One of the recent trends in our uncertain economy has been for corporations to accumulate cash to deal with unexpected downturns. This trend has already resulted in the IRS taking a closer look at whether corporations under audit have accumulated excess earnings to trigger this tax. The increase in tax rates will undoubtedly result in the IRS focusing even more attention on this issue, since the tax rate on excess accumulated earnings is essentially tied to the dividend rate.
The increase in the dividend rate will therefore result in a distribution dilemma: shareholders receiving dividends will pay the higher tax rate, but not paying dividends will undoubtedly result in the IRS looking at the excess accumulated earnings issue. Profitable corporations that want to minimize dividends will need to start planning to defend the accumulation of earnings by showing that the accumulation is due to planned expansion, acquisition or other purposes accepted by the IRS.
Dividends cause a second layer of tax because they are not deductible. Where one or more significant shareholders also provide services to a corporation, paying out earnings to the shareholder/employee as deductible salaries is a time-honored method of distributing earnings to shareholders without paying a second level of tax. Corporations that use a strategy of paying out profits as salary to shareholders often face IRS assertions that such payments exceed the amount of compensation that is reasonable. Since compensation is only deductible by a corporation if it is reasonable, the excess amount of salary can be recharacterized by the IRS as a nondeductible dividend. Such positions are likely to be more aggressively asserted by the IRS in 2013 and beyond given the increase in dividend rates.
The American Taxpayer Relief Act of 2012 includes an extremely confusing set of rules that make it difficult for business owners and their advisors to engage in tax planning, including the determination of the appropriate entity choice for a business. The variables in this analysis include:
The income levels of the owners (both in terms of AGI and taxable income)
Whether the owners are passive or active
Whether the company is (or will be) profitable enough to distribute earnings
The timing and manner of an exit event for the owners
Any business owner with a crystal ball that could determine exactly if and when distributions would be paid, and when and how the business would be sold, would be able to make the right entity choice with a high level of confidence. Absent this, a business owner must do the best he or she can in forecasting those future events. Ultimately, the benefit of the LLC or S corporation is that they are more flexible. An LLC can generally convert to a C corporation or an S corporation with no adverse tax result. A S corporation can likewise easily revoke its S election to be taxed as a C corporation if this becomes desireable. Once a business is characterized as a C corporation, it is generally very expensive (and usually prohibitively so) to convert to a LLC, and re-electing S status generally requires a five year waiting period. Although not irreversible, the decision to convert a pass-through entity to a C corporation should be examined very carefully. These difficult choices require strategic and thoughtful planning.