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 of Entity Considerations 3

Entity Options • Corporations: • 2 layers of tax. C Corporation • Easy to form. • Partnerships • Single layer of tax. P'Ship • Complex rules regarding allocations of income. • S Corporations S Corporation • Single layer of tax. • Restrictions on ownership. • LLCs LLC as DRE • Default to flow-through entities (disregarded or partnership). • Election available to treat as a corporation. LLC as Corp LLC as • Very flexible. P'Ship 4

Using a C Corporation, with Distributions A B $1,050,000 Opco Tax 21% of $5MM 50% 50% Distribute After Tax $3,950,000 ‘A’ Taxable Income $1,975,000 Opco ‘A’ Tax @23.8% $ 470,050 ‘A’ After Tax Cash $1,504,950 Earns $5MM in Taxable Income  DON’T FORGET STATE TAXES Distributes all After Tax Income  5

Using a Pass Through, with Distributions Case 1. Assume no 20% deduction  A Opco Tax - 0 - B Member Income $2.5MM $2.5MM Tax 37% $925,000 50% 50% After Tax Cash $1,575,000 $5MM Case 2 . Assume each member can claim the 20%  Opco deduction for qualified business income Opco Tax - 0 - Member Income $2.5MM $.5MM QBI Deduction Opco earns $5MM, which is allocated  $2.0MM Tax, Income pro rata to A & B Tax 37% $740,000 ETR 29.6% After Tax Cash $1,760,000 6

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% 39.6% 21.0% 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 Without 20% 199A Deduction With 20% 199A Deduction 37.0% 29.6%* *Assumes maximum 20% 199A deduction for active passthrough entity

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 163(j) limitation determined first at partnership level entity level Disallowed excess business interest Any excess business interest disallowed at the subject to carry forward at the partnership level is then allocated to partners CORPORATE level Carried forward limitation may become Excess business interest allocated to a partner is subject to limitation under IRC Sec. 382. 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. Situation 1: “Assets Over” Situation 2: “Assets Up” Situation 3: “Interests Over” A A B B A B 1 1 Termination 2 2 50% 50% Termination 1 1 Section 351 50% 50% 50% 50% C Corporation P’ship P’ship 1 1 Section 351 2 2 Termination 2 2 Section 351 C Corporation C Corporation P’ship • 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 of 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. 26

Partnership to a C Corporation (Cont’d) Situation 1: “Assets Over” Situation 2: “Assets Up” Situation 3: “Interests Over” A A B B A B 1 1 2 2 Termination 50% 50% Termination 1 1 Section 351 50% 50% 50% 50% C Corporation P’ship P’ship 1 1 Section 351 2 2 Termination 2 2 Section 351 C Corporation C Corporation P’ship • 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. 27