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Revisiting C Corporations after Tax Reform and Potential Tax-Free Sales of Corporate Stock by Barry M. Brant, CPA

Posted on December 17, 2018 by Barry Brant

The permanent reduction of the corporate income tax rate from a maximum of 35 percent to a flat 21 percent has led many businesses to reevaluate their current tax positions and reconsider their entity choice. The decision to convert from a pass-through entity to a C corporation, however, should not be based solely on how the IRS will tax business earnings in the short-term. Instead, business owners should consider a broader range of short- and long-term factors unique to their specific circumstances, including, but not limited to, their stage of development, the industry in which they operate, the makeup of their investors, their plans for distributing earnings, and their exit strategies.

Over the last few decades, pass-through structures have been the entity of choice for most closely-held domestic businesses. Owners of S corporations, LLCs and partnerships, could avoid both the U.S.’s corporate tax rate, which was among the highest in the world, and the imposition of a second level of tax on dividends distributed to their owners or the sale of corporate stock. On the contrary, owners of these businesses pay taxes just once, at their individual income tax rates, on their share of the entities’ profits. With tax reform and the reduced corporate tax rate changes, C corporations are now a more attractive structure for tax purposes. This is especially true when entities meet the requirements for issuing qualified small business stock (QSBS) and there is a likelihood of selling those shares as part of an exit strategy five years or more down the road.

Under Section 1202 of the tax code, individuals who acquired stock after Sept. 27, 2010, in a qualifying small business structured as a C corporation may exclude up to 100 percent of the gain they incur from selling those shares after Dec. 31, 2017. The amount of the gain eligible for exclusion can be as much as the greater of $10 million or 10 times the shareholder’s basis in the stock, which could translate to hundreds of millions of dollars in tax savings for qualifying C corporation shareholders. In other words, business owners and investors can realize a 0 percent tax rate on the profits they reap from selling stock in qualified small business corporations, provided they meet a long list of requirements. For example, they must have acquired the stock directly from the issuing entity or by gift or inheritance and held onto it for a minimum of five years before the sale. Special care should be taken to document any tangible or intangible property shareholders contribute to the corporation in exchange for the QSBS.

Electing to be a C corporation that issues QSBS is especially beneficial to start-up businesses that seek to raise as much capital as possible, in as many rounds as needed, from private investors and/or the public equity markets. Unlike S corporations that are limited to a maximum of 100 shareholders, C corporations can issue stock to an unlimited number of investors, including private equity funds.

On the downside, C corporations will continue to pass a second level of tax at a rate of 23.8 percent onto their shareholders when they pay dividends to them. However, the slashing of the corporate rate to 21 percent lessens this blow as does a business’s ability to control the timing of the dividend distributions and related tax liabilities they pass on to their owners.

In general, businesses in start-up and early stages are more likely to retain and reinvest earnings, building up ample working capital to finance their operations and continuous growth, rather than distributing profits to shareholders. In fact, owners of C corporations may limit their tax burden to only 21 percent of corporate earnings and avoid additional tax exposure for many years as long as they plan carefully and refrain from paying out dividends or becoming subject to an accumulated earnings tax. Conversely, owners of S corporations will pay taxes on all of their businesses’ earnings at a rate as high as 37 percent as well as a potential 3.8 percent Net Investment Income Tax (NIIT) regardless of whether or not they receive dividend distributions. The only saving grace for these pass-through entities, if they qualify based on such factors as their lines of business, their income, the wages they pay to employees and the cost of their fixed assets, is a new deduction of up to 20 percent on certain items of business income. Yet, even with the full benefit of this qualified business income (QBI) deduction, S corporation owners will still be subject to a top effective income tax rate of 29.6 percent plus potential Net Investment Income Tax of 3.8%, as opposed to C corporations which can limit their tax liabilities to a flat 21 percent rate, plus state income taxes, if any.

In order for shareholders to be issued QSBS, entities must have gross assets of less than $50 million on the date they issue stock to investors and immediately thereafter, taking into account the amount they raised through the stock issuance. In addition, they must use at least 80 percent of their assets to actively conduct non-service-oriented business activities, which specifically excludes those businesses that provide services in the fields of banking, finance, insurance, investing, hospitality, farming, mining and owning, dealing in, or renting real estate. In fact, no more than 10 percent of the value of the issuing company’s net assets may consist of real estate or stock and securities of unrelated corporations.

While the reduction of the corporate income tax rate may increase interest in C corporation status, there is little doubt that such an election will yield even more favorable tax savings for owners of start-up, early stage and smaller companies that intend to go public or be sold for a profit in the future. QSBS investors can enjoy tax-free income from the sale of the corporation’s stock or even roll over their gains free of taxes into shares of another qualified small business corporation without losing the benefit of the gain exclusion upon the sale of the replacement QSBS. With the new tax law, businesses and their owners should plan even more carefully than ever with the guidance of experienced advisors and accountants in order to maximize the potential benefits of a C corporation.

About the Author: Barry M. Brant, CPA, is director of Tax, Consulting and International Services with Berkowitz Pollack Brant, where he leads the firm’s private client group and provides guidance on complex tax matters, including multi-national holdings, cross-border treaties and wealth preservation and protection. He can be reached at the CPA firm’s Miami office at (305) 379-7000, or via email at info@bpbcpa.com.

 

 

Exporters, Other Businesses May Combine Tax Incentives to Yield Substantial Savings by James W. Spencer. CPA

Posted on December 10, 2018 by James Spencer

Tax reform’s aim to protect the US tax base and prevent domestic companies from shifting jobs, manufacturing and profits to lower tax jurisdictions overseas resulted in a significant benefit to export businesses. Not only does the new law preserve the preferential tax treatment of Interest Charge-Domestic International Sales Corporation (IC-DISC), it also introduces a new tax incentive for C corporations that sell American-made goods or services to foreign customers for consumption outside of the U.S.

Interest Charge-Domestic International Sales Corporation (IC-DISC)

U.S. businesses that sell, lease or distribute goods made in the US to customers in foreign countries may realize significant tax benefits when they create an IC-DISC to act as their foreign sales agent to which they pay commission as high as 4 percent of gross receipts or 50 percent of taxable income from the sale of export property.

Essentially, a qualifying business forms the IC-DISC as a separate US-based “paper” company, typically with no offices, employees or tangible assets, to receive tax-free commissions that the business can claim as deductions that ultimately reduce its taxable income. The amount of the tax savings the business may reap for the commission it pays to the IC-DISC can be as high as 37 percent, depending on its structure (21 percent for C corporations beginning in 2018) and its source of income. Only when the IC-DISC distributes earnings to shareholders will there be a taxable event. At that time, the shareholders will be liable for paying taxes on the IC-DISC earnings at lower qualified dividend rates not to exceed 23.8 percent.

While businesses that make IC-DISC elections are most commonly exporters and distributors of U.S.-manufactured products or their components, software companies, architects, engineers and other contractors who provide certain limited types of services overseas may also qualify to take advantage of this permanent tax benefit.

Foreign Derived Intangible Income (FDII)

To encourage U.S. corporations to keep their exporting operations and profits in the country, the TCJA introduces a new tax-savings opportunity in the form of a deduction of as much as 37.5 percent on profits earned from Foreign Derived Intangible Income (FDII).

This new concept of FDII is defined as income C corporations earn from (1) sales or other dispositions of property to a foreign person for a foreign use; (2) an IP license granted to foreign person for a foreign use; and (3) services provided to a person located outside of the U.S. The types of services that qualify for FDII are not severely restricted, like they are for IC-DISC applications.

Under the law, FDII earned after Dec. 31, 2017, is subject to an effective tax rate of 13.125 percent until 2025, when the rate is scheduled to increase to 16.046 percent for a total FDII deduction of 21.87 percent. That’s quite an incentive for domestic businesses to use the U.S. as its export hub and distribute products made in the country to foreign parties located outside the country!

It is important to note that like most provisions of the tax code, the FDII deduction is subject to a number of restrictions and calculation challenges. For example, it applies only to domestic C corporations, which under the TCJA are subject to a permanent 21 percent income tax rate beginning in 2018, down from 35 percent before tax reform. In addition, the amount of the deduction is reduced annually by 10 percent of the corporation’s adjusted basis of depreciable tangible assets used to produce FDII.

Planning Opportunities

Corporate taxpayers that combine the benefits of an IC-DISC and the new FDII deduction may receive enhanced tax savings. However, every business entity is unique and not all businesses will qualify to apply the benefits of both export tax incentives. However, with proper planning under the guidance of experienced tax professionals, businesses can maximize the benefits that are available to them.

For example, an S corporation or LLC with an IC-DISC may not realize the added tax savings of the FDII deduction, which is only available to C corporations. While an S corporation may consider changing its entity structure to a C corporation to take advantage of the lower tax rate, it must first consider its unique business goals and weigh them in context against all of the new provisions of the new tax code, which will affect the tax liabilities of both the business and its shareholders.

Companies doing business across borders can successful plan around the new provisions of tax law with the strategic counsel and guidance of knowledgeable advisors and accountants with deep experience in these matters.

About the Author: James W. Spencer, CPA, is a director of International Tax Services with Berkowitz Pollack Brant, where he focuses on a wide range of pre-immigration, IC-DISC, transfer pricing and international tax consulting issues for individuals and businesses. He can be reached at the CPA firm’s Ft. Lauderdale, Fla., office at (954) 712-7000 or via email at info@bpbcpa.com.

Information contained in this article is subject to change based on further interpretation of tax laws and subsequent guidance issued by the Internal Revenue Service

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