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Choice of Entity Decision Less Clear Under New Tax Law

POSTED ON May 2, 2018
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The income tax rate parity under the new tax law calls into question the default decision to organize as a passthrough entity.

While businesses used to default to organizing as passthrough entities to avoid a high corporate tax rate and double taxation under the old regime, the drop in the corporate tax rate from 35 percent to 21 percent may require planners to engage in a careful cost-benefit analysis to determine which structure is the most beneficial, Clifford Warren, special counsel to the IRS associate chief counsel (passthroughs and special industries), said May 1 at a Practising Law Institute panel in Chicago.

“In my personal view, this has gotten tougher this year because of tax reform,” Warren said. “We used to be confident sitting up here and saying you want to be in a partnership unless you’re going public, but that’s no longer true — it’s still probably true, but it’s definitely not as clear today as it used to be.”

Under the Tax Cuts and Jobs Act (P.L. 115-97), the corporate income tax rate was permanently lowered to 21 percent and partnerships, in some circumstances, are allowed to take a 20 percent deduction on taxable income. The partnership deduction excludes income from specific enumerated services — like law, health, and accounting — and is set to expire in 2026 and limited by wages paid and unadjusted basis in some types of property.

In response to claims that the TCJA mainly helped big businesses by making the corporate tax cut permanent and the individual and passthrough provisions temporary, some members of Congress are considering a second tax bill to make some temporary cuts permanent.

However, Eric B. Sloan of Gibson Dunn & Crutcher LLP said during the panel that some question whether the new corporate income tax rate will remain in place.

“There is a deep-seated skepticism about the corporate tax rate remaining at 21 percent, and I don’t know anyone that believes it will stay there in the long run,” said Sloan, who co-chairs the New York State Bar Association Tax Section’s Committee on Partnerships. Sloan said if people believe the corporate income tax rate will eventually rise, then locking into a C corporation is not necessarily a good idea.

Sloan added that while passthroughs are popular, organizing as an S corporation can often lead to headaches.

“I tend to see S corporations as mistakes, either actual mistakes or mistakes waiting to happen,” Sloan said, noting that S corps are simple and section 704(c), which applies to property contributed by a partner to a partnership, does not apply.

Warren pointed to a common saying regarding these structures: “There is no such thing as an S corporation because sooner or later, they invalidate themselves.”

“In fact, we get so many [private letter ruling] requests in connection with S corporation due diligence that we are developing a revenue procedure to address common S corp foot faults that we have ruled favorably on in the past,” Warren said. That way, similar taxpayers could rely on that guidance and save the time and cost involved with seeking their own private letter ruling, he added.

Capital or Profits Interest?

In discussing traps for the unwary in partnership planning, panelists noted that whether a partner has a capital interest or a profits interest can have significant tax consequences, but drawing the line isn’t always clear.

Stephen D. Rose of TPG Global LLC said if a partner joined a partnership and contributed services, that partner would have gain under section 83 when that interest is vested, as long as it’s a capital interest at grant. However, if the partner received a profits interest, it would not immediately be taxable. Rose said the main question to ask in determining whether an interest is capital or profits is whether that partner would receive anything on day 1 of the partnership if the assets were liquidated.

Warren responded that in some cases, reasonable minds can read the same partnership agreement to determine whether a partner has received a capital or profits interest and disagree on the outcome. The panel concluded that the best advice for taxpayers is to be clear in the agreement on which type of interest in the partnership is being issued.