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SOPHISTICATED CHOICE OF ENTITY, PART 1 & PART 2
First Run Broadcast: February 20 & 21, 2018
1PM EDT, 12PM CDT, 11AM MDT, 10AM PDT (60 minutes each day)
Choosing the right entity for a closely-held business is not about a single point in time but
planning for that business over long stretches of time and the likelihood of substantial change.
One of those changes is the change wrought by tax law, specifically the recently enacted tax
reform legislation. The new law substantially alters familiar tax law considerations when
choosing the right entity for client goals, particularly when considering a range of pass-through
entities. These and a multitude of other considerations often involve a sophisticated tradeoff of
benefits and costs. This program will provide you with a practical guide to sophisticated choice
of entity considerations, including detailed consideration of the new tax law.
Day 1: February 20, 2018:
• Advanced choice of entity considerations – management, tax, finance, regulatory,
employee benefit and other considerations
• Impact of industry norms, investor expectations, and regulatory requirements on choice
of entity
• Management and information rights, and the ability to restrict
• Fiduciary duties and liability of owners and managers, and the ability to modify these
duties
• Economic rights – choosing among capital rights, income rights, tracking rights
• Special considerations for service-based businesses
Day 2: February 21, 2018:
• Impact of new 2018 tax law on C Corps, S Corps, and pass-through entities
• Planning for distributions of property
• Anticipating liquidity events – sale of the company, liquidation of the company, new
investors/members
• Employment tax planning disparities among entities
• State and local tax considerations
• Owner and employee fringe benefit considerations
• When the first choice wasn’t correct – considerations when an entity needs to convert
Speaker:
Paul Kaplun is a partner in the Washington, D.C. office of Venable, LLP where he has an
extensive corporate and business planning practice, and provides advisory services to emerging
growth companies and entrepreneurs in a variety of industries. He formerly served as an Adjunct
Professor of Law at Georgetown University Law Center, where he taught business planning.
Before entering private practice, he was a Certified Public Accountant with a national accounting
firm, specializing in corporate and individual income tax planning and compliance. Mr. Kaplun
received his B.S.B.A., magna cum laude, from Georgetown University and J.D. from
Georgetown University Law Center.
Norman Lencz is a partner in the Baltimore, Maryland office of Venable, LLP, where his
practice focuses on a broad range of federal, state, local and international tax matters. He
advises clients on tax issues relating to corporations, partnerships, LLCs, joint ventures and real
estate transactions. He also has extensive experience with compensation planning in closely held
businesses. Mr. Lencz earned his B.S. from the University of Maryland and his J.D. from
Columbia University School of Law.
VT Bar Association Continuing Legal Education Registration Form
Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT 05601-0100. Fax: (802) 223-1573 PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name ________________________ Middle Initial____ Last Name__________________________
Firm/Organization _____________________________________________________________________
Address ______________________________________________________________________________
City _________________________________ State ____________ ZIP Code ______________________
Phone # ____________________________Fax # ______________________
E-Mail Address ________________________________________________________________________
Sophisticated Choice of Entity, Part 1 Teleseminar
February 20, 2018 1:00PM – 2:00PM
1.0 MCLE GENERAL CREDITS
PAYMENT METHOD:
Check enclosed (made payable to Vermont Bar Association) Amount: _________ Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # _______________________________________ Exp. Date _______________ Cardholder: __________________________________________________________________
VBA Members $75 Non-VBA Members $115
NO REFUNDS AFTER February 13, 2018
VT Bar Association Continuing Legal Education Registration Form
Please complete all of the requested information, print this application, and fax with credit info or mail it with payment to: Vermont Bar Association, PO Box 100, Montpelier, VT 05601-0100. Fax: (802) 223-1573 PLEASE USE ONE REGISTRATION FORM PER PERSON. First Name ________________________ Middle Initial____ Last Name__________________________
Firm/Organization _____________________________________________________________________
Address ______________________________________________________________________________
City _________________________________ State ____________ ZIP Code ______________________
Phone # ____________________________Fax # ______________________
E-Mail Address ________________________________________________________________________
Sophisticated Choice of Entity, Part 2 Teleseminar
February 21, 2018 1:00PM – 2:00PM
1.0 MCLE GENERAL CREDITS
PAYMENT METHOD:
Check enclosed (made payable to Vermont Bar Association) Amount: _________ Credit Card (American Express, Discover, Visa or Mastercard) Credit Card # _______________________________________ Exp. Date _______________ Cardholder: __________________________________________________________________
VBA Members $75 Non-VBA Members $115
NO REFUNDS AFTER February 14, 2018
Vermont Bar Association
CERTIFICATE OF ATTENDANCE
Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: February 20, 2018 Seminar Title: Sophisticated Choice of Entity, Part 1 Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.
Vermont Bar Association
CERTIFICATE OF ATTENDANCE
Please note: This form is for your records in the event you are audited Sponsor: Vermont Bar Association Date: February 21, 2018 Seminar Title: Sophisticated Choice of Entity, Part 2 Location: Teleseminar - LIVE Credits: 1.0 MCLE General Credit Program Minutes: 60 General Luncheon addresses, business meetings, receptions are not to be included in the computation of credit. This form denotes full attendance. If you arrive late or leave prior to the program ending time, it is your responsibility to adjust CLE hours accordingly.
© 2018 Venable LLP
Paul Kaplun, Partner
Corporate, Securities, and Business Transactions Practice Group
202-344-8535
Chris Davidson, Counsel
Tax and Wealth Planning Practice Group
410-244-7780
Sophisticated Choice of Entity After the Tax Cuts and Jobs Act
© 2018 Venable LLP
• The recent enactment of the Tax Cut and Jobs Act has dramatically changed the tax landscape for all taxpayers, but the legislation has a particularly significant impact on choice of entity consideration. While the typical non-tax considerations continue to play an important role, the tax changes may cause some taxpayers to re-evaluate their previous choice of entity decisions.
• While the new rules certainly create many opportunities for tax savings, careful planning is necessary to ensure that pass-through entities and their owners take maximum advantage of these new opportunities.
• Given the speed with which the legislation was passed, there are many unanswered questions as to how the new rules will apply.
• This presentation will assist practitioners in understanding how to best navigate some of these new rules, as well as an in-depth analysis of the impact of the new rules on the “choice-of-entity” decision.
2
Introduction
© 2018 Venable LLP
Sole Proprietorship C Corporation S Corporation
Limited Liability
Company (taxed as a
Partnership) Limited Partnership
Ownership; Liability of
Owners
- One owner; unlimited
personal liability
- Unlimited number of
shareholders without
restrictions as to types of
owners
- Shareholder liability
limited to the amount of
capital contribution
- Up to 100 shareholders
- Generally, only US
citizens or residents can be
shareholders
- Certain trusts and tax-
exempt organizations are
eligible shareholders
- Shareholder liability
limited to the amount of
capital contribution
- Unlimited number of
members without
restriction as to types of
owners (this chart assumes
at least two members)
- Member liability limited
to the amount of capital
contribution
- Unlimited number (but at
least two, one of whom is
a general partner) of
partners without restriction
as to types of ownership
- Unlimited personal
liability of general partner
- Limited partner liability
limited to the amount of
capital contribution
3
Choice of Entity Comparison Chart
© 2018 Venable LLP
Sole Proprietorship C Corporation S Corporation
Limited Liability
Company (taxed as a
Partnership) Limited Partnership
Formation/
Organizational Documents
- Trade Name Certificate
or equivalent, if
desired/necessary
- Articles/
Certificate of
Incorporation
- Bylaws
- Shareholders’ Agreement
- Articles/
Certificate of
Incorporation
- Bylaws
- Shareholders’ Agreement
- Form 2553 (Election of S
Corporation status); may
need to file state elections
as well
- Certificate of Formation/
Articles of Organization
- Limited
Liability/Operating
Agreement
- Certificate of Limited
Partnership
- Limited Partnership
Agreement
4
Choice of Entity Comparison Chart (continued)
© 2018 Venable LLP
Sole Proprietorship C Corporation S Corporation
Limited Liability
Company (taxed as a
Partnership) Limited Partnership
Management/
Governance
- Rests with sole
proprietor
- Board of Directors
responsible for overall
management
- Officers responsible for
day-to-day management;
serve at the pleasure of the
Board
- Shareholders may vote to
approve certain major
matters/
Transactions
- Some state statutes
permit elimination of
Board of Directors
- Board of Directors
responsible for overall
management
- Officers responsible for
day-to-day management;
serve at the pleasure of the
Board
- Shareholders may vote to
approve certain major
matters/
Transactions
- Some state statutes
permit elimination of
Board of Directors
- Flexibility in allocating
management
responsibilities between
members and managers,
including, if desired, the
adoption of a corporate
governance structure
- Interplay of governing
state statute and Limited
Liability/Operating
Agreement
- General partner
responsible for overall
management; limitations
can be imposed and
certain matters can be
subject to vote of the
limited partners
5
Choice of Entity Comparison Chart (continued)
© 2018 Venable LLP
Sole Proprietorship C Corporation S Corporation
Limited Liability
Company (taxed as a
Partnership) Limited Partnership
Equity/Capital
contributions
- Governed by owner’s
contribution to the
business
- Common and preferred
stock
- Multiple classes; series
within a class; differences
in rights and preferences
- Distributions
proportionate to stock
ownership within a class
where class preferences
exist
- One class of stock;
differences in voting rights
permitted
- Avoidance of second
class of stock through debt
and equity equivalent
issuances
- Distributions
proportionate to stock
ownership
- Membership interests
can be held in proportion
to ownership and can be
classified into multiple
classes with differences in
rights and preferences
similar to common and
preferred stock
- Distributions may be
disproportionate to
ownership
- Distribution between
general and limited partner
classes
- Distributions may be
disproportionate to
ownership
6
Choice of Entity Comparison Chart (continued)
© 2018 Venable LLP
Sole Proprietorship C Corporation S Corporation
Limited Liability
Company (taxed as a
Partnership) Limited Partnership
Employee Equity
Incentives
- Not applicable - Stock options
(nonqualified/
qualified – typically
incentive stock options
(ISOs))
- Restricted Stock
- Stock appreciation
rights/phantom stock
- Stock options
(nonqualified/
qualified – typically
incentive stock options
(ISOs))
- Restricted Stock
- Stock appreciation
rights/phantom stock
- Equity incentives need to
be structured to comply
with single class of stock
requirement
- Profits interests
- Options and equity
equivalent awards are
possible but not common
- Profits interests
- Options and equity
equivalent awards are
possible but not common
7
Choice of Entity Comparison Chart (continued)
© 2018 Venable LLP
Sole Proprietorship C Corporation S Corporation
Limited Liability
Company (taxed as a
Partnership) Limited Partnership
Tax Considerations
1. General - One level of tax to
owner; state law may
impose tax at business
level
- Potential for two levels
of tax
- Potential of two levels of
tax if S corporation was
formerly a C corporation
- One level of tax to
members; state law may
impose tax at entity level;
new audit rules may
impose entity level tax
- One level of tax to
partners; state law may
impose tax at entity level;
new audit rules may
impose entity level tax
2. Current Distributions - Not taxable - Generally taxable - Generally not taxable
unless amount exceeds
stock basis or if S
corporation was formerly
a C corporation with
earnings and profits
- Generally not taxable
unless amount exceeds
basis
- Generally not taxable
unless amount exceeds
basis
3. Self-employment tax - Applicable to owners - Not applicable - Not applicable but
subject to reasonableness
of wages
- May/may not be
applicable
- Applicable to general
partners
4. Sale of Ownership
Interest
- Gain/loss may be capital
and/or ordinary
- Gain/loss generally
capital
- Gain/loss generally
capital
- Gain/loss generally
capital
- Gain/loss generally
capital
8
Choice of Entity Comparison Chart (continued)
© 2018 Venable LLP
Sole Proprietorship C Corporation S Corporation
Limited Liability
Company (taxed as a
Partnership) Limited Partnership
Tax Considerations
5. Sale of Assets - One level of tax to owner - Potential for two levels
of tax
- Potential two levels of
tax if S corporation was
formerly a C corporation
- One level of tax to
members
- One level of tax to
partners
6. Liquidating
Distributions
- No tax - Generally taxable - Generally not taxable
unless amount exceeds
stock basis or if S
corporation was formerly
a C corporation with
earnings and profits
- Not taxable unless
amount exceeds basis
- Not taxable unless
amount exceeds basis
7. Potential for tax-free
organization
No Yes Yes No No
9
Choice of Entity Comparison Chart (continued)
© 2018 Venable LLP
• Corporate income tax rate is permanently lowered to 21%
beginning in 2018
• Corporate AMT permanently repealed
• Dividends received deduction reduced
10
C Corporation Changes
© 2018 Venable LLP
• New “below the line” deduction for “qualified business income” from pass-through entities and sole proprietorships
• Maximum deduction is 20% of “qualified business income” (QBI)
• Maximum 20% deduction is also available for qualified REIT Dividends and qualified cooperative dividends
• Non-corporate taxpayers (including estates and trusts) are eligible to claim the deduction
• Effectively reduces the rate on pass-through income to eligible taxpayers to 29.6%
• Sunsets in 2026
11
Pass-Through Deduction – In General
© 2018 Venable LLP
• Generally, the ordinary income, gain, deduction, and loss of a qualified trade or business
– What is a “qualified trade or business”? • Generally, any business other than a specified service business or the trade or business of performing
services as an employee
• Specified service business - a trade or business involving the performance of services in the fields of health, law, accounting, actuarial science, performing arts, consulting, athletics, financial services, brokerage services, or where the principal asset of the business is the reputation or skill of one or more of its employees, or which involves the performance of services that consist of investing and investment management, trading or dealing in securities, partnership interests or commodities.
• Excluded items: the taxpayer’s wages (or reasonable compensation), guaranteed payments, and investment-type income (capital gains, interest, dividends)
12
Pass-Through Deduction - Qualified Business Income
© 2018 Venable LLP
Subject to certain limits and thresholds, the deduction generally is the sum of:
• The lesser of:
– 20% of the taxpayer’s qualified business income; or
– The greater of:
• 50% of the W-2 wages with respect to the business, or
• 25% of the W-2 wages with respect to the business plus 2.5% of the unadjusted basis of all qualified property
• Plus 20% of qualified REIT dividends and distributions from publicly traded partnerships
• Plus 20% of qualified cooperative dividends
13
Pass-Through Deduction - Calculation
© 2018 Venable LLP
Availability and/or calculation of the deduction is subject to limits
based on the taxpayer’s income and the type of business
conducted:
14
Pass-Through Deduction – Limits
Total Taxable Income Not Exceeding Threshold
(Single - $157,500 /
Joint - $315,000)
Threshold Plus Phase In Over Threshold
(Single - $207, 501 / Joint
- $415, 001)
Specified Service Full 20% deduction, no
W2/basis limit
20% deduction subject to
phase-out, W2/basis limit
phased in
No deduction permitted
Non-Specified Service Full 20% deduction, no
W2/basis limit
20% deduction subject to
phase-in of W2/basis limit
20% deduction permitted
but fully subject to
W2/basis limit
© 2018 Venable LLP
• Example 1: A wholly-owned business purchases an office
building for $6M ($3M building, $3M land). The building
generates annual rental income of $500,000. The maximum
potential allowable pass-through deduction would be $100,000
(20% of $500,000). If the business paid no wages, the business
would qualify for a deduction of only $75,000 (2.5% x $3M =
$75,000).
15
Pass Through Deduction - Example
© 2018 Venable LLP
• Example 2: Same facts as Example 1, but assume $4M is
allocated to the building. The deduction would not be limited
and thus the full $100,000 (2.5% x $4M = $100,000) would be
deductible.
16
Pass Through Deduction - Example
© 2018 Venable LLP
• Example 3: Same facts as Example 1, but assume the business
pays $100,000 of W-2 wages. The full $100,000 pass-through
deduction would now be available, calculated as follows:
– 25% x $100,000 of W-2 wages = $25,000
– 2.5% x $3M unadjusted basis = $75,000
– $25,000 + $75,000 = $100,000
17
Pass Through Deduction - Example
© 2018 Venable LLP
• Deduction is limited to 20% of the excess of taxable income over net capital gain
• Example: $100,000 of QBI, $200,000 of long-term capital gain and $50,000 of itemized deductions, resulting in taxable income of $250,000.
• Before application of this limit, deduction is equal to 20% of QBI of $100,000, or $20,000
• Taxable income less net capital gain is $50,000 ($250,000-$200,000 = $50,000).
• So the deduction will be reduced under this limit from $20,000 to 20% of $50,000, or $10,000
• Note that dividends are not subtracted, even though taxed at capital gain rate
18
Pass Through Deduction – Taxable Income Limit
© 2018 Venable LLP
• Is rental real estate a “qualified trade or business”?
• Aggregation/grouping issues – multiple projects under common ownership
– Real estate management company model – do management company wages count?
– Two buildings, one fully-depreciated, with high income, the other brand new, with no or little income.
– If treated as separate businesses, no 20% deduction available
– If they can be aggregated, full 20% deduction available
• When is a principal asset of the business “the reputation or skill of one or more of its employees”?
• Will “reasonable comp” principles apply to partnerships?
19
Pass-Through Deduction - Open Issues
© 2018 Venable LLP
• Switch from W-2 employee to 1099 independent contractor (IC)
– Loss of employee benefits (e.g., health insurance, 401K, etc.)
– IC must pay all self-employment taxes
– Employer may prefer paying W-2 employees in order to “max out” on its pass-
through deduction
– Need to revisit employee vs. IC classification criteria
• Can a “specified service business” “spin off” qualifying portions of its
business (e.g., HR, IT, IP)?
• Separate books and records for two lines of business, one a “specified
service business” and the other a “qualified trade or business”?
20
Pass-Through Deduction – Planning Opportunities
© 2018 Venable LLP
• “Multiply” $157,500 per person threshold through children and trusts
• Switch from guaranteed payments (which don’t qualify) to preferred returns (which do qualify)
• S corp vs. LLC
– Wages paid to S corp owners “count” towards W-2 limit, guaranteed payments to LLC don’t because of K-1 rule
– Possible solution – use tiered structure, employed at lower-tier, own equity through upper-tier
– “reasonable comp” requirement for S corps
• Switch from 1099 (IC) to W-2 employee to increase W-2 limit
21
Pass-Through Deduction – Planning Opportunities
© 2018 Venable LLP
As a result of the new lower corporate rate, should taxpayers
reconsider their choice of entity?
*Assumes no 3.8% tax applicable and full use of 20% pass-through deduction
22
Choice of Entity – Effective Rates
C Corporation Pass-Through
Income Tax Rate 21% 29.6% (effective)*
Dividend/Exit Tax Rate 20% + 3.8% = 23.8% 0%
Aggregate Tax Rate 39.8% 29.6%
State/Local Tax Deduction
100%
Property taxes deductible, SALT
income taxes not deductible
© 2018 Venable LLP
• Potential for future changes
• Many disadvantages to C corp status
• Easy to move into C corp status, but difficult to move out
– Triggering of Section 311(b) gain on conversion/liquidation
– But S corp election possible after potential 5-year wait
• Limits on ability to defer C corp distributions
– Cash needs of shareholders
– Accumulated earnings tax
– Personal holding company rules
23
Choice of Entity – Other Considerations
© 2018 Venable LLP
• If a business is being conducted in corporate form, it may be
possible to work around some of the disadvantages of corporate
form through an F reorganization
• This can be helpful in the context of sales, employee
compensation, removing assets from corporate solution
24
Restructuring – F Reorganization
© 2018 Venable LLP
Step 1: A, B and C form Newco and contribute their S Corporation stock to Newco in
exchange for Newco stock. Newco makes an S corporation election and S Corporation makes a
QSub election. As a result, S Corporation becomes a disregarded entity for tax purposes.
25
S Corporation
A B C
A B C
Newco
S Corporation (QSub)
© 2018 Venable LLP
Step 2: S Corporation, now a QSub, converts to a LLC under a state law conversion statute
or by merger. As a result, the LLC continues to be a disregarded entity for tax purposes.
26
S Corporation (QSub)
Newco
LLC converts
Newco
LLC
A B C A B C
© 2018 Venable LLP
• REITs do especially well:
– Only one level of tax
– Shareholders entitled to a 20% qualified business income deduction for
ordinary distributions – with no W2/basis limits
• But REIT compliance and maintenance rules are onerous
27
Choice of Entity - REITs
© 2018 Venable LLP
Paul Kaplun Chris Davidson
Venable LLP Venable LLP
Baltimore, MD Baltimore, MD
202-344-8535 410-244-7780
[email protected] [email protected]
28
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