Evaluating Entity & Business Structure
Time for an Entity Review?
Much has happened in the tax arena lately, particularly relating to entities and structuring businesses and investments. Good practice dictates that one periodically review business and investment structures. Due to recent changes in the tax law, now may be the time for a review even if it has not been that long since your last review.
General “Legal Audit”
Your business and investment structures require frequent attention to insure they are properly maintained. Periodically you should verify that all required records are in place and up to date. Given the numerous reasons later enumerated for reviewing your entities at this time, you may decide to have a “legal audit” conducted on all of your entities.
Enactment of the Business Organization Code
Depending on how long your entities have existed, their documentation may be out of date. Texas enacted the Business Organizations Code in 2003 and it became effective in 2006. Beginning in 2010, the BOC began to apply to entities that were formed before 2006. I am still surprised at how many entities formed before 2006 have not brought their documentation up to date to be BOC compliant. If you own an entity formed before 2006 and have not gotten a review to determine whether any changes are needed by reason of the BOC, this may be a good time to do so.
Tax Audit Rules for Tax Partnerships
Several years ago, Congress adopted changes to the rules applicable to the audit and dispute resolution of federal income tax issues of partnerships. In the federal income tax arena, a “partnership” is a term of art. It can include entities and business structures that you may not consider to be a partnership. The term is not co-extensive with state law definitions of partnerships. For federal tax purposes, a “partnership” includes not only state law general and limited partnerships, but also
- LLCs that have more than one owner and that have not elected to be taxed as a corporation
- Joint ventures
- Joint operating arrangements in the oil patch
- Certain kinds of trusts
I will refer to any arrangement that is treated as a partnership for tax purposes as a “tax partnership” even where that arrangement does not fit the classic definition of a partnership.
In the beginning, tax partnerships were not audited. Rather the partners of a tax partnership were audited and those audits would include the tax effect of any tax partnerships in which the taxpayer was a partner. This proved cumbersome, especially for the government. So, TEFRA was enacted and tax partnerships began to be audited at the partnership level instead of the partner level.
Since that time, the federal tax law has provided for unified audits of tax partnerships. Not that long ago, however, Congress enacted an entirely new set of rules for tax partnership audits. Many of these rules are arcane so the tax bar has attempted for several years to get the rules changed to a more workable system that applies only to large and complex tax partnerships. They were unsuccessful. So, the new rules became effective for tax years beginning on and after January 1, 2018.
Since it will be years in the future before any tax partnerships will get audited for tax years beginning January 1 and later, these new rules will not have an immediate impact on audits already under way or that may begin during 2018. But these changes require you to consider amending your entity agreements to take the new rules into account.
For example, each tax partnership now needs a “partnership representative.” This person might be the same person as the tax partnership’s tax matters partner. But it could be someone different. And if your entity does not appoint someone to this position, the IRS can choose a partnership representative. The new rules also allow some tax partnerships to opt out of the rules or some aspects of the rules. But doing so requires entity action and, potentially, amendments to your entity documents or ownership structures.
By reason of these new rules, every entity that is a tax partnership needs to evaluate their existing agreements to properly take into account the new rules.
Entity Structures and Tax Planning under new corporate tax rates and 20% “pass-through” deduction
This is where it starts to get really complicated. The recently enacted “Tax Reform” laws have created a complex web of tax rates, new deductions, loss of many old deductions, and many nooks and crannies that haven’t yet been explored. The new rules have not lead to simplification – quite the opposite.
Since at least 1986, in most instances a pass-through entity such as a tax partnership or S corporation was the best structure, That may no longer be the case for many people and their businesses. C corporations will now pay a flat 21% tax rate. That rate is much lower than the higher individual tax rates. And may be lower than the pass-through rates even after consideration of the new 20% deduction on certain pass-through income. Of course, when you take earnings out of a C corporation, the distribution is likely to be subjected to an additional tax, probably at a 23.8% rate. This second tax will cause the double taxation imposed on corporate owners to exceed the individual tax. But if the second tax can be deferred or avoided, a C corporation may be a better structure.
Likely, you may need to use a combination of different entities for differing purposes and differing business objectives. No longer will one size fit all. Your choice of entity or entities and how they interrelate will depend on factors unique to your situation. But there are some conclusions that may be universally applicable:
- Pass-through status is almost always more desirable where the 20% 199A pass-through deduction is available and owners want to receive annual income rather than reinvesting in the business (such as for living expenses, private investments, etc.)
- Pass-through status is generally more desirable where owners want to receive annual income even if the 199A deduction is unavailable
- In contrast, where owners are growing the business and wish to reinvest earnings in growth, corporate status is preferable where there is no 199A deduction and may be preferable even where there is a 199A deduction depending on reinvestment rate and deferral period (assuming no sale)
- Creating a corporate partner in for a pass-through entity may be useful where tax savings make the added complexity worthwhile
- Estate planning and non-tax considerations may override income tax entity planning
Bottom line: you should re-examine your business and investment structures to take advantage of the new tax opportunities and to avoid the new tax pitfalls.
Discounts v. Basis Adjustment at Death
Tax Reform has temporarily doubled the exemptions applicable to estate, gift, and generation skipping taxes. And even when (and if) the doubling expires, the exemption amounts are quite large. Most closely held business structures result in the value of the underlying assets and businesses belonging to an entity to be discounted at the owner level. Where an estate is not taxable because its value does not exceed the exemption amounts, discounts can actually cause an increase in overall tax liability.
For example, suppose a tax partnership owns a ranch that has a value of $4,000,000 and a cost basis to the entity of $1,000,000. Let’s also suppose that the owner’s basis in the tax partnership interest is also $1,000,000. If the owner of the tax partnership has no other assets to speak of, the owner does not have a taxable estate and no estate tax would be imposed even if ownership of the tax partnership interest were valued at $4,000,000. But because the ranch is owned in the tax partnership, if the ownership interest is subject to discounts, the tax partnership interest is likely to be valued in the estate at $3,000,000 or less. This means that at death the basis of the ownership interest will increase from $1,000,000 to $3,000,000. With a Section 754 election, the tax partnership’s basis in the ranch will also increase to $3,000,000. But the discount causes a loss of $1,000,000 in potential basis increase. At a 23.8% capital gains tax rate, this amounts to an increase in tax on a future sale of the ranch of $238,000.
Under these circumstances, you may need to consider whether there are changes to your structure that you can make to avoid these discounts without sacrificing liability protection and income tax savings.
For additional information on this article,
please contact J.F. “Jack” Howell, III.