It is often the case that the optimal form of legal entity through which a business should operate, at least for income tax purposes, will depend in part upon the stage of its life cycle[i] in which the business finds itself.
For example, a start-up that is expected to generate losses during its initial years of operation may want to pass those losses along to those of its owners who have made significant capital contributions to the business.
In that case, a passthrough entity like a tax partnership, including one organized as a limited liability company, would seem most appropriate.[ii]
Of course, in order to make this decision, the owners of the business need to have made a financial forecast that can be used to predict cash flows and create a budget for the business.
Unfortunately, some owners do not spend enough time considering the form of organization in which their business should reside, let alone analyze and project its financial picture.
Then there are those businesses whose owners seek out the assistance of competent and experienced advisers, not only at the inception of the business but throughout its life cycle to account for changing conditions and circumstances – whether in the business, its industry, or the economy generally – and to ensure that the form in which the business is being operated is appropriate for its current and future goals and needs.
However, at the end of the day, one has to concede that fate or luck may sometimes intervene – manifested as events or circumstances beyond one’s control[iii] and not reasonably foreseeable – to render one’s plans useless, or close to it.[iv]
Tale of Two LLCs
In the last couple of weeks, I’ve encountered two businesses in different industries and at different stages of development – one is still quite “young,” while the other is well established and plans to continue growing by expanding its operations or making strategic acquisitions.[v]
Each business has several members and was originally formed as an LLC that was treated as a partnership for tax purposes.[vi]
The younger business has generated operating (ordinary) losses for almost three years, but its members have not been able to utilize all of them because they do not have sufficient basis for their membership interests.[vii]
Outflow of Cash
The established business has been profitable. Over the years, its items of income, deduction, gain, loss, and credit have been allocated among its members based upon their respective distributive shares of such items.[viii] The members have reported these items on their own tax returns and paid the tax thereon.[ix]
For every taxable year, the successful LLC was making quarterly distributions, plus an annual true-up distribution, to its members to enable them to pay their federal and state income taxes[x] with respect to such tax items for such year. The amount of the distribution for any tax year was determined by reference to the highest combined marginal federal and state income tax rate for individual New York residents for such year.[xi]
Conversion to “C” Corporation
Both LLCs recently converted from partnerships – nontaxable passthrough entities – to taxable C corporations,[xii] but for very different reasons.
Pursuant to the advice of its prior accountant and attorney, the start-up LLC recently converted to a C corporation by filing a certificate of conversion and a certificate of incorporation with the Delaware’s secretary of state – a so-called statutory conversion.[xiii]
The conversion was effectuated because the LLC and its members were advised that they would be better positioned to attract new investors as a C corporation than as a tax partnership.[xiv]
The conversion was treated as a tax-free contribution[xv] of the business’s assets by the LLC to a corporation (an “assets-over” transaction) in exchange for all of the shares of the corporation’s stock, followed by a liquidating distribution of such shares by the LLC to its members.[xvi]
Loss of Losses (or Lost Losses?)
As a result of the conversion, and the deemed liquidation of the tax partnership, the members of the start-up lost the ability to utilize their previously suspended LLC losses (described earlier). These suspended losses did not carry over to the successor corporation.[xvii]
Likewise, the established business converted from a tax partnership to a C corporation. It did so in order to retain in the business the cash that, as a passthrough entity, it had been distributing to its members to enable them to pay that portion of their personal income tax liability attributable to their interest in the LLC.
By converting to a C corporation, the business will pay federal income tax on its taxable income at a flat rate of 21 percent;[xviii] together with its state income tax, the corporation faces a combined marginal federal and state income tax rate of less than 30 percent.[xix]
The corporation’s shareholders – the former members of the partnership – will not be subject to tax with respect to the corporation’s income unless and until the corporation distributes its earnings and profits as a dividend.[xx]
The cash savings enjoyed by the corporation will then be reinvested in the business in furtherance of the corporation’s plan to continue growing. By using such “internally generated” cash, the business will not have to seek out new investors (and dilute its existing owners) or incur the burden of additional credit to fund its plans.
Assuming the corporation can demonstrate the legitimacy of its stated purpose for accumulating earnings in excess of its working capital needs, it should be able to avoid imposition of the accumulated earnings tax.[xxi]
Notwithstanding its relatively poor performance to-date, the younger business has fortunately caught the attention of a prospective buyer who is interested in purchasing for cash only certain assets – a stock deal is out of the question – assuming only certain obligations, and committing to invest additional capital to stabilize and grow the business.
There’s an issue, however: the double taxation arising from the C corporation’s sale of the desired assets, for which the corporation has next to no basis – the C corporation will pay income tax on its gain from the sale,[xxii] and its shareholders will pay tax when the after-tax proceeds from the sale are distributed to them, either currently as a dividend or in liquidation of the corporation.[xxiii]
Thus, what seemed to be a good deal for the start-up and its owners is turning out to be something else after accounting for what will amount to an effective aggregate federal and state corporate and shareholder income tax liability in excess of 50 percent.[xxiv]
Hindsight will inform them that, had they remained a partnership and not incorporated the LLC, they could have avoided an entity level tax on the sale of the assets, and they could have utilized their suspended losses to offset some of the individual gain that will pass through to them from the sale. The result: more money in their pockets on an after-tax basis.[xxv]
We have known for eons that storytelling is one of the most effective techniques for teaching, or even persuading, others. Whether it’s a fable or a parable, or even a court’s opinion, the lesson conveyed by a story may be indelibly imprinted in our collective memory.
The abbreviated tales of the two LLCs described above fall way short of this ideal.
That said, the time at which tax and other legal advice was requested, from whom it was sought, and the quality of the advice rendered, can have a significant impact upon the ultimate economic success of a business – as manifested upon the disposition of the business – as demonstrated by the experience of the two businesses described herein.
That is not to say that such advice will necessarily improve the service or product provided by a business, that it will help the business with delivering these more efficiently, that it will help expand its market, or that it will ensure its profitability.
However, the right tax advice at the right time can go a long way toward improving the economics of a business on a current basis by reducing the taxes imposed on the business and its owners, and thereby making cash available for reinvestment in the business.[xxvi]
Similarly, tax advice may have a significantly positive effect upon the after-tax economic consequences from the disposition of the business, whether to a third party or to a successor within the business.[xxvii]
As author Fran Lebowitz once said, “A dog who thinks he is man’s best friend is a dog who obviously never met a tax lawyer.”
[i] Why is there a tendency among our species to anthropomorphize – project human qualities or attributes – to non-human (some in government might say “inhuman”) things like a business? The reference to the life cycle of a business is one example.
[ii] Provided the allocation of losses has substantial economic effect, it should be respected by the IRS. If an S corporation were used instead, the losses could not be specially allocated only to certain shareholders without violating the one class of stock rule and resulting in the loss of the corporation’s “S” election. Of course, in the case of a C corporation, the losses remain with the business for future use.
[iii] Let’s call it reality.
[iv] The following line is attributed to President Eisenhower: “Plans are useless, but planning is indispensable.”
What does that mean? As Linda Richman would say, “Talk amongst yourselves.” (If you have to ask . . .)
[v] The first is a new client, the second is a long-time client.
[vi] Reg. Sec. 301.7701-3(b)(1)(i).
[vii] Outside basis. IRC Sec. 704(d).
[viii] IRC Sec. 704. Which shares are determined in accordance with the LLC’s operating agreement, and which are reported to each member on their respective Schedule K-1.
[ix] It bears repeating: a partnership is a flowthrough entity that it is not itself subject to income tax; rather, its income flows through and is taxed to its members without regard to whether the partnership has distributed such income to them. Without an agreement among the partners to provide for current distributions, the partners will realize phantom income.
[x] Including estimated taxes.
[xi] Assume a 37% federal rate plus a 10.3% N.Y. rate. We’re assuming these individuals are not NYC residents.
[xii] For what it’s worth, some folks – in my experience, mostly non-U.S. persons – describe taxable entities as being “opaque” and refer to passthrough entities as “transparent.”
[xiii] For tax purposes, the conversion to corporate status could have been accomplished by filing IRS Form 8832 – the “check the box” election. There are state law and “business” reasons for changing the actual legal form of the entity.
See also Rev. Rul. 84-111.
[xiv] In a discussion with the principals of the start-up, they were unable to articulate the reasoning behind this. Hell of a way to make a decision.
The established business also used the statutory conversion.
Presumably, they were told that investor entities with tax-exempt or foreign members preferred to invest in C corporations. (I guess there was no discussion about these potential investors using a “blocker” to make their investment instead.)
[xv] Under IRC Sec. 351, the application of which is mandatory if its conditions are satisfied. Some well-advised taxpayers will try to avoid the application of Sec. 351 in order to utilize their losses against the gain realized in the exchange.
[xvi] See Reg. Sec. 301.7701-3(g).
[xvii] See IRC Sec. 381. Even in a Sec. 351 exchange between two corporations, such tax attributes do not carry over unless the exchange is also described in IRC Sec. 368.
[xviii] You may recall that the Democrats have been proposing to increase the federal income tax rate on corporations to 35%. Let’s see what happens with the 2024 elections. If there is a rate hike, the corporation and its shareholders may be able to avoid double taxation by electing to be treated as an “S” corporation – assuming they are eligible; see IRC Sec. 1361 – though they will have to contend with the 5-year (at least for now) recognition period for the federal built-in gain tax. IRC Sec. 1374. (As an active business, the corporation and its shareholders won’t have to worry about the excise tax under IRC Sec. 1375.)
[xix] I should add that the established LLC will ultimately be looking for a public company buyer for its stock or it will go public itself.
In case you’re wondering, the exclusion of gain under IRC Sec. 1202 will not be available to the shareholders (even assuming they satisfy the 5-year holding period requirement) because the business did not satisfy the gross asset test at the time of its incorporation.
[xx] Actually, or constructively – always a possibility in the case of a closely held corporation.
[xxi] IRC Sec. 531 et seq. This federal tax is imposed at a rate of 20% of the corporation’s accumulated taxable income. Basically, the rate at which a dividend to an individual shareholder would have been taxed.
[xxii] At a 21% percent federal rate. IRC Sec. 11.
[xxiii] At a 23.8% federal rate: 20% long term capital gain plus 3.8% surtax on net investment income. IRC Sec. 1(h) and Sec. 1411.
[xxiv] Federal corporate tax at 21%, N.Y. state corporate tax at 7.25%, federal individual capital gain tax at 20%, federal surtax on net investment income at 3.8%, N.Y. state personal income tax rate at 10.3%. (If any of the individuals were N.Y.C. residents, add another 3.876%.)
[xxv] In case you’re wondering, a rescission is not available (the conversion was in late 2022).
[xxvi] Remember the old BASF commercials: “We don’t make a lot of the products you buy. We make a lot of the products you buy better”? Tax plays a similar role.