Business Structuring Aspects of the PATH Act

STEVEN B. GORIN, JD

The Protecting Americans from Tax Hikes Act of 2015 (the “PATH Act”) was enacted on December 15, 2015. Extensive legislation, the PATH Act permanently reduced the built-in gains recognition period from 10 years to 5  years for C  corporations making an S  election. It also made permanent the exclusion of gain on the sale of certain C  corporation stock originally issued to the seller. This article discusses business restructuring in light of the PATH Act.

First, the article considers the impact of the legislation on existing C corporations contemplating an S election. Second, the article examines the legislation’s permanent exclusion of gain on certain C corporation stock. Third, the article concludes that, despite the implications of the PATH Act, the partnership remains a recommended form of business entity.

S ELECTIONS FOR EXISTING C CORPORATIONS
If a corporation is willing to endure certain limitations on ownership and capital structure, it can make an S election to achieve pass-through taxation. Former C corporations that convert to S corporations face three primary consequences:

LIFO Recapture – If a C corporation inventoried its goods under the last-in-first-out (LIFO) method immediately before making an S election, it must include a LIFO recapture amount in its income for its last taxable year as a C corporation. Appropriate basis adjustments are made to the inventory to reflect the income inclusion. The corporation pays tax imposed on this conversion in its last year as a C corporation and its first three years as an S corporation.1

Excess Passive Investment Income – A former C  corporation with accumulated earnings and profits (E&P)2 may owe a supplemental tax and lose its S status if it has excess passive investment income.3 The corporation can avoid this treatment by carefully planning its gross receipts or by distributing its E&P.Distributions of tax-exempt income received by the corporation may become taxable as a dividend to the extent of the corporation’s E&P.5

Built-in Gains Tax – Assets that have appreciated prior to the effective date of the conversion to an S corporation have what is known as “built in gain.” The sale of these assets during a specified “recognition period” will trigger a built-in gain tax. The tax is imposed at the maximum corporate rate applied to all appreciation that accrued prior to the subchapter S election.

The PATH act did not affect the LIFO recapture and passive investment income rules, but it did make a significant change to the recognition period for the built-in gains tax. Under prior law, the recognition period — historically 10 years —was temporarily reduced to 7 years for taxable years beginning in 2009 and 2010, and to 5 years for taxable years beginning in 2012, 2013 and 2014. The PATH Act made the 5-year recognition period permanent for all tax years beginning in 2015. Thus, if the fifth year of an S corporation’s recognition period ended in 2015, the gain from an asset sale in 2016 will not be subject to built-in gains tax. But for any asset disposed of within 5 years of the S election,6 double taxation generally applies.

In addition to the flow-through taxation under the normal subchapter S rules, the corporation will be subject to a corporate-level tax. The corporate-level tax applies to the lesser of the gain on disposition or the unrealized gain on the effective date of the S election.7 Generally, any item of income properly taken into account during the recognition period will be recognized as built-in gain if the item would have been properly included in gross income before the beginning of the recognition period by an accrual method taxpayer.8

Although the PATH Act’s reduction in the built-in gains tax recognition period from 10 years to 5 years is welcome relief, it is just one factor in considering the effect of an S  election. For instance, one could also achieve the growth in productive assets outside a corporate structure by forming a preferred partnership.9

PERMANENT EXCLUSION OF GAIN ON CERTAIN C CORPORATION STOCK
Before the PATH Act, a non-corporate taxpayer could exclude 50% of the gain from the sale of “qualified small business stock.” Any remaining gain was taxed at 28%. In this context, “qualified small business stock” means stock acquired directly from a C corporation that had $50 million or less in gross assets and that satisfied certain active trade or business requirements. Additionally, the stock must have been held for more than five years. The percentage exclusion was temporarily increased to 75% for stock acquired after February 17, 2009 and before September 28, 2010, and to 100% for stock acquired after September 27, 2010 and before January 1, 2015.10 The PATH Act made the 100% exclusion permanent for all stock acquired on or after January 1, 2015. The amount of the exclusion is limited to the greater of:11

  1. $10 million ($5 million for married filing separately),12 reduced by the aggregate amount of eligible gain taken into account under this rule for prior taxable years and attributable dispositions of stock issued by such corporation; or
  2. 10 times the aggregate adjusted bases of qualified small business stock issued by the corporation and disposed of by the taxpayer during the taxable year.

Does the permanent exclusion on the sale of qualified small business stock make C corporations more attractive than S corporations or entities taxed as partnerships? The answer depends on the context. If the gain from the sale of a business is attributable to self-created goodwill, the owner’s basis in the entity’s equity will not reflect the self-created goodwill. That is true no matter what kind of entity is involved. In this context, the sale of qualified small business stock is more favorable than the sale of S corporation stock. It is also more favorable than cash sales of partnership interests, but not as favorable as a seller-financed sale of a partnership interest.

If, on the other hand, the owner of a pass-through entity would not recognize gain on the sale, the exclusion on the sale of qualified small business stock provides no particular advantage. If and to the extent that the sale of the business interest arises from reinvested earnings, the basis of a partnership interest13 or stock in an S corporation is increased.14

Furthermore, if a pass-through entity redeems only part of a shareholder’s ownership, the reinvested earnings might offset part or all of the gain on the sale – perhaps even that attributable to self-created goodwill. Finally, the exclusion is available only for qualified stock issued, gifted, or bequeathed to the taxpayer, making it unavailable to subsequent purchasers of the stock. If the sale of a business is structured as an asset sale, the seller’s gain is often capital gain. C corporations pay a higher tax on capital gains than the owners of pass-through entities. This can be especially important when an entity sells only a business line, rather than the entire business. When the entity sells all of its assets, it might as well liquidate to take full advantage of the exclusion on the gain on sale of the stock and let the shareholders move the sale proceeds outside of a potentially risky business environment.

Notwithstanding the PATH Act, this author continues to be a diehard partnership fan and believes that lower C corporation tax rates rarely make C corporations more attractive than flow-through entities.

ENDNOTES           
1Code §1363(d)(1)
2 Reg. § 1.1375-1(b)(4) refers to Code § 1362(d)(3) and the regulations thereunder in determining E&P. E&P is based on C corporation principles under Code § 312 and taxed by Code § 316 when distributed. Code § 1371(c). E&P are the earnings and profits of any corporation, including the S corporation or an acquired or predecessor corporation, for any period with respect to which an S election was not in effect. Reg. § 1.1362-2(c)(3).
3 Code §§ 1362(d)(3), 1375. Certain S corporations may disregard pre-1983 earnings and profits. 2007 Small Business Act P.L. 110-28, Sec. 8235.
4 Planning before the conversion might also help. Starr and Sobol, S corporations: Operations, T.M. 731-2nd, suggests at IV.B, Comment: When a C corporation converts to an S corporation, accumulated E&P is likely to be overstated, since timing differences originating in C status will tend to “reverse” while in S corporation status. As a result, excessive dividend distributions will be necessary to fully deplete the account. Conversely, when an S corporation converts to a C corporation, these timing differences may prove advantageous in that the accumulated E&P would reflect the reversal in C status while not being affected by the origination of the item in S status. Instances where timing differences come into play when switching from C to S or S to C status include: accelerated cost recovery deductions for taxable income, but straight-line for accumulated E&P; installment method elected for taxable income, but not allowed for accumulated E&P; and special LIFO inventory adjustments required for accumulated E&P, but generally not required for taxable income.
5 Code  §  1368(e)(1)(A). This includes tax-free receipts beyond just muni bonds. See also Revenue Ruling 2008-42 (providing guidance on the accumulated adjustments accounts of S corporations).
6 Code § 1374(d)(7) generally provides a 5-year recognition period, which was 7 years for a sale in 2009 or 2010 or 10 years for a VOLUME 10 ISSUE 1 PAGE 17 sale before then. Code § 1374(d)(7) describes the recognition period as follows: (A) In general. The term ‘recognition period’ means the 5-year period beginning with the 1st day of the 1st taxable year for which the corporation was an S  corporation. For purposes of applying this section to any amount includible in income by reason of distributions to shareholders pursuant to section 593(e), the preceding sentence shall be applied without regard to the phrase ‘5-year›. (B) Installment sales. If an S corporation sells an asset and reports the income from the sale using the installment method under section 453, the treatment of all payments received shall be governed by the provisions of this paragraph applicable to the taxable year in which such sale was made. Letter Ruling 201150023 includes some nuances as the 2011 transition rules related to an installment sale. The ABA Section of Taxation S corporations Committee meeting in May 2015 discussed various nuances to Code § 1374(d)(7) before the PATH Act enacted the language quoted above.
7  Code § 1374. Reg. § 1.1374-2(a) provides that an S corporation is taxed is the lesser of: (1) its taxable income determined by using all rules applying to C  corporations and considering only its recognized built-in gain, recognized built-in loss, and recognized built-in gain carryover (pre-limitation amount); (2) its taxable income determined by using all rules applying to C corporations as modified by section 1375(b)(1)(B) (taxable income limitation); and (3) the amount by which its net unrealized built-in gain exceeds its net recognized built-in gain for all prior taxable years (net unrealized built-in gain limitation).
8 Reg. § 1.1374-4(b)(1). This determination disregards any method of accounting for which an election by the taxpayer must be made unless the taxpayer actually used the method when it was a C corporation. Reg. § 1.1374-4(b)(3), Example (4) discusses deferred prepayment income, and Example (5) discusses changes in accounting methods. For further discussion of various items of built-in gain, see McMahon and Simmons, “Where Subchapter S Meets Subchapter C,” Tax Lawyer, vol. 67, No. 2 (Winter 2014).
9  In a preferred partnership, one or more partners has a preferred interest and one or more partners has a common interest. The preferred interest includes a capital account that receives a percentage return on that capital account, which preferred return is paid generally before making distributions to the partners owning the common interest. A common interest is a capital account plus a flat percentage of the profits distributed after the preferred interest receives its distributions. The goal of a preferred partnership is to maximize the initial value of the preferred partnership interest and to minimize the initial value of the common interest.
10 Code § 1202
11 Code § 1202(b)(1)
12  Code § 1202(b)(3)
13 Code § 705. However, a partner does not have the flexibility of a shareholder to pick and choose which shares to sell.
14 Code § 1367

ABOUT THE AUTHOR Steven B. Gorin is a partner in Thompson Coburn LLP.  This article adapts an article in his quarterly newsletter, which links to “Structuring Ownership of Privately-Owned Businesses: Tax and Estate Planning Implications.”

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