2019 Year-End Tax Guide

THE MARCUM 2019 YEAR-END TAX GUIDE | www.marcumllp.com

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CONVERSION OF AN EXISTING BUSINESS It is anticipated that a 21% corporate rate and the unavailability of the Section 199A deduction to certain pass-through businesses will cause a number of pass-through businesses to convert to C corporations. Businesses that may convert may be service businesses that are ineligible for the benefits of both Section 199A and Section 1202. Care must be given to the structure of the conversion. 1. S corporation to C corporation For stock to meet the definition of QSB stock, the issuing corporation must be a C corporation on the date of issuance. An S corporation stock can never qualify as QSB stock, even if the S corporation later converts to a C corporation. Thus, if the S corporation revokes or terminates its election, generally only newly issued shares to new shareholders will meet the QSB stock requirements.

Example: A invests $100,000 to form a new business. The business is expected to earn $200,000 in net income annually for five years, which A will withdraw from the business in full as distributions. After five years, A believes the business will be worth $3 million. Assume that, as the owner of a pass-through business, A would qualify for a full Section 199A deduction, and the stock in the corporation would meet the definition of QSB stock. The federal tax consequences of pass-through versus C corporation status is shown as below: Based on this example, the Section 1202 exclusion allows A to save $478,000 as a C corporation, despite incurring double taxation on operating income. In addition, the 1202 exclusion may apply for state taxes. INTERPLAY OF SECTION 1202 WITH SECTION 199A

Taxation as passthrough vs C Corporation

Passthrough

C Corporation

2. Partnership to C corporation Converting to a C corporation allows the owners to qualify for the benefits of Section 1202. The holding period of the stock will begin on the date of the transfer, and the partners’ basis in the stock will be the basis of the assets transferred to the corporation. As a result, only appreciation occurring after the incorporation will be eligible to be excluded under Section 1202.

Income for 5 years

$1,000,000

$1,000,000

Tax rate (including 199A or dividend Tax

29.60%

39.80%

Federal tax for 5 year income

$296,000

$398,020

Sales proceeds

$3,000,000

$3,000,000

Basis (annual earnings were distributed in full)

$(100,000)

$(100,000)

Federal tax on gain (20% for passthrough)

$580,000

NA (Sec 1202)

Total federal tax over life cycle of business

$876,000

$398,020

The 20% deduction offered by Section 199A to owners of passthrough businesses was designed to allow those owners to keep pace with the tax cuts offered to their corporate counterparts. Section 199A, however, with its limitations, exceptions to limitations, phase-ins and phaseouts, provides benefits that are not always guaranteed. Interestingly, businesses that are not qualified for the benefits of Section 199A will also likely not qualify for a Section 1202 exclusion. Section 199A provides that for business owners with taxable income in excess of a threshold, no deduction is permitted against income earned in a "specified service business." These specified service businesses are also included among those ineligible businesses under the Section 1202 provision.

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