Revoking S Corp Election to Take Advantage of Tax Reform...

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Revoking S Corp Election to Take Advantage of

Tax Reform: Converting From S Corp to C Corp

MONDAY, SEPTEMBER 24, 2018, 1:00-2:50 pm Eastern

FOR LIVE PROGRAM ONLY

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SEPTEMBER 24, 2018

Revoking S Corp Election to Take Advantage of Tax Reform

Cindy Grossman, Partner

Giordani Swanger Ripp and Jetel, Austin, Texas

[email protected]

Stephen L. Phillips, Senior Partner / CFO

Phillips Golden, Austin, Texas

[email protected]



Notice

ANY TAX ADVICE IN THIS COMMUNICATION IS NOT INTENDED OR WRITTEN BY

THE SPEAKERS’ FIRMS TO BE USED, AND CANNOT BE USED, BY A CLIENT OR ANY

OTHER PERSON OR ENTITY FOR THE PURPOSE OF (i) AVOIDING PENALTIES THAT

MAY BE IMPOSED ON ANY TAXPAYER OR (ii) PROMOTING, MARKETING OR

RECOMMENDING TO ANOTHER PARTY ANY MATTERS ADDRESSED HEREIN.

You (and your employees, representatives, or agents) may disclose to any and all persons,

without limitation, the tax treatment or tax structure, or both, of any transaction

described in the associated materials we provide to you, including, but not limited to,

any tax opinions, memoranda, or other tax analyses contained in those materials.

The information contained herein is of a general nature and based on authorities that are

subject to change. Applicability of the information to specific situations should be

determined through consultation with your tax adviser.

Converting from S Corp to C CorpTaking Advantage of Tax Reform

Authors & Co-Presenters

Stephen L. PhillipsPhillips Golden LLPAustin, Texas, USA

www.phillipsgolden.com

Cindy L. GrossmanGiordani, Swanger, Ripp & Jetel LLP

Austin, Texas, USAwww.gsrjlaw.com

A Strafford Publications, Inc. Webinar

September 24, 2018 1:00-2:50p.m. Eastern

http://www.phillipsgolden.com/

http://www.hutchinslaw.com/

Copyright 2018 – Phillips Golden LLP

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• The information presented in this presentation is intended for educational and discussion purposes only. It is not intended to be and cannot be used or relied on for legal or tax advice.

• The authors disclaim perfection and would appreciate that errors of any type be brought to their attention.


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• 10,000’ View• What’s Changed ? – Tax Cut & Jobs Act of 2017• What’s the Same ? – So-Called Double-Tax of C Corps• TCJA affects All Choice of Entity Decisions

• Incentives to Convert to C Corp• Administrative Reasons to Convert• Domestic Incentives• Foreign Incentives• TCJA and Prior Existing Incentives

• Disincentives to Convert to C Corp• Domestic / Foreign Reasons• TCJA and Previously Existing Issues

• Transition Tax• Double-Tax• Accumulated Earnings Tax• Personal Holding Company Tax


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• Converting and Revocation Issues• Terminating the Election

• Post-Conversion Housekeeping

• Partial Conversions – (Don’t Be Greedy)• Partially Convert to C Corp

• A Reverse Incentive for “Blocker” Corporations

• Can You Ever Go Back ?• Re-Electing S Corp Status

• Alternatives to Re-Electing S Corp Status


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• Choice of entity always an important and complex decision• State law – which type of entity (GP, LP, LLP, LLC, Corp)• Federal tax law - pass-through (S Corp or partnership) or C Corp• Multiple variables – income, employment, state, foreign taxes• How will key principals be paid

• Active (wages, guaranteed payments) OR• Passive (dividends, distributions)

• Change in choice of entity• Whether to choose or convert from S Corp to C Corp• Additional complexity due to effect of conversion• What if tax law changes ?

• Tax Cuts & Jobs Act of 2017• TCJA has heightened the analysis due to many fundamental changes• Both domestic and foreign provisions are relevant• Is a C Corp “better” ? Sometimes ? Ever ?• It depends…


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• The authors have spent considerable time over decades:• Urging clients to avoid C Corps (and even S Corps), and • Moving clients out of C Corps (and even S Corps) (e.g.

partnership freezes)

• Selection of C Corp (or S Corp) is often made in disregard of benefits and flexibility of Subchapter K (partnerships)

• Tax dollars are often wasted and lost, forever, due to use of C Corps

• In this regard, see:

Why Do Venture Capital Funds Burn Research and Development Deductions, Johnson, Calvin H., John T. Kipp Chair in Corporate and Business Law, University of Texas School of Law, 29 Virginia Tax Review 29 (2009)

• Nonetheless, despite our misgivings, let’s dig in….


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• H.R. 1 (PL No. 115-97) - December 22, 2017• Known as the Tax Cuts & Jobs Act of 2017 (“TCJA”)• Generally effective January 1, 2018 (but many exceptions) • Most significant U.S. tax code revision since Tax Reform Act of

1986• Introduced some simplicity, but much new complexity in many

respects

• Domestic changes - personal, corporate, pass-through• Marginal tax rates cut (especially for C Corps; less so for

individuals)• Deductions curtailed and even eliminated in some cases

• Mortgage interest; state and local taxes for individuals• BUT, state and local tax deduction maintained for C Corps• Carrybacks for net operating losses no longer allowed

• Certain business deductions created or enhanced• Cost-recovery deductions; 100% bonus depreciation (all entities)• IRC§ 199A deduction – 20% (pass-throughs and individuals)


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• Foreign changes • Move to quasi-territorial foreign tax system

• One time tax on “trapped” foreign earnings in foreign corporations – transition tax

• Disincentives to locate intangible assets overseas (“GILTI”)

• Incentives to utilize US located intangible assets abroad (“FDII”)

• C Corps are especially favored with regard to territorial taxation of subsidiaries (100% dividend exclusion)


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• C Corps deserve closer look at least due to marginal rate cut

• Most C Corp provisions are permanent; individual provisions sunset• At least until the next election• C Corp marginal rate is an easy target for a revenue raiser

• Pass-throughs, however, have the new IRC§ 199A 20% deduction available

• Tried and true planning techniques are in question• Previously, pass-through entity (S Corp or partnership) usually preferred for

privately held businesses• Maximum marginal rates of tax on operating income were fairly close, 35%- C Corp

versus 39.6%-individual • Further, C Corp shareholders:

• Pay tax generally at a rate of 20% on qualified dividends; and• Also pay 3.8% IRC§ 1411 net investment income tax on dividends

• Pass-throughs avoid additional tax on distributions to owners

• Structure of cross-border transactions may change• US tax rate is lower than many foreign tax rates• Foreign income may be taxed in US under GILTI provision regardless of planning

• Off-the-cuff analysis is impossible (dangerous)


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• Achieve simplicity• Pass-through taxation is perceived to be “hard”

• Complicates individual tax returns (raises audit risk)• Intertwines business and individual taxation

• S Corp taxation somewhat complex due to pass-through considerations

• Partnership taxation very complex (but very flexible)

• Obtain financing (even IPO)• Venture capital providers frequently desire C Corp• Universe of S Corp investors is small (no C Corps or

partnerships)

• This presentation focuses on tax efficiency (in a vacuum)

15L O O K I N G B E Y O N D O U R B O R D E R S

TCJA Incentives to Convert to C Corp –Domestic

• Tax Rates

- 21% corporate tax rate vs individual pass-through rate up to 37%

◦ While corporate rate can be significantly lower than the individual pass-through rate, the double layer of tax on a distribution from a C corporation can undermine the low corporate rate

◦ The individual shareholder’s tax rate and the use of profits by the business both matter

- Businesses that reinvest ordinary income profits back into the business (in other words, that don't distribute remaining profits to shareholders on a regular basis) will see more benefit when their shareholders are in higher brackets

- 199A will impact the analysis, and in many cases shareholders will have diverging interests. Shareholders of specified service businesses will have different results if they are under or over the income thresholds.

- Businesses subject to high state and local taxes may benefit more because these are not subject to deduction caps in C corporations

- Post-transition termination period distributions are treated favorably



• Businesses Reinvesting Profits

- The 21% C corporation rate applies only at the level of the corporation.

- If the corporation issues a dividend to the shareholder, that dividend is subject to tax at 20%, plus another 3.8% if the Net Investment Income Tax of Sec. 1411 applies.

- Thus, effective tax rates can range from 36.8% to 40.6% on distributed profits.

- If a business does not distribute its profits, but rather reinvests them into the corporation, the 21% corporate rate allows a greater portion of the profits to be reinvested after taxes than in an S corporation.

◦ Major Caveat to this analysis: A C corporation is only better in the profit reinvestment scenario under circumstances in which the shareholders are high-income, and thus would be subject to the higher individual rates. See next slide.

- BUT consider that if the income of the business is eligible for the 199A deduction, the shareholder may fare better with an S-corporation, where the effective rate with the 199A deduction could be closer to 30%.



• Example of C Corporation benefit to high-income shareholder when profits are reinvested.

• Growth on deferred tax is the goal here.

• Example assumes married filing jointly, and all example income is taxed in bracket shown.

C Shareholder 37% bracket

S Shareholder 37% bracket

S Shareholder 24% bracket

Corporate Income $100,000 $100,000 $100,000

Corporate-level tax $(21,000) -0- -0-

Shareholder-level tax -0- $37,000 $24,000

Available for reinvestment

$79,000 $63,000 $76,000

Tax on distribution $(15,800) -0- -0-

Available for distribution

$63,200 $63,000 $76,000

Effective tax rate 36.8% (or 40.6%) 37% (or 40.8%) 24%


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• Initial tax at entity level – post TCJA• The tax rate for C Corps on all income is fixed at 21%• The tax rate on the operating income of a S Corp is 29.6% assuming

• Shareholders pay tax at the new maximum noncorporate rate of 37%, • Materially participate in the business, and • Take full advantage of the new IRC§ 199A 20% deduction• If shareholder s do not materially participate, additional 3.8% tax under

IRC§ 1441 applies creating combined tax rate of 33.4%

• Before distributions to shareholders, C Corp clearly favored

• Additional tax on distributions• Distributions from a C Corp

• Generally are taxed as qualified dividends at a 20% rate • Results in a combined rate of 36.8%• Further, the qualified dividend generally will be subject to an additional tax

of 3.8% under IRC§ 1411, resulting in a combined tax rate of 39.8%

• Distributions from an S Corp - generally can be made with zero additional federal tax.

• Assuming shareholder materially participates in business, IRC§ 1441 tax does not apply

• After considering distributions to shareholders, S Corp clearly favored


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• Tax gain exclusion for sale of certain C Corp stock

• “Qualified small business stock” (“QSBS”) of “qualified small business corporation” (“QSBC”) qualifies for gain exclusions

• To qualify:• QSBC must be domestic C Corp • QSBS must be acquired from the QSBC at original issue in

exchange for money, property (other than stock), or services• Aggregate gross assets of the QSBC must not exceed $50 million

immediately after or at any time prior to issuance• Measured by adjusted basis• Increase after issuance does not matter

• During substantially all of the SH’s holding period, at least 80% of the QSBC’s assets must be used:• In the active conduct of a qualified trade or business• Many exclusions – professional services, farming, hotels• IRC§ 1202 is more restrictive than IRC§ 199A


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• If QSBS held for more than 5 years • 100% gain exclusion - If acquired after September 26,

2010• 50% or 75% exclusion - If acquired prior to September 27,

2010 (depending on exact date of acquisition)

• Excluded gain is not subject to alternative minimum tax

• Per-taxpayer limits on the exclusion with respect to each QSBC:• $10 million, or, if greater• 10 times adjusted tax basis of stock• But, adjusted tax basis has a special meaning (see below)


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• Other restrictions / qualifications• S Corp cannot qualify as QSBC (C Corp only)

• Further, if S Corp directly converted:• Stock is not QSBS -- because stock is not originally issued

• But, the converted C Corp could issue additional stock that is QSBS (assuming other qualifications met)

• S Corp can, however, hold QSBS as a shareholder

• How can existing S Corp take advantage of IRC§1202 ?


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• S Corp drops-down of assets to new C Corp sub• IRC§ 351 transaction• Stock held by S Corp can be QSBS• New C Corp sub can issue new stock that can be QSBS

• If desired, S Corp could spin-off/split-off C Corp sub via IRC§ 355

• Special adjusted basis rule for QSBS:• Applies upon contribution of appreciated property to C Corp in

exchange for QSBS• Adjusted basis of stock includes appreciation (fair market value)• Thus –the 10 times basis rule is based on this adjusted basis• Existing appreciation, however, is not qualified for exclusion• This rule provides for some interesting planning• Utilize pass-through for early ramp-up; convert later


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• For example, assume:• Product idea will cost $2M to bring to prototype • Initially organize “T” as an S Corp and raise $2M seed

investors (friends and family). • Develop prototype to value stage of $5M based on bona-

fide valuation

• T then contributes all assets to new C Corp subsidiary, S• If T holds S stock (QSBS) for five years, gain will be

excluded (subject to regular limitations)• In this case exclusion is greater of $10M or 10 times

adjusted basis• Due to special rule, adjusted basis is $5M• Thus, gain excluded would be $45M ($5M existing at date of S

formation is not qualified)

• S could also issue new QSBS for new consideration


TCJA Incentives to Revoke S Election:Foreign Considerations

• Foreign provisions of TCJA favor C corporations:

- New IRC§ 951A tax on “global intangible low taxed income” ("GILTI“)

◦ Owners of "controlled foreign corporation" are subject to tax on low-taxed passive income earned from CFC, but shareholders that are domestic C corporations get a 50% deduction (37% after 2025).

◦ C corporation shareholder of CFC is allowed an 80% foreign tax credit against GILTI, but individual/pass-through shareholders are not

- New IRC§ 250(a) - Deduction available to domestic C corporations with "foreign derived intangible income“ (“FDII”). ◦ The effect is a deduction of 37.5% against FDII, resulting in an

effective tax rate of 13.125% on FDII.

◦ After 2025, this deduction is reduced to 21.87%, resulting in an effective tax rate of 16.41% on FDII.



• GILTI Details

• Prior to enactment of IRC§ 951A, most CFC planning involved avoidance of Subpart F income inclusion: earnings and profits of a CFC were permanently deferred until distributed, with the exception of Subpart F income (See IRC§ 953 and IRC§ 954) and investment earnings from U.S. property

• Income subject to accelerated tax under Subpart F or U.S. property investment rules was not taxed a second time upon distribution, and basis in CFC is increased

• Effective for tax years of controlled foreign corporations beginning after December 31, 2017, each person who is a United States shareholder of any controlled foreign corporation for any taxable year of such United States shareholder shall include in gross income such shareholder's global intangible low-taxed income for such taxable year.

• Computation is done on a U.S. shareholder basis, not on CFC basis

• Simply expressed, GILTI is a tax on the CFC’s net low-tax, passive income after deducting a 10% return on the CFC’s basis in certain tangible assets owned by the CFC



• IRC§ 951A tax is paid at U.S. Shareholder's rate

- For U.S. Shareholders that are individuals and passthroughs, this could be a rate up to 37%

- For U.S. Shareholders that are domestic corporations, the rate is 21%

- Subject to dividend tax upon distribution by domestic corporation to its shareholders, resulting in double tax

- HOWEVER: If a U.S. Shareholder of a CFC is a domestic C Corporation, it may deduct up to 50% of its GILTI income, resulting in an effective U.S. tax rate of 10.5%

C Corporation U.S. Shareholder

Individual U.S. Shareholder Individual U.S. Shareholder with Sec. 962(b) election

U.S. Tax Rate 21% Up to 37% 21%

Sec. 250 Deduction 50% (37.5% after 2025) None ???

Effective Tax Rate 10.5% (13.125% after 2025) Up to 37% 10.5% or 21% (13.125% or 21% after 2025)

Indirect Foreign Tax Credit 80% allowed 0% allowed 80% allowed

Tax rate on distribution to individual

20%/23.8% 0%/3.8% 20%/23.8% (qualified) or 37%/40.8% (non-qualified)

Combined rate 28.4%/31.8% 37%/40.8% 31.8% to 57%


Reasons to Remain/Elect S Corp Status –Domestic Incentives

• S corporation with QSUBs

- If a QSUB has liabilities in excess of basis in its assets, revoking parent S election may trigger gain under 357(c)

• Asset sale resulting in long term capital gains

- To the extent assets are mainly LTCG, S corporation shareholders will pay tax at 20% on the gain on the capital assets meeting the 1-year holding period, with no second level of tax

- In a C corporation, the entity will pay tax at 21%, and cash is distributed to shareholder as dividend subject to tax again at 20% (and an additional 3.8% if net investment income tax applies)

S Corporation C Corporation

LTCG on sale $100,000 $100,000

Entity-level tax on LTCG -0- $(21,000)

Remaining for distribution $100,000 $79,000

Shareholder-level tax on distribution

$(20,000) $(15,800)/($18,802)

After-tax cash $80,000 $63,200/$60,198

Effective Tax Rate 20% 36.8%/39.8%



Background on IRC§ 199A

• A business eligible for the IRC§ 199A deduction will likely benefit from retaining S Corp status

• An individual, estate, or trust generally may deduct

- 20% of qualified business income from a partnership, S corporation, or sole proprietorship, and

- 20% of qualified REIT dividends, qualified cooperative dividends, and qualified publicly traded partnership income.

• Qualified business income (“QBI”):

- QBI is determined for each qualified trade or business of the taxpayer.

- A qualified business is a business other than –

◦ a “specified service trade or business” described below, or

◦ the business of performing services as an employee.

- QBI for a taxable year means

◦ The net amount of qualified items of income, gain, deduction, and loss with respect to the taxpayer’s qualified businesses.

◦ Items are treated as qualified items only to the extent they are effectively connected with the conduct of a trade or business within the United States.

- There is also a wage and tax basis limitation that applies to reduce the 20% deduction for taxpayers with taxable income thatexceeds $157,500/$315,000.

◦ 50% of W-2 wages; or

◦ 25% of W-2 wages plus 2.5% of tax basis (unadjusted) of assets used in trade or business



IRC§ 199A Background (continued):

• Qualified items do not include specified investment-related income, gain, deduction, or loss. For example, qualified items of income, gain, deduction, and loss do not include –

- Capital gains and losses,

- Dividends, income equivalent to a dividend, or payments in lieu of dividends described in IRC§ 954(c)(1)(G), or

- Interest income other than that which is properly allocable to a trade or business.

• Qualified business income (QBI) is determined for each qualified trade or business of the taxpayer. A qualified trade or business is a business other than

- a “specified service trade or business”, or

- the business of performing services as an employee.

• Specified service trade or business means any 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 any trade or business where the principal asset of that trade or business is the reputation or skill of one or more of its employees or owners, or which involves the performance of services that consist of investing and investment management, trading, or dealing in securities, partnership interests, or commodities.



• Qualified Business Income Example

- Shareholder interests are generally aligned across all tax brackets such that all benefit from remaining an S corporation

S Corporation Shareholder (37% bracket)

C Corporation

Income (100% QBI) $1,000,000 $1,000,000

Entity-level tax -0- $(210,000)

Remaining for distribution

$1,000,000 $790,000

Shareholder-level tax $(296,000) $(188,020)

After-tax cash $704,000 $601,980

Effective Tax Rate 29.6% 39.8%



• Specified Service Business with shareholder earning less than $157,500/$315,000

- Shareholder is automatically eligible for Sec. 199A deduction because shareholder is below phaseout thresholds

- These shareholders are in the 24% rate bracket, subject to additional 20% deduction for QBI

- But what if other shareholders are in higher tax brackets and therefore not eligible for Sec. 199A? Their effective rates may be closer to that of the C corporation (up to 37%)

S Corporation (24% bracket)

C Corporation S Corporation (37% bracket)

Income (100% QBI)

$100,000 $100,000 $100,000

Entity-level tax -0- $(21,000) -0-

Remaining for distribution

$100,000 $79,000 $100,000

Shareholder-level tax

$(19,200) $(15,800)/($18,802) $(37,000)

After-tax cash $80,800 $63,200/$60,198 $63,000

Effective Tax Rate 19.2% 36.8%/40.6% 37%



• Review: Questions to ask when considering revocation of S election:

- Is the business eligible for IRC§ 199A deduction?

◦ If so, to what extent? The higher the IRC§ 199A deduction, the more likely remaining an S corporation will make sense

◦ Due to their taxable income, are some of the shareholders eligible for IRC§ 199A and others not? Higher-income shareholders may benefit from C corporation status, whereas lower income shareholders may benefit more from S corporation status.

- Balance of power considerations when drafting shareholder agreements

- How does the business use its profits?

◦ A business that reinvests profits may be better off as a C corporation to take advantage of tax deferral (but see accumulated earnings tax discussion).

◦ A business that distributes profits to shareholders won’t benefit from deferral, and may be better off as an S corporation.

◦ Again, what tax bracket will each shareholder be taxed in?


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• Some portion of the corporation’s earnings (will be) (should be) paid to key shareholders as wages

• Wages (and self-employment income) will be subject to: • Maximum income tax rate of 37%• Further, will be subject, to employment taxes

• 12.4%% social security tax combined employer / employee rate up to maximum of $128,400 in wages (2018)

• 2.9% medicare tax combined employer / employee rate on all wages• 1.8% additional medicare tax for earnings over $200,000

• S Corp allows planning to avoid additional medicare tax on investment earnings (active shareholder distributions not taxable0

• IRC§ 199A considerations:• Wages received do not qualify as a qualified business• But, wages of a qualified business are considered as part of the

calculation of limitations on 199A deduction (compare guaranteed payments to partner/employees, which are not)

• Computation of “sweet spot” for payment of wages versus distributions is necessary

• Further, W-2 wages form the basis for contribution to qualified retirement plans


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• Typically, buyer of business of target business desires to purchase assets to achieve basis step-up (write-offs)

• Initial tax at entity level:• The tax rate for C Corps is fixed at 21% (no differential for

capital gains)• The tax rate on most or substantial portion of the asset sale gain

of a S Corp, will likely be taxed at maximum long-term capital gain rate – 20% (IRC§ 199A 20% deduction not applicable to gain)

• Even before distributions to shareholders, S Corp clearly favored

• Additional tax on distributions:• Distributions of sale proceeds from a C Corp

• Generally are taxed as qualified dividends at a 20% rate • Results in a combined rate of 36.8% (same as from operations income)• Further, the qualified dividend generally will be subject to an additional

tax of 3.8% under IRC§ 1411, resulting in a combined tax rate of 39.8%• Distributions of sale proceeds from an S Corp

• Generally can be made without additional federal tax. • Thus, final combined rate is 20%• S Corp is clearly and heavily favored after considering distributions


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• Under IRC§ 338 certain purchases of stock of a corporation can be treated as “deemed” asset sales• Typically requires purchase of 80% or more of stock within

12 months• Purchaser must generally be a single corporation• If target is C Corp, target typically must be consolidated or

affiliated subsidiary of parent corporation• Target can be an S Corp (under IRC§ 338 (h)(10) election)

• Under IRC§ 336(e), however, buyer of stock can be any type of taxpayer • Only allowed since regulations in 2013 (still unknown)• Particularly useful for S Corp targets (for example, private

equity partnership can purchase)• Further, multiple purchasers are allowed• Consider planning possibilities for LLC treated as S Corp

and purchased by private equity fund (LLC cannot be S Corp, BUT can be a partnership going forward)


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• Under IRC§ 531 C Corps are restricted in the amount of earnings they can accumulate• An “accumulated earnings tax” of 20% can be

assessed (plus interest from due date of return)

• Prevents unreasonable accumulation of earnings (and avoidance of “double-tax”)

• This tax is assessed upon audit (thus interest could be huge due to delay between return due date and audit)

• C Corp can agree to “consent dividend” in lieu of paying tax (deemed dividend distribution, then recontribution)

• Presumptively reasonable amounts:• $250,000 for most C Corps

• $150,000 for “personal service corporations”


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• Over these amounts, C Corp must prove accumulated earnings are for reasonable needs of business

• Reasonable needs of business include:• Specific, definite, and feasible plans for use of the earnings

accumulated in the business• Amounts necessary to redeem the C Corp’s stock from a

deceased shareholder’s estate, but the amount cannot exceed:• Reasonably anticipated such estate’s total estate and inheritance

taxes, and • Funeral and administration expenses• Under current law after TCJA – estate taxes may well be zero

• Business expansion, constructing a new facility, and investing in newer and more productive equipment

• Minutes and other contemporaneous records of planning will be paramount


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• Accumulated earnings tax does not depend on the liquidity of the C Corp

• Chief Counsel Advice 201653017: • C Corp holds solely multiple limited partnerships, contributed by

sole shareholder• Limited partnership agreements made all distributions to

partners discretionary• Except, distributions to pay taxes on allocated income were made• C Corp audited• Held: Accumulated earnings tax applies, because:

• C Corp was mere investment company• No reason demonstrated for the limited partnership interests to be held

in C Corp solution• This is so even though the C Corp or its directors or shareholders did

not control the limited partnerships

• Accumulated earnings tax does not apply to S Corps, passive foreign investment companies, tax-exempt corporations, or “personal holding companies” (but see PHC tax next slide)


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• Personal holding company (“PHC”) tax can apply (IRC§ 541 et seq.) and equals:• Regular corporate income tax,

plus

• An additional tax of 20% of the undistributed “personal holding company income” (“PHCI”)

• A PHC is defined as C Corp where:• Five or fewer persons own more than 50% of the

value of the C Corp’s stock, and

• At least 60% of the “adjusted ordinary gross income” (“AOGI”) is PHCI

• Constructive ownership rules apply


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• PHCI consists of the following:• Dividends, interest, royalties, and annuities;• Adjusted income from rents• Adjusted income from mineral, oil, and gas royalties (with

some exceptions);• Copyright royalties (with exceptions);• Produced film rents (with exceptions);• Compensation for the use of property if 25% or more of the

C Corp stock is owned, directly or indirectly, by an individual entitled to the use of the property; and

• Amounts received under a contract for personal services rendered by an individual who owns 25% or more of the C Corp’s stock.

• Rental income not consider PHCI if: • The rental income totals at least 50% of AOGI and • Dividends paid or considered paid, and consent dividends,

equals at least to the amount by which other PHCI exceeds 10% of ordinary gross income.


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• AOGI is calculated by making certain adjustments, including:• Rental income is reduced (not below zero) by rent

expense, property taxes, interest and amortization allocable to the rented property, and depreciation

• Mineral oil and gas royalties are reduced (not below zero) by depletion, property or severance taxes, interest and rent allocable to the property producing such income

• Interest income on judgments, tax refunds, and condemnation awards is excluded


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• Avoid prohibited concentration of stock ownership

• Accelerate or defer PHCI and non-PHCI into different years if possible

• Use consent dividends

• Excess dividends in certain prior years can be counted in later years

• Deficiency dividend procedure allowed if discovered on audit (but restricted)

• Takeaway – PHC tax is another C Corp provision that creates need for increased administrative and accounting attention


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• C Corps cannot pay excessive compensation to key persons:• Perceived by IRS to be another double-tax avoidance scheme• Challenge would come up on audit, years after the tax year at

issue (interest and penalties could be high)• Remedy is deemed dividend + elimination of deduction• These particular audits are expensive and fact intensive (experts

required)

• To avoid excessive compensation claim:• Compensation studies must be used to substantiate

compensation• Contemporaneous minutes and other planning materials must be

maintained

• Note the change in focus between S and C Corps:• S Corp – focus is on paying “enough” compensation (IRS concern

is employment tax avoidance)• C Corp – focus is on paying “too much” compensation (IRS

concern is double-tax avoidance)


Reasons to Remain/Elect S Corp Status –Foreign Incentives

• IRC§ Sec. 965 "Transition Tax"

- Shareholders of S corporations that are U.S. Shareholders of a “deferred foreign income corporation” may elect to postpone payment of 965 transition tax until a triggering event.

- A “deferred foreign income corporation” is a

◦ (1) controlled foreign corporation, or

◦ (2) a foreign corporation that has a 10% corporate U.S. Shareholder, that has accumulated post-1986 foreign income.

- CFC: a foreign corporation in which more than fifty percent of the stock is owned by U.S. Shareholders

- U.S. Shareholder: U.S. person who owns 10% or more of a foreign corporation



• IRC§ 965 Transition Tax (continued)

- “Triggering Event” is defined as:

◦ Termination of S corporation status

◦ Transfer of S corporation shares to someone who is not an “eligible transferee”

- An eligible transferee is a United States person that is not a domestic pass-through entity)

- Must enter into a transfer agreement with the Commissioner within 30 days of the triggering event. See Prop. Treas. Reg. 1.965-7(c)(3)(iv)(B)(4).

◦ Liquidation of S corporation; S corporation ceases doing business, or ceases to exist

◦ Due date for this deferral election is the due date of the S corporation shareholder’s tax return for the year that includes the last tax day of the tax year of the S corporation in which the S corporation as a IRC§ 965(a) inclusion (See. Prop. Reg. 1.965-7(c)).



• Certain trusts can hold S Corp stock

- Qualified subchapter S trust (“QSST”)

◦ Essentially a grantor trust

◦ Must have single beneficiary

◦ Must distribute all income

- Electing small business trusts (“ESBT”)

◦ Can have multiple beneficiaries

◦ Does not have to distribute all income

◦ BUT, pays tax on S Corp income at highest individual rate

• Under TCJA, expanded beneficiary class for ESBTs

- Now includes nonresident alien individuals

- Not so for QSST


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• S Corp can voluntarily convert to a C Corp at any time• To be effective on the 1st day of the taxable year, the

corporation must revoke by the 15th day of the 3rd

month of that tax year

• A revocation filed after the 15th day of the 3rd month of the tax year will take effect at the start of next taxable year

• Example: • XYZ Corp's tax year starts on April 1. If ABC Corp.

wants to convert to a C Corp for the current year, it must revoke by June 15 (the 15th day of the 3rd month of its tax year). Otherwise, C Corp status is not effective until April 1 of the following year.


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• No specific form is required

• File a statement titled "Revocation of S Corporation Status"

• File with the IRS Service Center where the S Corp’s original election was filed

• Statement must:• Identify the name of the S Corp, the tax identification

number, and the number of outstanding shares

• Be signed by the person authorized to sign the corporation's tax returns

• Must contain consent signed by shareholders owning more than 50 % of the S Corp stock, including the nonvoting shares


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• The IRS can terminate the S Corp election for violating one or more of the eligibility requirements • Having more than 100 shareholders, • Having 1 or more ineligible shareholders, or • Having more than one class of stock

• Also: An S Corp can be terminated if it has:• Accumulated earnings & profits (from C Corp years), and • Passive investment income exceeding 25% of gross income for

the prior 3 consecutive years.

• Terminations are generally effective on the date of the termination event

• TCJA provides relief for “voluntary” terminations (see below

• Query: Could “inadvertently terminated” S Corp obtain private letter ruling “fixing” the termination so it can then voluntarily terminate ?


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• No immediate gain or loss is realized upon conversion to C Corp

• Possible increased state and local taxes

• Change in accounting method (see below)

• Post-conversion distribution treatment (see below)

• Inadvertent termination:• If at midyear, requires two tax returns for that year.

• Bad results -- See TCJA relief for “voluntarily terminated” S Corp elections below


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• Congress believed the TCJA tax rate cut would foster conversion to C Corp; thus, certain relief is provided

• Only “eligible terminated S corporations” qualify

• Defined as a C Corp which:• Was an S Corp on December 21, 2017;• Makes a voluntary revocation of its S Corp election

under IRC§ 1362(a) during the two-year period beginning on December 22, 2017; and

• The shareholders of such C Corp, as of the date of revocation, are the same shareholders holding the same interest as on December 21, 2017

• Query: What if a shareholder dies between December 21, 2017 and revocation date ?


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• New IRC§ 481(f) - accounting method change • Because of limitations applicable to C Corps, the C Corp

may no longer qualify for cash-basis accounting under IRC§ 448

• If the converted S Corp must change from the cash method of accounting, the S Corp may take required IRC§481(a)(2) adjustment into account ratably during the 6 tax year periods beginning with the year of change (typically only 4 tax years are allowed)

• IRC§ 448• C Corps must generally use accrual accountingunless• Average gross receipts of prior 3 years do not exceed $25Mor• C Corp is a personal service corporation (substantially all

activities of which involve the performance of services in the fields of health, law, engineering, architecture, accounting, actuarial science, performing arts, or consulting)


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• New IRC§ 1371(f) – extended period to take “accumulated adjustments account” (“AAA”)

• Per existing IRC§ 1377(b)(1)(A), if S Corp voluntarily revokes its S Corp election:• A “post-termination transition period” (“PTTP”)

begins after the last day of its S year and ends one year after such last day, or the due date (as extended) for filing the return for such last year as an S Corp, whichever is later

• Distributions of money by the C Corp during the PTTP are applied against and reduce the adjusted basis of the shareholders stock to the extent the distribution does not exceed the C Corp’s “accumulated adjustments account”


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• New IRC§ 1371(f) – extended period to take AAA distributions

• Under new IRC§ 1371(f)• An eligible terminated S Corp can avoid dividend

treatment on all or a portion of the distribution even after the PTTP

• After the PTTP, the AAA will be allocated to the distribution, and the distribution will be chargeable to the corporation's accumulated earnings and profits in the same ratio as the amount of such AAA bears to the amount of such accumulated earnings and profits


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• Consider going “half-way” with conversion to C Corp

• Consider IRC§ 351 subsidiary formation• Reincorporate portion that qualifies for IRC§ 1202

• Reincorporate portion that doesn’t qualify for IRC§199A

• Consider IRC§ 355 spin-off of portion of business• To attract non S Corp qualified investors


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• Subchapter K – partnership tax rules may provide solution

• Consider contribution of some or all business to partnership• Allows investment by investors that do not qualify as

S Corp shareholders

• But preserves pass-through taxation

• Preserves ability to utilize IRC§ 199A at parent (S Corp) and subsidiary (partnership) level


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• Can you ever go back? Maybe…• Timing

• Once revocation is made, must wait 5 years to re-elect

• This period can be shortened upon request to IRS

• Would change in law (increase in C Corp rates) be accompanied with relief in form of shorter period ?

• Problem: Post-conversion shuffling of shareholders (some may not qualify as S Corp shareholders)

• Effect of re-election• Built-in gain IRC§ 1374 will apply

• For succeeding 5 years, any gain existing at election date must be treated as if corporation was C Corp

• This time period, occasionally, has been shortened by specific tax law


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