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Provisions,
cont. from page 15
existing LLCs and S corporations
may want to explore conversion to
C corporation status prior to the end
of 2013. Will the exclusion be extended
beyond 2013 or made applicable
for California income tax purposes?
There is certainly reason to
hope so, given that the economy is
likely to remain very sluggish well
beyond 2013 or even return to recession
as a result of the anti-growth
policies currently being pursued in
Sacramento and Washington.
S Corporation: Built-in
Gains Relief Provision
C corporations can gain the benefit
of a single level of taxation by converting
to S corporations. However,
converted S corporations remain
subject to tax on built-in gains on
assets that existed at the time of
conversion. If the S corporation disposes
of any BIG assets during the
10-year period following conversion,
the realized built-in gains are
taxed at the highest C corporation
tax rate, currently 35 percent. As a
result of economic stimulus legislation
in 2009 and 2010, the holding
period for BIG assets was reduced.
For tax years beginning in 2009 and
2010, the holding period was seven
years. For tax years beginning in
2011, the holding period was five
years, meaning that in 2011 an S
corporation could sell BIG assets
held as little as five years without
being subject to BIG tax.
Like the relief provision for QSBS
discussed above, this S corporation
relief provision expired at the end
of 2011. However, ARTA 2012 extended
the five-year holding period
through the end of 2013 and made it
retroactively applicable to 2012.
What Wasn’t in ATRA
2012 (but may be on
the horizon):
The U.S. corporate tax system has
grown increasingly out of sync with
the corporate tax structures in other
developed countries. The U.S. currently
taxes corporate income at a
top rate of 35 percent - the highest
among advanced world economies.
The average is closer to 25 percent
in most of the developed world.
Moreover, most of the other developed
countries have a territorial tax
system, under which a company
is taxed only on income generated
domestically. The U.S., on the
other hand, taxes a corporation on
its worldwide income. Tax credits
are available for taxes paid in a foreign
jurisdiction, but if those taxes
are imposed at a lower rate (which
will usually be the case) the U.S.
corporation effectively pays the
higher U.S. tax rate. U.S. taxation of
foreign earnings can be delayed by
keeping the earnings inside foreign
subsidiaries, but the earnings will
be subject to U.S. taxation when
repatriated to the U.S. According to
J.P. Morgan, U.S. companies control
$1.7 trillion in foreign earnings held
outside the U.S., a portion of which
would doubtless be repatriated and
used for investment in the U.S. but
for the disincentives in the current
corporate tax system.
There is an emerging consensus
on both sides of the political aisle
that the U.S. corporate tax system
needs to be reformed to make it
more competitive. President Obama
has at least paid lip service to the
notion in the presidential debates
last fall. Proposals for legislative
reforms are being actively debated,
and the impetus for taking action is
strong given the serious imbalance
between the U.S. corporate tax system
and that of our major trading
partners.
The outcome of reform proposals
is far from certain, but what would
be the implications of a reduction in
top U.S. corporate tax rates to something
in the 25 percent ballpark? A
top corporate rate significantly below
the individual rate, currently
39.6 percent, will reduce the tax
incentive for forming pass-through
entities (LLCs and S corporations).
There was a time in the past when
a similar dynamic prevailed. For example,
in the 1960s and 70s the top
individual rate was 70 percent, but
the top corporate rate was 35 percent.
In those times it was not uncommon
for closely held businesses
to operate as C corporations. It was
even common to hold real estate in
C corporations – something that is
considered the height of lunacy today.
Nonetheless, if we again see a
significant rate differential, it may
be “back to the future.”
Even without legislative reform,
the temporary extension of the
100 percent exclusion for QSBS discussed
above gives the C corporation
a comparative advantage in
some situations through the end
of 2013, and maybe later if it is extended.
s
1
P.L. 112-240, signed by the President on
January 3, 2013.
2
The definition of “qualified trade or business”
excludes investment companies,
professional services and consulting,
banking, insurance and other financial
services, farming, oil & gas or mineral extraction,
and the hotel, motel or restaurant
business.
George S. Cabot is a Partner at
PremierCounsel LLP, with offices
in San Francisco and Lafayette.
George is a Certified Tax Specialist
with a business transactional practice
focusing on structuring business
entities, M&A and entity level
tax planning.
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16
MARCH 2013