Mark Lubin's article “Tax Pitfalls Associated with Closely Held Businesses”
Reprinted with permission from the Pennsylvania CPA Journal, a publication of the Pennsylvania Institute of Certified Public Accountants.
Tax Pitfalls Associated with Closely Held Businesses
By Mark L. Lubin, CPA, JD, LLM
Most tax practitioners are familiar with the fundamentals of structuring closely held businesses, but important structuring considerations are sometimes overlooked. This column highlights some pitfalls that might not always come to the attention of practitioners structuring business arrangements.
Through familiarity with potential exposures and the exercise of caution, unnecessary tax expense and exposure can be avoided. This column, however, focuses primarily on closely held C corporations and multiowner flow-through structures (S corporations and partnerships). References to partnerships include LLCs that are taxable as such. Various considerations – such as tax rate differentials, qualified business income deductions, compensation-related issues, and procedural considerations –are beyond the scope of this column.
Well-known benefits of pass-through structures include the absence of entity-level taxation and the ability to pass losses through to owners. However, these structures have concerns not present with C corporations:
- Pass-through entity owners may be allocated income without receiving cash to cover resulting tax liabilities. Partnership agreements (including LLC operating agreements) and S corporation shareholder agreements often provide for “tax” distributions to cover such liability. With S corporations, distributions should be made proportionately to avoid violating the one-class-of-stock requirement. 1
- The owners’ ability to use start-up losses is often a material consideration. Basis generated by third-party partnership debt can enhance the ability to use such losses. 2 However, restrictions such as the at-risk and passive activity loss limitations prescribed by IRC Sections 465 and 469 may impair tax benefits from such losses.
- The net investment income tax, which typically applies to stock sales, can sometimes be avoided on dispositions of businesses conducted though pass-through structures. However, limitations under current proposed regulations could impair that benefit.
Partnerships are more flexible than S corporations regarding varying economic arrangements amount equity holders due to the S corporation one-class-of-stock requirement. Partnerships, though, may result in certain exposures not presented under other structures:
- Partnerships are often considered favorable for businesses that envision making noncash distributions because they can generally distribute appreciated assets without gain recognition. However, various subchapter K limitations can negate that benefit. 3
- Partnership interests issued in exchange for business assets or services can bring on a variety of other issues. For example, “disguised sale” and “anti-mixing bowl” rules apply in certain situations where property is contributed to partnerships. 4 While profit interests can often be issued for services without current taxation, service partners and their advisers should be aware of the three-year, long-term capital gain holding period imposed by Section 1061, and the potential for taxation under the “disguised service” rules. 5
- Partnership tax audit rules are considerably less “user-friendly” than the audit rules applicable to corporations, and their application can result in liability exceeding the amount imposed on partners under the IRC.
While less flexible than partnerships, corporations often provide greater certainty as to tax consequences. However, their use also involves exposures:
- Contributions of appreciated assets and assets encumbered by indebtedness are more likely to attract taxation when made into a corporate structure. For example, the 80% control requirement for nonrecognition on corporate contributions can be problematic if noncontributing key individuals receive substantial equity. 6 Also, IRC Section 357(c) (regarding gain recognition where indebtedness on contributed property exceeds basis) is more restrictive than treatment under corresponding partnership rules.
- Failure to elect subchapter S status (where desired) throughout a corporation’s existence can have adverse implications. Former C corporations are subject to a corporate level “built-in” gain tax on assets disposed of within a five-year recognition period. 7 Moreover, S corporations with earnings and profits from C corporation years that receive “passive” income can be subject to corporate-level taxation and potential subchapter S termination.
- Limited types of trusts, such as grantor trusts, can be eligible S corporation shareholders. Family and estate planning considerations or a grantor’s death sometimes result in termination of grantor trust status. That can require a new S election or cause a trust to become an ineligible shareholder. 9
- Structures involving subsidiaries are often desirable, but distributions to C corporations in those structures can result in unanticipated income, personal holding company, or accumulated earnings tax liability. 10 Those consequences can often be mitigated, especially with advance planning.
1 See IRC Section 1361(b)(1)(D) and Reg. Sec. 1.1361-1(1).
2 Compare IRC Sections 723 and 752 with Section 1366(d)(1). Moreover, the potential for inside partnership basis step-ups regarding later purchases of partnership interests may be attractive. (See Sections 754 and 743.)
3 See IRC Section 731(c) (distributed marketable securities generally treated as money), Section 751 (concerning certain transactions involving partnerships with “hot” assets), and the discussion herein relevant to certain distributions where property was previously contributed.
4 IRC Sections 707(a)(2), 737, and regulations thereunder; see also Section 704(c), generally concerning allocations relating to contributed property.
5 IRC Section 707(a)(2)(A); Prop. Reg. Secs. 1.707-2 and -9.
6 Compare IRC Section 351(a) and Reg. Sec. 1.351-1(a)(1) with IRC Section 721(a) (partnership contributions not subject to similar requirement).
7 IRC Section 1374. Exposure to this tax can require tracking of asset basis and fair market value at significant cost.
8 IRC Sections 1375 and 1362(d)(3).
9 IRC Section 1361(c)(2).
10 See e.g., IRC Sections 243(b)(1)(B), 541, 543(a)(1), and 531.
Mark Lubin is special counsel at the law firm Chamberlain Hrdlicka in Philadelphia, where he specializes in tax planning and complex business transactions. He can be reached at firstname.lastname@example.org.