Some Of The TC&JA’s Corporate Tax Changes

by Farrell Fritz, P.C.
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Our last three posts focused on those provisions of the Tax Cuts and Jobs Act[1] that apply specifically to pass-through entities, including partnerships and S corporations.

https://www.taxlawforchb.com/2018/01/the-2017-tax-act-other-pass-through-tax-provisions-part-ii/

https://www.taxlawforchb.com/2018/01/the-2017-tax-act-other-pass-through-tax-provisions-part-i/

https://www.taxlawforchb.com/2017/12/the-new-deduction-for-qualified-business-income-tax-simplification-gone-awry/

Today, we turn our attention to domestic C-corporations (“C-corp”) and to some of the ways in which the taxation of their U.S.-sourced income is impacted by the Act.[2]

Why a “C” Corp?

By far, most closely held U.S. businesses are formed as pass-through entities, including sole proprietorships, partnerships, limited liability companies (“LLC”), and S corporations (“S-corp”).

That being said, a number of closely held businesses are C-corps. Many of these would not qualify as S corps (for example, their capital structure may include preferred stock, or some of their shareholders may not be eligible to own stock of an S corp.). Others were formed before the advent of LLCs. Still others were formed as C-corps so as to avoid the pass-through of their taxable income to their shareholders (for example, where the owners were taxable at a higher individual income tax rate, or where the owners would be subject to self-employment tax on their share of the business income, or where the business did not plan to distribute its profits to its owners).

What is it?

A “corporation” is a business entity that is organized under a federal or state law that describes or refers to the entity as “incorporated” or as a “corporation.”

It also includes a business entity that was not formed under one of these laws but that elects to be treated as a corporation (an “association”) for tax purposes.[3]

In general, a C-corp is a corporation for which its shareholders cannot elect that it be treated as an S corporation (for example, because it is not a “small business corporation”), or have not so elected for whatever reason.

How is it Taxed?

A C-corp. is a taxable entity. It files an annual tax return on which it reports its gross income and its deductions, and calculates its taxable income, on which it pays a corporate-level income tax.

When the C-corp. distributes its after-tax profits to its shareholders in the form of a dividend, the shareholders pay tax on the amount distributed to them.

Thus, the C-corp.’s taxable income is taxed twice: once to the corporation and, upon distribution, to its shareholders.

Prior to the Act, corporate taxable income was subject to tax under a graduated rate structure. The top corporate tax rate was 35% on taxable income in excess of $10 million.

As in the case of other taxpayers, certain items of revenue and certain items of expenditure are excluded in determining a C-corp.’s taxable income. Some of these items were modified by the Act.

For example:

  • the gross income of a corporation generally did not include any contribution to its capital;
  • a corporate employer generally could deduct reasonable compensation for personal services as an ordinary and necessary business expense – however, the Code limited the deductibility of compensation with respect to a “covered employee” of a publicly held corporation to no more than $1 million per year, subject to an exception for performance-based compensation (including, for example, stock options and SARs);
  • a C-corp. could reduce its dividends received from other taxable domestic corporations by 70%-to-100% of such dividends, depending upon its ownership interest in the distributing C-corp.;
  • Interest paid or accrued by a C-corp. generally was deductible in the computation of its taxable income, subject to various limitations;
    • for example, the Code limited the ability of a C-corp. to deduct its interest expense in certain situations where the corporation’s debt-to-equity ratio was “too high” and the deduction would not be “offset” by a matching inclusion in the gross income of the creditor (the “earnings stripping” rules);
  • if a C-corp. had a net operating loss (“NOL”) for a taxable year (the amount by which the C-corp.’s business deductions exceeded its gross income), the NOL could be carried back two years and carried forward 20 years to offset the C-corp.’s taxable income in such years.

In addition, a 20% alternative minimum tax (AMT) was imposed on a C-corp. if its AMT (based on its alternative minimum taxable income, which was calculated to negate the benefit of certain preferences and income deferrals that were allowed in determining its regular taxable income) exceeded its regular tax.

The Act

As a result of the Act:

  • the corporate tax rate is reduced to a flat 21%;[4]
  • the term “contribution to capital” does not include (a) any contribution in aid of construction or any other contribution as a customer or potential customer, and (b) any contribution by any governmental entity or civic group (other than a contribution made by a shareholder as such) – thus, these contributions will now be taxable;
  • the performance-based exception to the limitation on the deductibility of certain compensation paid by a publicly traded corporation is eliminated, and the limitation is extended to include certain corporations the equity of which is not publicly traded, such as large private C- or S-corps with registered debt securities;[5]
  • the 70% and 80% dividends received deductions are reduced to 50 percent and to 65%, respectively;
  • the earnings stripping rules are expanded such that the deduction for business interest for any taxable year (including on debt owed to unrelated persons) is generally limited to the sum of (a) business interest income for such year, plus (b) 30% of the corporation’s adjusted taxable income for such year;[6]
    • “adjusted taxable income” means the taxable income of the corporation computed without regard to (1) any item of income, gain, deduction, or loss which is not properly allocable to a business; (2) any business interest or business interest income; (3) the amount of any NOL deduction; and (4) certain other business deductions;
    • “business interest” means any interest paid or accrued on indebtedness properly allocable to a business (it excludes investment interest);
    • “business interest income” means the amount of interest includible in the gross income of the corporation for the taxable year which is properly allocable to a business (and not investment);
    • the amount of any business interest not allowed as a deduction for any taxable year may be carried forward indefinitely;
    • significantly for smaller businesses, the limitation does not apply to a corporation if its average annual gross receipts for the three-taxable-year period ending with the prior taxable year does not exceed $25 million;
    • significantly for real estate businesses, at the corporation’s election, any real property development, redevelopment, construction, reconstruction, acquisition, conversion, rental, operation, management, leasing, or brokerage trade or business, is not treated as a trade or business for purposes of the limitation – thus, the limitation does not apply to such an electing trade or businesses;
  • the carryover NOL deduction for a taxable year is limited to 80% of the corporation’s taxable income, the two-year carryback is repealed, and carryovers may be carried forward indefinitely;[7]
  • the corporate AMT is repealed.

These changes are effective for taxable years (and for losses arising in taxable years) beginning after December 31, 2017.[8]

Employee-Shareholders?

The Act also made certain changes that may affect the “rank-and-file” employees of a corporation to whom the corporate employer may offer shares of its stock as compensation for their services.

“Property” for Services

In general, an employee to whom shares of employer stock are issued as compensation must recognize ordinary income in the taxable year in which the employee’s right to the stock is transferable or is not subject to a substantial risk of forfeiture, whichever occurs earlier (“vesting”).

Thus, if the employee’s right to the stock is vested when the stock is transferred to the employee, the employee recognizes income in the taxable year of such transfer, in an amount equal to the fair market value (“FMV”) of the stock as of the date of transfer (less any amount paid for the stock).

If, at the time the stock is transferred to the employee, the employee’s right to the stock is unvested – for example, the employee must render a specified number of years of service in order for the stock to vest – the employee does not recognize income attributable to the stock transfer until the taxable year in which the employee’s right becomes vested. In that case, the amount includible in the employee’s income is the FMV of the stock as of the date that the employee’s right to the stock becomes vested (less any amount paid for the stock).[9]

In general, these rules do not apply to the grant of a nonqualified option on employer stock. Instead, these rules apply to the transfer of employer stock by the employee on exercise of the option; specifically, if the right to the stock is substantially vested on transfer (the time of exercise), income recognition applies for the taxable year of transfer. If the right to the stock is unvested on transfer, the timing of income inclusion is determined under the rules applicable to the transfer of unvested stock. In either case, the amount includible in income by the employee is the FMV of the stock as of the time of income inclusion, less the exercise price paid by the employee.[10]

The Act

In the case of a closely held business, the grant of stock in the employer corporation has almost always been limited to a small number of executive, or “key,” employees of the corporation.

Over the years, many such employees have, for various reasons, sought ways to further defer the recognition of compensation income attributable to unvested stock (for example, by extending the required period of service).[11]

The Act actually provides a way to achieve such additional deferral, but in a way that does not benefit a corporation’s top executives, and that is not likely to be utilized by established closely held businesses, though it may help some start-up companies.[12]

Under the Act, a qualified employee may elect to defer the inclusion in income of the FMV of qualified stock transferred to the employee by the eligible employer in connection with the exercise of a stock option or the settlement of a restricted stock unit (“RSU”):

  • the election to defer income inclusion (“inclusion deferral election”) with respect to qualified stock must be made no later than 30 days after the time the employee’s right to the stock is vested;
    • A corporation is an eligible corporation if
      • no stock of the employer corporation was readily tradable on an established securities market during any preceding calendar year, and
      • the corporation has a written plan under which, in the calendar year, not less than 80% of all employees who provide services to the corporation in the U.S. are granted options, or RSUs, with the same rights and privileges to receive qualified stock;
  • If an inclusion deferral election is made, the income must be included in the employee’s income for the taxable year that includes the earliest of:
  • the first date the qualified stock becomes transferable;
    • the date the employee first becomes an excluded employee;
      • an excluded employee with respect to a corporation is any individual (1) who owned 1% of the corporation at any time during the calendar year, or who owned at least 1% of the corporation at any time during the 10 preceding calendar years, (2) who is, or has been at any prior time, the CEO or CFO of the corporation, (3) who is a family member of such individuals, or (4) who has been one of the four highest compensated officers of the corporation for the taxable year, or for any of the 10 preceding taxable years;[13]
    • the first date on which any stock of the employer becomes readily tradable on an established securities market;
    • the date five years after the first date the employee’s right to the stock becomes substantially vested; or
    • the date on which the employee revokes the inclusion deferral election.

Having Fun Yet?

The more I read and analyze the Act, the more I realize its potential implications for closely held businesses, and the more I recognize[14] that “only time will tell,” as the saying goes.

That being said, the C-corp-related changes under the Act, discussed briefly above, raise some interesting questions, among which are the following:

  • Will the reduced rated rate induce an S-corp or its shareholders to give up its “S” election, either by revoking it, or by admitting new investors or changing its capital structure?[15]
  • Will the reduced rate cause the shareholders of a target C-corp to abandon their attempts to by-pass the C-corp, to the extent possible, in connection with the sale of its business?[16]
  • Will the limitation on the deduction of interest cause a corporation to rethink its capital structure, causing it to rely less on borrowed funds?
  • Will the elimination of the two-year NOL carryback, plus the addition of the 80%-of-taxable income cap, have an adverse effect on the recovery of a distressed corporation?[17]

The answers to these, and other, questions will best be answered by considering the unique facts and circumstances of each closely held corporate taxpayer and of its shareholders.

Taxpayers will have to review the Act’s changes with their tax advisers, consider and map out the implications thereof as to their business, and then plan accordingly.

[1] Pub. L. 115-97; the “Act.”

[2] Please note that some of the items discussed herein are not unique to C-corps, but because C-corps are liable for tax (unlike their pass-through brethren – at least in most cases), I chose to discuss these items as they apply to C-corps. By the same token, other C-corp-related changes have been covered in other posts; for example, re the application of the cash method of accounting, see https://www.taxlawforchb.com/2018/01/the-2017-tax-act-other-pass-through-tax-provisions-part-i/

[3] For example, a single member LLC that would otherwise be disregarded for tax purposes, but for which “the box has been checked” to treat it as an association/corporation for tax purposes.

[4] This 21% rate will also be applied to situations that determine tax liability by reference to the corporate tax rate; for example, the calculation of the built-in gains tax on S-corps.

[5] For example, a private company that does not qualify for an exemption to the securities registration requirements may have to register an offering of debt or convertible debt.

[6] This limitation rule also applies to partnerships and S corps at the entity level; special rules are provided for passing through the consequences of the rule to partners and S-corp. shareholders.

[7] See the discussion of “excess business losses” for non-corporate taxpayers at https://www.taxlawforchb.com/2018/01/the-2017-tax-act-other-pass-through-tax-provisions-part-i/

[8] It should be noted that existing indebtedness is not grandfathered under the new limitation for deducting interest.

[9] If the employee’s right to the stock is unvested at the time the stock is transferred to the employee, the employee may elect, within 30 days of transfer, to recognize income in the taxable year of transfer (a “section 83(b)” election). If the election is made, the amount of compensatory income is capped at the amount equal to the FMV of the stock as of the date of transfer (less any amount paid for the stock).

[10] A section 83(b) election does not apply to the grant of options by a closely held corporation. Moreover, under Sec. 409A of the Code, the exercise price of a nonqualified option cannot be less than the FMV of the underlying stock at the time the option is granted; otherwise, any spread may be includible in the employee’s income.

[11] Though doing so also defers the start of their holding period for the stock.

[12] Query whether this adds anything to the benefit provided under Sec. 83(b) for a stock in a presumably little-to-no-value start-up corporation.

[13] Except for family, basically the employees to whom such stock or options have traditionally been granted.

[14] Like the tax pun there? “Realize” and “recognize.”

[15] Perhaps – at least where the S-corp is not planning a sale of its business or is not in the habit of making regular distributions to shareholders. Before the Act, a non-materially-participating shareholder of an S-corp faced a tax of 43.4% (39.6% + 3.8%) on his pro rata share of the corporation’s income vs. a maximum C-corp tax rate of 35%; after the Act, the comparison is between 40.8% (37% + 3.8%) and 21%.

[16] For example, by arguing for the presence and sale of personal goodwill.

[17] For example, by removing its ability to receive a refund from those earlier years.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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