Dave Cain: Welcome to unsuitable on Rea Radio. The award-winning financial services and advisory podcast that challenges your old school business practices in their traditional business suit culture. Our guests are industry professionals and experts who will challenge you to think about the suit and tie while offering you many full modern solutions to help enhance your company’s growth. I’m your host Dave Cain.
On the last episode of unsuitable, we learned about some of the general implications business owners are going to face as the result of the tax cut and jobs act. On today’s episode, which is also part two of our tax reform miniseries for business owners, we’re going to learn a little more about the tax reductions and deductions. Owners of C Corporations and flow through entities have been left to consider.
Chris Axene, a principal at Rea & Associates and tax planning specialist is back to talk about the flow through business income deduction in the new 21% C Corp tax rate, and whether or not business owners should reconsider their choice of entity. Welcome back to unsuitable Chris.
Chris Axene: Dave, thanks for having me back. This is a topic that I’m really passionate about so I’m glad to be here today.
Dave: You know, in preparation for this, I found an article that you wrote back in, I believe it was in 2010. It’s still pretty much applicable to the topic at hand, maybe even more os.
Chris: Sure. Choice of entity, it never goes out of style and in fact, we did a podcast earlier in the year about the topic as well. It’s always timely and relevant and not unlike an annual physical, choice of entity is something you should look at periodically to make sure that it’s still, what you have is relevant for where you are in your business.
Dave: Lets get a couple definitions out of the way before we start. You and I talk in this tax lingo and we use the term flow-through entity. Let’s define what a flow-through entity is.
Chris: Sure. A flow-through entity is an entity that can either be an S Corp, a partnership, or I suppose you could also call a sole proprietorship a flow-through entity. And what the flow through entity part of it means is that the income flows through the entities books and it gets ultimately reported in the tax paid on the individual owners’ personal tax return.
Dave: So one of the things we’re going to talk about, or the main thing we’re going to talk about today is we fielded many calls, emails, and there’s been a lot written in various publications that you may be flirting with the idea of converting an existence flow-through entity like an S Corp or LLC, to a C Corp by certain deadlines. There seems to be a rush and some excitement about maybe doing that and I think you’re throwing a little bit of caution in the wind, and that’s what we want to talk about today.
So the first thing is, lets talk about a manageable tax rate. We hear the term more manageable tax rate. What in the heck does that mean?
Chris: That’s a good question. I don’t know what a more manageable tax rate means. In terms of the conversation I think in the press with regard to business in come, when you have C Corps at 21% but you have businesses that aren’t operated as a C Corp, they’re operated in a flow through structure, their tax rate isn’t the same. So you could have a manufacturing business that is either organized as a C-Corporation, same business instead of being organized as C, they chose to be an S-Corporation and they have to different rates of tax. And I think philosophically, the question is that the right answer.
Dave: Right, right. So, bottom line there is if my personal income tax rate is above the 21%, I might consider, in this discussion, is run out, convert everything to a C to take advantage of that more manageable 21%.
Chris: Right, so. That’s right. C-Corps, they’re all the rage and a lack of complete and full transparency in the market place, you’re purely reacting to the sole fact that C-Corps pay tax at 21% and flow through entities, if they’re eligible for the deduction, would pay tax at a maximum of 29.6, so you have a higher tax right at the individual level and so let’s save some dollars.
Dave: You know, I’ve heard you speak with clients and our internal tax huddle meetings, you use the term or phrase, observe the forest through the trees.
Chris: Yeah, so don’t get caught up in 21% rate where there’s other factors that need to go into this analysis and this conversation with our clients. And the reason they come to us as valued and trusted advisors is they know that we’re going to clue them in on to the entire picture and not let them stay focused on only one small part of it that another way to say that is, we’re not going to allow them to save a dollar today and pay five dollars tomorrow because they made the wrong decision.
Dave: You know really, what you’ve been preaching is that yes, switching to a C and 21% bracket certainly may be a short term benefit, but then again you have to weigh it against some of the long term detriment that we’re going to talk about here in a minute. You use the term, and we hear, double taxation. I think you use the word, two layers of taxation and that’s where I think C-Corps, where this gets a little bit off the rails. But let’s talk about two layers of taxation and what does that mean?
Chris: C Corporation, so unlike a flow through where the income passes through and is reported and paid on the individual’s personal tax return, a C Corporation is a tax payer itself. It pays tax and files a tax return on its own and pays taxes at 21%. Because of our tax structure that we have thanks to the 86 Reform Act, which is the last time we had significant tax reform.
Dave: That was Reagan. I was practicing then, were you?
Chris: I was a baby in diapers when you were practicing, so I wasn’t around for that act as CPA, but that was the last time we had significant tax reform and part of those changes were in the C Corp world, the entity pays taxes on a dollar profit at it’s level, and then if it distributes that profit out to the shareholders in the form of a dividend, those shareholders are going to pay taxes again at dividend rates on their personal return, and a dividends isn’t deductible to the company. So that’s where the two layers of tax come in.
Dave: Right.
Chris: You have one at 21% inside the corp and then you have another one at as high as 23.8% on the residual coming out on the individual’s tax return.
Dave: And that’s always been the case in the discussion between C corporation and flow through, but again, what you said earlier, observe the forest through the trees. This is one of those hidden things that may come back to haunt you.
Chris: Right, so that gets lots in the conversation of all the bright lights are on a low tax rate. But if you’re distributing out all of your profits currently and you change to C and you continue to distribute all your profits, you’re going to end up paying a tax rate higher than if you just stayed as a flow through entity.
Dave: You know, if you and I sat down for a planning meeting and we looked out for the next two, three, and five years, and I shared with you that what I want to do with my profits is I want to reinvest the profits for success and keep them within the company. Would that be a situation where we might look at conversion to a C corporation?
Chris: Yeah, that certainly is one factor that could be a check in the plus column for the C-Corporation, so in essence, you’re taking away that second layer of tax because you’re reinvesting those profits and you’re more, less deferring that to a point in the future and so, implicit in that conversation is the owner or owners are still taking out a reasonable compensation under either structure as flow through or a C Corp, so that part hasn’t changed. They’re getting what they need out of the business that way.
In the profits, they’re retaining and so really the nuance starts to come into play where, in a flow through entity, you’re taxed on the profits whether you distribute them out or not. In a C Corp, at the maximum individual rate, in a C Corp, you’re going to pay taxes at 21% and if you don’t distribute that out, that’s all you pay currently. So there is a difference there and that’s why it’s a benefit. There’s also, in Ohio, for Ohio clients, Ohio does not have an income tax on C Corporations. They do tax the business income of individuals and that’s more or less a three percent tax savings.
Dave: And there, you bring up another point that’s missed, has been missed, in a lot of circles is that these are federal tax cuts but you’ve got to look at this state and local issues too because those rates and polices maybe changing accordingly.
Chris: Yeah, to go back to your metaphor, the 21% tax rate trees is a pretty nice sized looking tree, but there’s an entire force behind it that if you don’t have a competent advisor advising you on and helping you understand the impact of the rest of it, you’re going to miss the bigger prize, I think.
Dave: So if I’m a C and I decide that I want to retain the profits within the business and keep those profits in, does that increase my basis in my company?
Chris: In the C-Corp world it does not, so you don’t get any credit, if you will, for retaining the profits in that regard, and so that can have a detriment down the road. And so you bring up, again, and your point is well taken because lots of things go into this conversation and with the business owner. This is a decision that shouldn’t be made lightly and you have to arm yourself with all the facts and make a well reasoned decision ultimately.
Dave: I’m looking for some free tax advice in our normal day to day, when I have a client issue and I come to you, you charge my clients, so I think i get some free tax advice here coming. I got an idea I want to run by you.
Chris: All right, shoot.
Dave: Okay. 2018, my budgeted net income is through the roof. I had a lot of things that are going to hit. My profit is just going to be fantastic, best year ever. I’m going to switch to a C corporation, take advantage of that 21% and then in 2019, I’m going to flip flop back to an S Corporation, because I love my S corporation. So I’m just going to flip flop after this next year. What do you think? So free advice?
Chris: So I will give you some valuable advice to say that you’re not going to get what you think you’re going to get, particularly when you’re in S Corp and if you elect to be a C Corp, then you have to wait five years before you can go back to an S, if that’s what you wanted to do. Again, it serves to reiterate that these things, these decisions have consequences and you can’t just willy-nilly, as you say, flip flop back and forth one year versus the next.
Dave: So flip flopping is not an option or a plan.
Chris: That’s not a good tax planning strategy.
Dave: Now I thought I was on to something. So accounting methods, there’s some new rules regarding some accounting methods in the tax change, the tax changes. Talk to me about a little bit of accounting methods and how accounting method could trigger tax liability. Accounting method change.
Chris: Yeah, so C Corporations have a limitation on the ability to use cash versus accrual versus other flow through entities, and of course on a prior episode last week, we talked about the 25 million dollar threshold for small business and underneath that, you could use the cash method of accounting, regardless of what entity type you are. But if you happen to be in an industry that currently allows cash method of accounting, because you don’t have inventory, that’s what the primary reason why you have to go to accrual, and you switch to see C corp and you’re above that 25 million dollars, well now you have to change from cash to accrual. So again, consequences of actions. Anybody can file a form and change what they are but the tax ramifications of doing that are real and to the uninitiated, it’s a trap for the unwary.
Dave: Was that in the small print in the tax reform act. Did I miss that?
Chris: What’s that?
Dave: What you just talked about. About the accounting method change could trigger liabilities. I never read that.
Chris: Well, that’s the value of the CPA.
Dave: The planning.
Chris: Yeah, lot of traps. It’s easier to be a planner than it is to be a fixer.
Dave: You know in my flow through entity, my LLC or S Corporation, I’ve worked years and years on this. I’ve got a lot of good will, lot of intangible build up in certainly looking at that 21% tax rate to switch to C Corporation but I’ve got this good will and it’s a big, big number. What advice would you give to me if I’m thinking about switching my flow through to a C corporation.
Chris: Yeah, so inherent in this is the factors, the stars algin, and it make sense to convert to a C Corporation and so as a part of that, what are some of the planning steps to move from the current flow through entity type, whether it’s a partnership or an S Corp, or even a sole proprietorship, to C Corp and then intangible aspect of that is what you’re getting at. The goodwill, the workforce in place, the reputation of the business, who does that belong to? Does that belong to the owner because of their efforts? I think of Colonel Sanders back in the day and going to the KFC because of him and his recipe.
Dave: Right.
Chris: Just as an example. So it’s identifying that ahead of the conversion to keep it out, because again, what we’re trying to do here is, this goes back to the C Corp, two layers of tax and on eventual sale of the business down the road, whether that’s five years, ten years or longer than that, is if we can keep cash out of the corporate vehicle, then we can keep it segregated from that two layers of tax. So we’re leaving it behind in the conversion process. And we have to identify those upfront, as a part of that. That’s the reason it’s a planning point if we’re going to convert.
Dave: I got another thought I want to run by you. I have, again, a very successful S Corporation I’ve elected in side the S Corporation, which is a pass through entity, to keep the earnings, keep the cash inside the business. Now I want to convert to a C Corporation. Can I still get those retained earnings in the S Corporation out after I converted. Does that make sense?
Chris: Sure. So under the old law, you had a limited window because what you’re getting as I mentioned earlier, in a flow through entity, you’re taxed on the profits, whether you actually distribute the cash or not. So that builds up in the S Corp example, something called the triple A account. So, that represents dollars that you already paid taxes on. The cash is sitting on the company and the S Corp, and so you can distribute that out at a later time, so called tax free because you’ve already paid the tax on it. Well if you convert to a C Corp, absent this provision, now you’ve kind of trapped those dollars, that pool of previously taxed dollars in the corporate vehicle, and you’ve already paid the money on it and if you absent this and you distribute it out as a dividend, then you pay tax again. So potentially, three layers of tax there. So we’ve always had a one year window in which to pull out the so called, previously taxed earnings out of the triple A pool after you convert to a C.
Under the new law, what’s happened there is they’ve done two things. One they’ve extended it out to a two year window, so they gave us a little longer period of time if the cash flow isn’t there in the company shortly after you’ve converted, or you need to keep it for working capital. So that was the kind of, I’m going to give you something but the take away, I’m going to take from you piece of that potentially is, with regard to whether or not that S Corp that we historically had at one point in time, prior to being an S Corp has been a C Corp in the beginning. And if it had earnings from when it was a C Corp, now we have to recoup some of those as we pay out dollars in this so called post transition period from moving from S to C. And the long and the short of it is those dollars, if we have the right set of facts that would result in some of those dollars being taxed as a dividends versus being return tax free.
Dave: Wow, that would be an expensive mistake. Could be.
Chris: It would be. It’s one of those things where you at least want to know ahead of time what’s in front of you versus having done it and then us having to deliver some bad news once we found out.
Dave: Let’s switch gears. Let’s say I’m a relatively new business, startup business, again things go on, I’m an LLC, love it. I’m a bit under water because I’m a new business but I’m going to be profitable. My forecast and protection show I’m going to be really profitable. I want to convert to the C Corporation, take advantage of the 21%. There’s got to be a downside to that selection.
Chris: Yeah, and this is another example of a trap waiting to be sprung. Again, you cannot, under the … the rules haven’t really changed in this regard. If you incorporate, it’s basically the term of art, we’re going to incorporate either or sole proprietorship or partnership, we’re going to change it to a C Corp, and is under water. So the balance sheet to liability is exceeding the assets. At the time of that conversion, there’s a tax on that difference. So it is the extent that the liabilities exceed the basis of the assets that you’re transferring. That triggers a real tax and you don’t have a transaction that generated any cash. All you did was file a form that said I want to move from being a sole proprietorship or a partnership to now I want to be a C Corp and IRS hand you a bill for tax dollars.
Dave: So that’s a deal breaker.
Chris: That’s an oops.
Dave: That’s an oops. So again, if we want to, there’s a lot of folks out there looking at taking advantage of this new shiny 2018 corporate tax rate that is permanent, as far as we know, and the time is running out to make the election. I believe it’s either March or April to make that election to C, well maybe that’s not the thing to do this year. I think it’s stop, drop and roll and do some heavy analysis.
Chris: Right, so there’s a limited window to have retroactive effect for your conversion. So the period you’re referring to is there’s a 75 window so if we wanted to change our entity type to a C Corporation effective 1/1 of 18, we would need to make that election no later than 75 days, more or less March 15th of this year. The tax law just passed. There’s additional guidance we need from the IRS that might have an impact on our decision to change and so for those reasons, my advice to my clients and the people that I talk to is, let’s not get hasty and feel like we have to be rushed to make an election for 2018.
In my mind, the worst thing that can happen is, let’s wait a year and, yeah, we’re not getting the benefit of 21% tax rate for 18 but let’s take the time to do the right analysis to educate and arm the client, the business owner with data points so that they can make an informed decision and then do it in 19. I think we’ll all be far better served by doing that versus to rush to a judgment now and then hope we made the right one, and if we didn’t then, we’re stuck.
Dave: You know, the good news is there’s a lot of great options out there for business owners as we sit here today and that’s really kind of neat to look at that going forward. But as you said, there’s a tremendous amount, and I don’t want to use just tax planning, it’s business planning, it’s succession planning, it’s family planning, it’s employee planning, it’s all of the above that goes into the equation. Let’s not let that shiny 2018 tax rate blind our decision. We have work to do.
Chris: Here’s something else too, that comes into play in terms of choice of entity and as the year progresses and we continue to read what’s in the law and get guidance from the IRS, they’ll be other, perhaps moments of epiphany that we have to help advise our clients but, one of the other areas is while we may not want to elect to be C Corp, perhaps if we’re currently in a partnership context. We do business as a partnership and it’s the really, only the partners are the ones that do the work, they’re the only one involved in the business, there might be some planning to consider in terms of choice of entity to take advantage of the flow through deduction that is available, that if, again, if they have the right set of facts, they may not be able to take advantage in their current from as a partnership that if we convert to an S, they could.
Dave: Our guest today has been Chris Axene with Rea & Associates. This guy know his tax stuff without a doubt. I think I’m going to take you out to a Blue Jackets game and write that off and get some free information. Oh wait, we can’t do that can we?
Chris: You can do it and as long as you buy be a hot dog and a pop, we’ll go for it.
Dave: Throughout this tax reform miniseries, you’ve heard us say a lot about the importance of planning and gathering expert advice and insight before making a major decisions, particularly if you have potential financial implications. Obviously, the tax cuts and job act has provided us with a lot of unknowns. I urge everybody listening to give your CPA a call to determine your own next steps. In the meantime, be sure to check out part one of our tax reform mini series for business owners. We’ve also included a lot of great insight on our website. Check out our tax reform research center at www.reacpa.com/taxreform. Finally, be sure to subscribe to unsuitable on iTunes or follow Rea & Associates on social media using the #ReaRadio for any tax reform developments. Until next time, I’m Dave Cain encouraging you to loosen up your tie and think outside the box.
Disclaimer: The views expressed on unsuitable on Rea Radio are our own and do not necessarily reflect the view of Rea & Associates. The podcast is for informational and educational purposes only and is not intended to replace the professional advice you would receive elsewhere. Consult with a trusted advisor about your unique situation so they can expertly guide you to the best solution for your specific circumstance.