Spring 2018 issue of Horizons

For entities taxed as partnerships, the new pass-through deduction provides significant new tax benefits. Available to non-corporate partners, the 20% deduction is calculated on the lesser of taxable income or qualified business income (QBI). QBI is generally taxable income excluding most investment income and capital gains (or losses). The deduction is then limited to the greater of 50% of W-2 wages, or 25% of W-2 wages plus 2.5% of qualified tangible property. The deduction reduces individuals’ new top income tax rate from 37% to 29.6%. Taxpayers with pass-through income from specified service businesses (e.g. health, law and accounting) are not generally eligible for the deduction. These excluded businesses are currently broadly defined and the ultimate determination may be complex. Additionally, the benefits in a fund structure may be limited, as certain income will be investment income, and there are generally no W-2 wages at the fund level. The ultimate determination will depend on the pass- through structure. Corporation versus Partnership A winner can be difficult to determine. Looking again to the new tax rates, corporate income is set at an attractive 21% while individual rates, adjusted for the 20% pass-through deduction, are now at 29.6%. These percentages do not take into account the added complication that individual state taxes are deductible only up to $10,000, while corporations face no such limitation. At first pass, the 21% taxed corporation wins. That is until you remember that corporations have the double tax problem. Corporations pay income tax on their earnings and then distribute after-tax income as a dividend to their shareholders who pay another tax. The good news is these dividends are likely qualifying dividends taxed at a maximum capital gain rate of 20%. Add the two taxes together and you have an effective tax rate of 36.8% (We ignore the 3.8% net investment income tax for this discussion).

At second blush, the 29.6% pass-through partner wins. However, the structure of the fund, and the use of intervening blockers may negate some or all of these benefits. Ultimately, the choice of entity type will depend on several factors, including fund and holding structure, expectations about taxable income and cash-flow during the holding period, the likely form of sale (stock vs assets) and expectations about future changes in corporate and individual income tax rates. Deemed asset acquisitions (e.g. section 338(h)(10)) will continue to be attractive to buyers, and potentially more so, due to provisions that allow for the immediate expensing of qualified tangible property, including used items. The additional tax benefits to the buyer will need to be continuously modeled against the additional tax expense to sellers in asset and deemed asset acquisitions. If a stock sale does occur, and because most buyers prefer to purchase assets, a buyer is likely to negotiate a lower purchase price for a stock sale. But the reduced tax bite of a stock-only sale, when compared to the double tax incurred in an asset sale, may be enough to overcome the reduced purchase price, particularly if that stock meets the definition of “qualified small business stock” under code section 1202. Section 1202 says that once the corporate stock is held for five years, non-corporate owners may exclude 100% of the gain from taxable income. The headline to the Act may, for some, be the reduction in the corporate federal tax rate from 35 % to 21 %.

Spring 2018

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