Tax and Financial News January 2017
Reconsidering C Corporations
Once considered a last resort for entity choice, C corporations deserve reconsideration, especially surrounding the dreaded double taxation issue.
Double taxation refers to the two levels of taxation that C corporation income goes through. First, the income is taxed at the entity level and then again when the shareholder withdraws any earnings as a dividend. Current tax law puts the top corporate tax rate at 35 percent and the dividend rate at 23.8 percent, making quite a dent. Let’s take a look at an example.
Sample Corporation earns $1 million in income; it pays $350,000 (35 percent) at the corporate tax level, leaving $650,000. Then the sole shareholder takes the entire remaining amount as a dividend, paying another $154,700 in taxes at the individual level, leaving him with $495,300 – or only about 50 percent of the actual income.
So given this, why would anyone choose to operate as a C corporation? Well, for newly forming businesses, there might be two reasons: Section 1202 stock and President-Elect Trump’s tax plan.
Corporate Tax Reform Under Trump’s Plan
One of Trump’s signature campaign issues was his position that the 35 percent U.S. corporate tax rate is too high; he proposed dropping it to 15 percent. In combination with this tax cut, he also has proposed eliminating the 3.8 percent net investment income tax and lowering the top dividend rate to 20 percent. You can see the obvious difference before even running the numbers, but let’s look at our prior example to see exactly how this would shake out.
Trump’s plan passes, and Sample Corporation earns $1 million and now pays $150,000 (15 percent) at the corporate tax level, leaving $850,000. Then the sole shareholder takes the remaining amount as a dividend and pays another $170,000 in taxes at the individual level, leaving him with $680,000. Sound great? Well, we need to compare apples to apples. How do C corporations stack up if Trump also cuts the tax rate on S corporations and partnership income?
Trump’s campaign promise was to lower all business income taxes to the 15 percent rate, requiring a divergence from the current law no longer taxing partnerships and S corporations at individual tax rates as pass-through income. If this is the case, the member in an LLC or the shareholder in an S corporation would pay only $150,000 on the same $1 million in income that our C corporation shareholder paid under Trump’s new plan. In the end, this means there is still a tax rate spread of 17 percent (32 percent for C corporations versus 15 percent for partnerships and S corporations).
So even with Trump’s proposed changes, C corporations are still at a comparative disadvantage due to double taxation. What could make a difference? To answer that, we need to look at the treatment of Section 1202 stock.
Section 1202 Stock – What is It?
Qualified small business stock is a stock that meets three requirements. First, on the date it is issued, the issuing entity must be a domestic C corporation with total assets of $50 million or less. Second, the acquiring shareholder must acquire the stock directly from the C corporation, not from an existing shareholder. Third, the issuing C corporation must be an “active business.” (These three requirements are much more technical than this; however, the detail is beyond the scope and purpose of this article.)
Section 1202 Stock – How it makes a Difference
The magic happens when you combine the prospective Trump tax cuts with Section 1202 stock. It makes C corporation status an attractive consideration for newly formed entities. Shareholders in C corporations would still pay more in current taxes, but the long-term payoff when you sell can be huge. Let’s look at an example to illustrate.
Under the new tax structure, you set up Sample Corporation as a C corporation with $100,000 of cash and then sell the stock years down the road for $8 million. In this case, you could exclude the entire gain of $7.9 million from taxation at the 20 percent dividend rate, saving you $1.58 million.
If you had an S corporation instead and sold the same business for the same $8 million, you would pay the 20 percent tax on your $7.9 million gain (this assumes you distributed all of your earned income).
As you can see, when you combine the two elements, a C corporation would cost more up front but not as much in the end. So, keep your eyes and ears open to see what happens with corporate tax reform as it might change your decisions going forward.
General Business News January 2017
Business Leases: Essential Elements to Have (and Avoid)
Whether for a first-time commercial lease or if it’s time to move to a bigger and better building with a new business lease, understanding all of the elements in the contract can avoid a lot of potential problems down the road.
Types of Leases
An important, if not the most important, consideration is to understand the type of business lease you sign. Whether it’s a gross lease, a modified gross lease or a net lease, each one determines which party is responsible for specific expenses. A gross lease generally includes the cost of building maintenance, real estate taxes and insurance in the monthly rental fee. Under a modified gross lease, the tenant is usually responsible for expenses directly related to the unit such as maintenance, repairs and utilities, but the landlord covers taxes and insurance. Net leases vary, but common costs the lessee is responsible for often include monthly bills such as insurance, maintenance, utilities and property taxes.
Financial and Privacy Expectations
Unlike residential leases, a commercial lease may not provide as much protection for the lessee. For example, a business lease might not have a security deposit cap or protect the occupant’s privacy as well as a residential lease.
It also is important to learn how improving or modifying the leased building works, especially in reference to build-outs. Find out if custom modifications are permitted during construction and determine which party pays for and has ownership over these types of improvements. Read this section of the lease carefully to assess how fixture ownership works during the term of the lease and after it ends.
Long and Short Term Building Use Considerations
Coming to a meeting of the mind is essential before, during and after the lease term when it comes to transfers, subletting and dispute resolution. Investigate whether the lease can be assigned to another party during the its term or if unused office or manufacturing space can be subleased to a third party. Other concerns include how and where disputes will be settled – mediation versus arbitration versus court proceedings.
Another consideration for a lease is compliance with the American Disability Act (ADA). Businesses that open their doors to the public, along with many internal office environments, may be subject to ADA required modifications such as braille signs and wheelchair ramps. Specify how those modifications will be paid for, including the exact percentages for split expenses.
Understanding Your Rental Space and Signage Ability
Less commonly known, the space subject to lease is referred to as the demised premises. While individual terms vary, it often consists of the address to be leased, the site’s square footage and the physical locations within the building to be used (basement, office space, parking spaces, points of public access, etc.).
While this is only a start and each lease contract is unique, working with a real estate agent or broker and an attorney is the only way to ensure the right language is included in your next lease agreement.
Tip of the Month January 2017
Tip: New Provision Restores Health Plan Options
Small business owners struggling to find health plans for their staff and facing limited affordable options will welcome new provisions that again allow them access to health reimbursement arrangements (HRAs). Under the revised Qualified Small Employer Health Reimbursement Arrangements (QSEHRAs), small business owners with less than 50 full-time employees are no longer prevented from helping pay for individual employee’s health insurance through reimbursement arrangements. As of Jan. 1, 2017, the revision effectively restores an alternative that had been popular with the small business sector prior to the launch of the Affordable Care Act.
Small business owners again will be able to take advantage of these programs – now known as QSEHRAs – and the programs will be considered a part of their tax-advantaged employer contributions to employees. Prior to 2013, an HRA was a more cost-efficient alternative to group insurance programs for many small business owners. The fines levied against small employers who stuck with HRAs after the launch of ACA far exceeded penalties imposed for not offering health care coverage at all.
The Small Business Healthcare Relief Act is part of the 21st Century Cures Act – signed into law by President Obama on Dec. 13, 2016 – designed to address (at least in part) some unintended consequences of ACA. It overwrites specific ACA requirements and penalties, allowing small business enterprises that meet the following criteria to offer HRAs again:
- Fewer than 50 employees who work 130 hours per month or 30 plus hours a week for 120 consecutive days;
- No group health plan currently in place;
- Must be provided to all eligible employees under the same terms;
- Funds provided solely by the employer (no salary contributions);
- Employees to provide proof of coverage in order to receive payment for their (and their family members’) medical care expenses.
There are caps on the small business HRAs (QSEHRAs) that meet the law’s requirements. For a single employee, the maximum is $4,950, and for an employee with dependents, it is $10,000.
In order to prevent double-dipping, the law prohibits an employee from receiving both government subsidies to lower the cost of their health care insurance premium and funds through a tax-free QSEHRA. Employers and employees are required to file the appropriate IRS documentation.
This measure will help small business owners offer health coverage to their employees. It restores a previous option to employers who had preferred to offer HRAs before the ACA took the option away. However, choosing the right health insurance plan still remains a complicated task. Make sure you get sound advice from your insurance and tax experts to help you identify the best option for your business.