Choice Of Entity

<p>The federal gift tax is an excise tax on the right to transfer property during life.<a href="#_ftn1" name="_ftnref1">¹</a> The donor is generally responsible for paying the gift tax. The payment of the gift tax by the donor is not treated as a gift. The gift tax is a cumulative tax and the tax rates are progressive. Gifts made in prior years are taken into account in computing the tax on gifts made in the current year with the result that later gifts are usually taxed in a higher bracket than earlier gifts (a drop in tax rates could obviate this result). Moreover, the tax is a <em>unified</em> tax; the same tax that is imposed on taxable gifts is imposed on taxable estates. The maximum gift tax rate for 2011 and 2012 was 35 percent. Under the American Taxpayer Relief Act of 2013, the top estate and gift tax rate increased to 40 percent, and the exclusion amount was set at the $5 million level, as indexed for inflation annually to $5.49 million in 2017. The 2017 Tax Act raised the exemption amount to $11.18 million in 2018, $11.4 million in 2019, $11.58 million in 2020, $11.7 million for 2021, $12.06 million for 2022, $12.92 million for 2023 and $13.61 in 2024.<a href="#_ftn2" name="_ftnref2">²</a><br /> <br /> A gift tax return (Form 709), if required, must generally be filed by April 15 of the year following the year in which the gift was made. A six-month extension for filing is available. Tax is generally due by April 15, but certain extensions for payment may be available. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="915">915</a>.<br /> <br /> The Federal Gift Tax Worksheet, below, shows the steps for calculating the gift tax. Calculation starts with determining what constitutes a gift for gift tax purposes (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="893">893</a>). In general, gifts include gratuitous transfers of all kinds. Two spouses can elect to have all gifts made by either spouse during the year treated as made one-half by each spouse ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="904">904</a>). A qualified disclaimer is not treated as a gift ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="895">895</a>).<br /> <br /> Gifts are generally valued at fair market value on the date of the gift ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="916">916</a>). Special rules apply for a wide variety of investments and to net gifts ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="900">900</a>), and Chapter 14 special valuation rules apply to transfers to family members of certain interests in corporations, partnerships, or trusts ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="934">934</a>).<br /> <br /> Several exclusions are available. A $18,000 in 2024 ($17,000 in 2023, $16,000 in 2022, and $15,000 in 2018021<a href="#_ftn3" name="_ftnref3">³</a>) annual exclusion is available for present interest gifts on a per donor/donee basis. An unlimited exclusion is available for qualified transfers for educational and medical purposes. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="905">905</a>.<br /> <br /> Several deductions are also available. Unlimited marital ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="912">912</a>) and charitable ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="913">913</a>) deductions are available for certain transfers to the donor&rsquo;s spouse and to charities.<br /> <br /> The amount of taxable gifts subject to the federal gift tax equals gifts made during the year reduced by all exclusions and deductions.<br /> <br /> The federal gift tax is imposed on taxable gifts. As discussed above, the federal gift tax rates are generally progressive and the tax is based on cumulative taxable transfers during lifetime. To implement this, the tax is calculated on total taxable gifts, the sum of the taxable gifts made during the year (current taxable gifts) and prior taxable gifts, and the gift tax that would have been payable on prior taxable gifts (using the current tax rates) is then subtracted out. 2010 TRA provided that the amount of the unified credit is computed taking into account the credit for prior years&rsquo; gifts using the gift tax rate for the current gift to determine the tentative tax.<a href="#_ftn4" name="_ftnref4">⁴</a> Thus, a donor can make gifts equal to the applicable exemption amount (see above) and prior taxable gifts without incurring a gift tax liability.<br /> <br /> <hr><strong>Planning Point:</strong><p> A gift made after August5, 1997 cannot be revalued if the gift was adequately disclosed on a gift tax return and the gift tax statute of limitations (generally, three years from the date of filing) has passed.<a href="#_ftn5" name="_ftnref5">⁵</a> Consider filing gift tax returns even for non-cash annual exclusion gifts.<br /> <br /> </p><hr><p><br /> <br /> The tentative tax is then reduced by the unified credit ( Q <a href="javascript:void(0)" class="accordion-cross-reference" id="914">914</a>) to produce gift tax payable.<br /> </p><table align="center"><br /> <tbody><br /> <tr><br /> <td style="text-align: center" colspan="3" width="539"><strong>Federal Gift Tax Worksheet</strong></td><br /> </tr><br /> <tr><br /> <td width="269">Current Year</td><br /> <td width="135"></td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135"></td><br /> </tr><br /> <tr><br /> <td width="269">Current Gifts</td><br /> <td width="135"></td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135"> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="893">893</a></td><br /> </tr><br /> <tr><br /> <td width="269">&ndash; Annual Exclusions</td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135"> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="905">905</a></td><br /> <td width="135"></td><br /> </tr><br /> <tr><br /> <td width="269">&ndash; Qualified Transfers Exclusion</td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135"> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="905">905</a></td><br /> <td width="135"></td><br /> </tr><br /> <tr><br /> <td width="269">&ndash; Marital Deduction</td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135"> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="912">912</a></td><br /> <td width="135"></td><br /> </tr><br /> <tr><br /> <td width="269">&ndash; Charitable Deduction</td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135"> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="913">913</a></td><br /> <td width="135"></td><br /> </tr><br /> <tr><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="269">&ndash; Total Reductions</td><br /> <td width="135"></td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135"></td><br /> </tr><br /> <tr><br /> <td width="269">Current Taxable Gifts</td><br /> <td width="135"></td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135"></td><br /> </tr><br /> <tr><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="269">+ Prior Taxable Gifts</td><br /> <td width="135"></td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135"></td><br /> </tr><br /> <tr><br /> <td width="269">Total Taxable Gifts</td><br /> <td width="135"></td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135"></td><br /> </tr><br /> <tr><br /> <td width="269">Tax on Total Taxable Gifts</td><br /> <td width="135"></td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135">Appendix D</td><br /> </tr><br /> <tr><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="269">&ndash; Tax on Prior Taxable Gifts</td><br /> <td width="135"></td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135">Appendix D</td><br /> </tr><br /> <tr><br /> <td width="269">Tentative Tax</td><br /> <td width="135"></td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135">Appendix D</td><br /> </tr><br /> <tr><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="269">&ndash; Unified Credit</td><br /> <td width="135"></td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135"> Q <a href="javascript:void(0)" class="accordion-cross-reference" id="914">914</a></td><br /> </tr><br /> <tr><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="269">Federal Gift Tax</td><br /> <td width="135"></td><br /> <td style="width: 110.7pt;border-bottom: solid windowtext 0.5pt;padding: 0pt 5.4pt 0pt 5.4pt" width="135"></td><br /> </tr><br /> </tbody><br /> </table><hr align="left" size="1" width="33%"><a href="#_ftnref1" name="_ftn1">1</a><p>. IRC &sect; 2501.<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>. American Taxpayer Relief Act of 2012, Pub. Law No. 11240, &sect; 101; Rev. Proc. 2016-55, The 2017 Tax Act, Pub. Law. No. 115-97, Rev. Proc. 2018-18, Rev. Proc. 2018-57, Rev. Proc. 2019-44, Rev. Proc. 2020-45, Rev. Proc. 2021-45, Rev. Proc. 2022-38, Rev. Proc. 2023-34.<br /> <br /> <a href="#_ftnref3" name="_ftn3">3</a>. Rev. Proc. 2018-57, Rev Proc. 2019-44, Rev. Proc. 2020-45, Rev. Proc. 2021-45, Rev. Proc. 2022-38, Rev. Proc. 2023-34.<br /> <br /> <a href="#_ftnref4" name="_ftn4">4</a>. IRC Section2505(a).<br /> <br /> <a href="#_ftnref5" name="_ftn5">5</a>. IRC &sect; 6501(c)(9).</p></p><br />

<div class="Section1"><br /> <p class="PA">For many pass-through business owners, the choice of entity decision may be strongly impacted by whether the business intends to distribute most of its income to the owners each year (as many small businesses do). Regardless of the form the distribution takes, the double tax structure that arises in the C corporation context will often result in a C corporation generating a higher effective tax rate, depending upon the business owner&rsquo;s income tax bracket.</p><br /> <p class="PA">If a C corporation does not distribute most of its income, the accumulated earnings tax and personal holding company tax must be considered (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8960">8960</a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8961">8961</a>). Both taxes are designed to prevent a C corporation from stockpiling earnings within the corporate structure in order to avoid tax at the individual level. The 20 percentaccumulatedearningstax applies when the corporation accumulates earnings beyond the reasonable business needs of the corporation. The 20 percent personal holding company tax can also become important for closely held corporations that derive more than 60 percent of adjusted gross income from passive investments (such as dividends, interest and rent).</p><br /> <p class="PA">Businesses that would most likely benefit from C corporation structure after enactment of the 2017 tax reform legislation generally include capital-intensive businesses, such as a manufacturing company that has a legitimate business reason for leaving large amounts invested within the corporation (e.g., for purchasing and maintaining equipment).</p><br /> <br /> </div><br />

<div class="Section1"><br /> <p class="PA">Beyond the pure tax aspects, small business clients should be advised that tax laws have a tendency to change even when they are characterized as permanent. If the small business converts to C corporation status, problems can result if it turns out that the conversion was ill-advised or the rules change in the future. For example, once an S corporation converts to C corporation status, it cannot convert back to an S corporation for five years.</p><br /> <p class="PA">Further, if the owner does decide to convert back to an S corporation in the future, taxes on built-in gains may apply and issues surrounding accumulated earnings and profits arise.</p><br /> <p class="PA">Accounting issues can arise if the pass-through entity is required to change its accounting method as a result of the conversion. Under the new legislation, any accounting adjustments under IRC Section 481(a) that are required because of the conversion of an &ldquo;eligible terminated S corporation&rdquo; (such as changing from the cash to accrual method of accounting) must be taken into account ratably during the six tax years beginning with the year of the change. Eligible terminated S corporations are basically S corporations that convert within two years of the passage of the tax legislation, where the ownership structure remains the same. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9044">9044</a> to Q <a href="javascript:void(0)" class="accordion-cross-reference" id="9058">9058</a> for a more in-depth discussion of small business accounting issues post-reform.</p><br /> <br /> </div><br />

<div class="Section1"><br /> <br /> Under the 2017 tax reform legislation, C corporations are now subject to a flat 21 percent income tax rate at the entity level and pass-through business income is taxed at the individual level, where a maximum 37 percent rate now applies. While this seems simple on the surface, the true calculus post- tax reform is not nearly so straightforward.C corporation income must eventually be distributed by the corporation to its owners, where it is then taxed a second time, at the individual level. If the income is salary, the maximum 37 percent ordinary income tax rate may apply, but the corporation may deduct the payment. If the distribution comes in the form of dividends, a maximum long-term capital gains rate of 23.8 percent (including net investment income tax) may apply and no deduction is permitted. This structure makes dividend distribution more appealing, but even the effective tax rate on dividends creeps up to 39.8 percent when the double tax is factored in. If a sale of the C corporation is contemplated, the double tax issue arises once again.<br /> <br /> Pass-through entities may be entitled to all or part of a new 20 percent deduction for qualified business income. The availability of this deduction depends upon the business&rsquo; annual income and the type of business in which the entity is engaged. Specified service trades or businesses can only take advantage of the full deduction if income is less than the annual threshold levels plus $50,000 ($100,000 for joint returns). The applicable threshold levels for 2024 are $383,900 (married filing jointly) or $191,950 (single filers); and for 2023 were $364,200 (married filing jointly) or $182,200 (single filers).<a href="#_ftn1" name="_ftnref1">¹</a><br /> <br /> Further, when the pass-through entity&rsquo;s income exceeds the thresholds (regardless of business type), the 20 percent deduction is capped at the greater of (1) 50 percent of W wage income or (2) the sum of 25 percent of the W wages of the business plus 2.5 percent of the unadjusted basis, immediately after acquisition, of all &ldquo;qualified property&rdquo; (basically, depreciable business property).<br /> <br /> Additionally, state-level taxes on corporate and pass-through (individual) income should also be included in the choice of entity analysis. See Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> for a discussion of the impact of the accumulated earnings tax and personal holding company tax on the choice of entity analysis. Some special considerations that can arise in the case of S corporations are discussed Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a> and Q <a href="javascript:void(0)" class="accordion-cross-reference" id=""></a>.<br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>. Rev. Proc. 2022-38, Rev. Proc. 2023-34.<br /> <br /> </div></div><br />

<div class="Section1">Sole proprietors and S corporations with only a single shareholder may wish to examine their choice of entity decisions to more fully take advantage of the Section 199A deduction for QBI (see Q <a href="javascript:void(0)" class="accordion-cross-reference" id="8931">8931</a>). Generally, reasonable compensation paid by an S corporation to its shareholder is included in the W wage limit and excluded from QBI.<a href="#_ftn1" name="_ftnref1">¹</a> A sole proprietor is not subject to similar requirements (the Section 199A proposed regulations make clear that the reasonable compensation rule applies only in the S corporation context).<a href="#_ftn2" name="_ftnref2">²</a>If the business&rsquo; income for the year exceeds the relevant threshold levels, these rules would maximize the QBI deduction if the business was organized as an S corporation. If income fell below the relevant thresholds, the sole proprietor would obtain the larger QBI deduction, as illustrated in the examples below.<br /> <p style="padding-left: 40px"><em>Example</em>: A sole proprietorship and S corporation with one shareholder each generate $500,000 in QBI for the year, and neither business has any qualified property. The S corporation shareholder pays himself reasonable compensation for the year of $100,000. The sole proprietor is not required to pay himself a wage. Both businesses are subject to the W and UBIA limitations because their income exceeds the relevant threshold levels. The S corporation&rsquo;s QBI deduction for the year is limited based on the statute&rsquo;s W limitation, so is limited to $50,000 (50 percent of W wages, i.e., the shareholder&rsquo;s reasonable compensation). The sole proprietor&rsquo;s QBI deduction (also phased out) is zero, because wages and UBIA both equaled zero.</p><br /> <p style="padding-left: 40px"><em>Example: </em>If each business described in the example above instead earned $100,000 (i.e., below the income thresholds), the W wage and UBIA limitations would not apply. Assume the S corporation shareholder paid himself $40,000 in reasonable compensation for the year. The sole proprietor&rsquo;s QBI deduction is $20,000 (simply 20 percent of $100,000). The S corporation shareholder must reduce his QBI for the year by the amount of reasonable compensation ($40,000) before calculating the deduction. Thus, his QBI deduction for the year is only $12,000.</p><br /> <br /> <div class="refs"><br /> <br /> <hr align="left" size="1" width="33%"><br /> <br /> <a href="#_ftnref1" name="_ftn1">1</a>.IRC &sect; 199A(c)(4)(A).<br /> <br /> <a href="#_ftnref2" name="_ftn2">2</a>.Prop. Treas. Reg. &sect; 1.199A-3(b)(2)(ii)(H).<br /> <br /> </div></div><br />