The Tax Cuts and Jobs Act (“TCJA”) that was signed into law in 2017, made forming a company and making an appropriate tax election a challenging decision, and the election results have made it even harder. While it looks like Biden is our new President, the Democrats have not taken control of the Senate, so getting new tax legislation passed seems unlikely, but you never know. New Companies who plan to be around for a long time need to make decisions today that will stand the test of time. If Democrats can win a few more seats in the 2022 Senate election, when 22 Republican seats out of 34 total are up for election, the likelihood of more tax law changes increases substantially.
C-Corporations, long considered the devil of double taxation, became more attractive with TCJA by lowering the tax rate to 21%, but Biden is proposing to raise that rate to 28%. Biden, however, is considering imposing a 12.4% Social Security tax on Wages over $400,000, and recharacterizing capital gains and dividends as ordinary income for taxpayers making over $1,000,000. These changes will make it harder to get money out of a C-Corporation on a tax efficient basis. For all of these reasons, I would put C-Corporations in the High-Risk category when forming a new corporation. In general, if you would have made a C-Corporation election before 2017, you may still want to make one now, because it hopefully won’t be any worse than the rules that were in place prior to TCJA.
S-Corporations also got a temporary boost from TCJA with a 20% Section 199A deduction for qualified business income (“QBI Deduction”), subject to lots of exceptions, but that expires in 2026. Assuming you can make an S-election (you have permitted and a limited number of shareholders), then an S-Election still makes a lot of sense for small businesses. That is especially true if Biden’s tax rules don’t take into account that many small business owners generally take a smaller salary for their efforts but make larger distributions of profits. While their salary is subject to Social Security and Medicare/Medicaid taxes, distributions of profit, are not. Normally, a taxpayer could escape the additional 12.4% Social Security tax on income over $400,000 (because they will continue to pay out profits as opposed to high salaries), but Biden is also proposing to phase out the QBI Deduction for any taxpayer making over $400,000. If the QBI Deduction survives until 2026 it could still provide some interim tax benefit for some S-Corporations. Active owners of an S-Corporation can also still enjoy the benefit of making distributions of profits free of the net investment tax that is otherwise imposed on passive income at a rate of 3.8%. Passive investors, however, will continue to pay that tax. All-in-all S-Corporations appear to have a much Lower Risk profile than C-Corporations.
Limited liability companies that default to partnership tax rules under Subchapter K, but which can also make elections to be “S” or “C” corporations, are likely to continue to be a popular start-up (or end up) vehicle for many entrepreneurs. While an S-Corporation may get you started and may provide some additional tax benefits early on, many S-Corporations come to an end when the business is sold to a private equity firm or when venture capital investors come to the table. Private equity and venture capital funds generally cannot be owners of an S-Corporation, so the tax status of an entity usually needs to change when these investors or owners take over. A popular F-Reorganization can convert an S-Corporation to a partnership for tax purposes which will permit PE and VC investors. Entities that are taxed as a partnership can also benefit from Section 199A deduction if they qualify which hopefully will remain in place until 2026. Perhaps the biggest downside to partnership taxation for active entrepreneurs is that their active earnings are subject to self-employment taxes at 12.4% up to the current social security maximum and unlimited Medicare/Medicaid taxes at 3.8%. Active entrepreneurs who expect to lose money early on, however, can continue to deduct losses from their business and offset other active business income. Investors are subject to passive loss limitations, but can offset passive losses with other passive income. I would put entities taxed as a partnership in the net Neutral Risk, but would be wary of the additional Social Security tax on self-employment income over $400,000.
Biden has also proposed including a 15% minimum tax on corporate “book income” which could be folded into existing alternative minimum tax calculations and would be similarly directed at corporations that file a return showing little taxable income as a result of very substantial deductions. Biden’s current version of the 15% AMT “book income” tax floor is proposed only for corporations reporting over $100 million of annual/fiscal period income.
A final point to ponder, is the impact that a Global Pandemic could have on our political system. Normally that would sound like something from a far-fetched Pundit who was looking for media headlines, but unfortunately, it’s our current reality. What if Covid-19 swept through the House or Senate and we lost several members of Congress? The Seventeenth Amendment to the Constitution allows state legislatures to empower the governor to appoint a Senate replacement to complete the term or to hold office until a special election can take place. Some states require a special election to fill a vacancy while others require the governor to appoint a replacement of the same political party as the previous incumbent. A House seat, on the other hand, generally requires a special election. All states, territories, and districts require special elections to fill any vacant House seats during the first session of a Congress. During the second session of a Congress, however, procedures often vary depending on the amount of time between the vacancy and the next general election. The law also provides that a state governor can cause a special election in extraordinary circumstances; namely, a crisis in which the number of House vacancies exceeds 100. Let’s hope that never happens.