To C or not to C? – That Is the Question

Brooke Bodziner:

Hi, my name is Brooke Bodziner. I'm director here at EisnerAmper and I'm excited to be here today.

Jennifer Sklar:

Thanks, Brooke. So I was thinking that our audience might be interested in understanding some of the ways that we work with our clients to implement tax planning strategies to reduce their overall tax rate, given the fact that many of them operate in different foreign jurisdictions. So I think we're going to welcome the audience into a day in the life of Jen and Brooke in the international tax group at EisnerAmper. So everyone is always happy when you can help them save on their tax bill. So I have a new client scenario, so we'll go through the same analysis that we do with all of our new clients that come in. So I have a new client. She told me that owning a business is a scam.

Brooke Bodziner:

Oh.

Jennifer Sklar:

Yes. She says that she works for the government. She pays so much in taxes that she pays more to the government than she puts into her own bank account. So she's pretty much had it.

Brooke Bodziner:

Oh. Hmm. That is pretty terrible. But she's an excellent candidate of someone we might be able to help.

Jennifer Sklar:

That's true. So I haven't even told you what she does for a living yet. She owns an advertising business and she's extremely successful and she expects to sell her business in the near future for a lot of money. She built an algorithm and it is in very high demand. So she's going to be able to exit her business for a lot of money.

Brooke Bodziner:

So let me guess. When she founded her company as a startup, she forms a pass-through entity, didn't she?

Jennifer Sklar:

That is correct. She formed a limited liability company, which as everybody knows is generally the most tax efficient or at least was pre 2017 TCJA for a domestic or a US citizen or resident. So she's now an 85% owner of a partnership and she picks up about a million dollars in business profits on her personal tax return. She's at probably around a 39% tax rate effective tax rate and she lives in Texas, so there's not even a state tax there. So she really just wants to keep reinvesting the profits into the partnership, get as much value as she can so that when her and her partner sell, they'll get a big payout.

Brooke Bodziner:

They're not taking distributions are they?

Jennifer Sklar:

No. Nope. Just normal guaranteed payments.

Brooke Bodziner:

Corporations lose their tax efficiency when you add that second layer of tax and it's only going to be levied if there's distributions. But if they're not taking distributions with the 21% corporate tax rate, it's entirely possible that a corporation could be more tax efficient. I mean, I've seen a lot of businesses that are very successful building their business, reinvesting the profits, and when we do the analysis, the corporation blows the partnership out of the water.

Jennifer Sklar:

Does it help at all with the exit strategy?

Brooke Bodziner:

If you hold that C corp for five years or more, we could be looking at massive savings on exit on the capital gains.

Jennifer Sklar:

That is very true, good old 1202, which we are not getting into. A very significant domestic tax provision, but something that we always have to consider and bring in our domestic tax counterparts if that's something that's going to happen. But in this particular instance, she's got a lot of suitors and she's really looking to exit the business probably within the next couple of years. And I think the most important fact that I'm going to let you know is a lot of her business activities are from foreign unrelated parties. So she gets, most of her income actually comes from European customers.

Brooke Bodziner:

So do you think we can get this business to qualify for the FDII deduction?

Jennifer Sklar:

FDII means foreign derived intangible income, and essentially it was part of the 2017 TCJA package. It was one of the bright spots, one of the very few bright spots, and it actually provides a benefit to C corp taxpayers.

Brooke Bodziner:

That was a tough year of changes. It was a tough few years.

Jennifer Sklar:

We're still feeling the effect.

Brooke Bodziner:

Yeah. And we saw the implementation of the guilty tax, which was the current taxation of controlled foreign corporations earnings even if those corporations didn't make distributions to their owners. But we saw in the legislation that the intent was to create this carrot and stick regime between guilty and FDII to incentivize keeping IP within the United States. They wanted to create a special deductions, the FDII deduction for those companies that kept the important assets in the United States. But when it comes to FDII and guilty for that matter, I really don't like to say their full name because they're misnomers. They apply to all kinds of income, not just intangible income.

Jennifer Sklar:

You're right, and that's probably one of the biggest confusing points is that, I mean, I'm hoping that now because it's been a significant amount of years since it was enacted, that people are finally realizing that these types of provisions are not just for intangible income, but there is a concept of a return on tangible income that you have to consider when you're thinking about taking the FDII deduction regardless of whether the corporation is trying to claim the benefit from a sale of tangible property, a sale of goods, or a sale of services.

Brooke Bodziner:

That's true. As part of the FDII calculation, you have to have a qualifying income that's going to exceed this deemed tangible income return, which is a threshold that you need to have earnings in excess of in order to qualify for the special deduction.

Jennifer Sklar:

So there's a tangible income component?

Brooke Bodziner:

To this deduction, whether or not you're selling intangible services or you're selling tangible goods. You still have to look at your tangible fixed assets and figure out what this threshold is that you need to surpass.

Jennifer Sklar:

So sometimes the definition of tangible matters and sometimes it doesn't. Intangible versus tangible matters in the calculation, but not necessarily in how they actually decided to term the particular provision.

Brooke Bodziner:

Yeah.

It's really looking at how much investment in fixed assets the corporation has put into place in the US and what we're leveraging off of those assets to then make revenue that we could possibly be taxing at a preferential rate.

Jennifer Sklar:

Right. I mean, essentially the whole point, they want to keep businesses, the government wants to keep businesses operating in the US, they want substantial assets to be in the US. They want the roots of the companies to be in the US not to be in foreign jurisdictions where the revenue is earned and then not in the US tax net. So it makes perfect sense. So the special deduction, which is 37.5%, brings up corporate tax rate or could potentially bring a corporate tax rate down to like 13.125%. Do I have that right?

Brooke Bodziner:

You do, but I think it's important to say potentially bring it down because in order to have your effective tax rate be that low, you'd need a business to generate only qualifying foreign revenue and have no tangible fixed assets. So in practice, I've never seen anyone be able to pull that off, have you?

Jennifer Sklar:

No, I've never seen that, a rate that low, but there's no disputing that this is an absolute dream to have as a tool in our toolbox to get our taxes for our clients down.

Brooke Bodziner:

Oh, there's no argument there. And there is a sunset on that deduction rate. It's December of 2025, but it's only going down from 37.5% to 27.875%.

Jennifer Sklar:

So what would the ETR be on that if we had ideal facts and circumstances?

Brooke Bodziner:

It's 16.4 some decimal places out after that percent.

Jennifer Sklar:

16%. So it's still above the 15% mark, which is important considering the global focus on that 15%. But we're not getting into the OECD pillars one and two, so we're going to, I digress.

Brooke Bodziner:

But it's still a really good rate.

Jennifer Sklar:

It's still a really good rate. Okay. So back to foreign revenues. I suspect that they're all unrelated parties that she's working with, but obviously we need to confirm that.

Brooke Bodziner:

Wait though, what is she selling? Is she selling licenses to the algorithm or the software for the algorithm or is she selling a service of some sort?

Jennifer Sklar:

So that's a good point and I think that we need to make sure that we understand if there's more than one type of revenue that she has, we'll have to make sure that we understand that. Obviously she's dealing with an intangible, so there's going to be licensing revenue here. I don't know if there's any corresponding service that may be a component to that. So if she sold a service to a related party, for example, that related party, as long as they don't sell back to the US, that service revenue should qualify as qualifying income.

Brooke Bodziner:

Okay. But for the license part, we'll just need to find out if she has the data to substantiate that it really is foreign customers. So basically just like the IP of where the license was downloaded, that it's overseas, that should be good enough to meet the rules for substantiation.

Jennifer Sklar:

Yeah, I think that that's probably an easier case than when we're dealing with services. There's latitude in terms of figuring out who the actual end user is and whether they're in a foreign jurisdiction or not. So we should model this out for her and her partners so they can see what this is going to look like. Right. As we do with all of our clients, we have our wonderful Excel spreadsheet where we take into account all the different assumptions, alternatives, and we model everything out. We layer on different facts and we figure out what the best most tax efficient structure would be. We'll show partnership tax consequences versus corporate tax consequences side by side. And we'll be able to just be able to tell, the numbers will tell us,

Brooke Bodziner:

Yeah.

Jennifer Sklar:

The best way to go.

Brooke Bodziner:

Absolutely. And I'll make sure to account for the change in the treatment of the guaranteed payments. They'll become salaries for the corporate structure for her and her partners. And not only will we get a deduction for those salaries, but the payroll taxes will be deductible by the corporation.

Jennifer Sklar:

Right. So we've got some in addition to the benefits of the international tax provision of FDII, we've obviously got the benefit of the domestic tax rate changing to 21%. And then we've just got our basic deductions that a corporation gets, which obviously continue on. So we're also going to need a trial balance.

Brooke Bodziner:

Yes. And we should talk to her about the expenses. We will want to know if there's any expenses that are directly related to only generating foreign revenue. Perhaps there are trade shows that are overseas and the only benefit of attending those trade shows is getting foreign customers. Similarly, expenses that only relate to US source revenue. We'd want to know about those because the allocation and apportionment of expenses amongst the foreign deduction, eligible income and the non deduction eligible income are extremely important to this overall calculation.

Jennifer Sklar:

Yeah. So in our world of international tax, as we know, allocation and apportionment is always important, whether it's for the purposes of FDII, whether it's for the purposes of foreign tax credits, whatever it may be, it's something we always have to focus on. So no different here. And of course I want to be on that call to help you get all the facts together. I can tell you that there's no debt, so we don't have to worry about allocating interest expense, which as we know is a whole animal of its own.

Brooke Bodziner:

Yes, and that's music to my ears. Love to just cross that one off. And so what about the change in the entity type? I mean are we going to be able to do that tax-free?

Jennifer Sklar:

Well, as we always do in all of our models, we're going to have to address that. But generally speaking, assuming that the assets of the partnership exceed the liabilities, we're not going to have a taxable event on the conversion to a C corp. But that's obviously something that we need to consider and we could potentially have a cost, but it could still be significantly less than the benefit of continual savings every year. So it's another part of the analysis.

Brooke Bodziner:

So we're going to use a check the box election, which is a US tax fiction.

Jennifer Sklar:

Correct.

Brooke Bodziner:

And this election deems the partnership to contribute all of its assets and liabilities to a new corporation in exchange for stock in the new corporation.

Jennifer Sklar:

That's correct.

Brooke Bodziner:

And that is a section 351 transaction, which is a tax-free cash or assets for stock transaction.

Jennifer Sklar:

That is correct. So as long as it will be a good section 351, as long as the, while it'll still be a good 351, even if liabilities exceed assets, it doesn't bust the 351. It essentially just gives you what we call in corporate tax world boot. So any excess liabilities over assets will be treated as income, but it doesn't bust the 351.

Brooke Bodziner:

Right. I can always bust the 351 by losing the ownership.

Jennifer Sklar:

Well, there's a few ways you could do it, but that is one way to do it.

Brooke Bodziner:

Okay.

Jennifer Sklar:

And here we've got at least 80%, so we're good.

Brooke Bodziner:

And then the partnership, now they own stock in the new corporation. So they're going to be deemed to liquidate by distributing the stock to their partners. And now the partners they own stock in this new corporation and their cost basis is their capital accounts from the partnership. Right.

Jennifer Sklar:

It's a transferred basis, which is essentially the case whenever you have something that's tax-free, you have to take a carryover or transfer basis so that any built-in gain is recognized at some future time. So you get tax-free now, but you have to hold onto any built-in gain that potentially is there prior to the transaction. So the liquidation should also be under subchapter K partnership rules. The liquidation should also be tax-free as well.

Brooke Bodziner:

And we can make the selection retroactively.

Jennifer Sklar:

Yep. As long as we haven't filed the tax return for the year, we should be good to go. We can do a retroactive election to the beginning of the year.

Brooke Bodziner:

That's really easy. It's so much easier than having to have an attorney put together articles of incorporation for an entirely new corporation.

Jennifer Sklar:

I agree. That's much more costly for a client to create an actual C corp than it is to check the box and just have it taxed as C corp for tax purposes. So if only everything we did was this simple.

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