The coronavirus (COVID-19) pandemic has resulted in significant public market losses. Private company values also may be depressed. Tax planning during this time for both businesses and individuals may provide long-term benefits when valuations rise again.
The 2017 Tax Cuts and Jobs Act reinvigorated the debate as to whether to operate in corporate or partnership (including limited liability company taxed-as-partnership) form. For corporations, the Act lowered the federal tax rate to 21 percent and repealed the alternative minimum tax, but reduced the benefit of net operating losses (NOLs) through the rate reduction, new limitations on the use of NOLs against future income, and the elimination of NOL carrybacks. Certain “qualified business income” of partnerships became partially deductible, but partners who are individuals face new limitations on the ability to deduct state and local taxes. These changes layer on top of the classic corporation-partnership tax dichotomy: Corporate earnings are taxed twice (at the corporate level and again at the shareholder level upon distribution) whereas partnership earnings are taxed once at the partner level. The result is a more nuanced choice-of-entity analysis based on projected income and cash flow use.
Even if a corporation wishes to operate in partnership (or LLC) form (via conversion, merger or otherwise), the two levels of tax imposed on corporations often serve as a threshold impediment. Moving from corporate to partnership form is considered a deemed tax liquidation event: The corporation is taxed on any appreciation built into its assets, and its shareholders are taxed to an extent on the deemed liquidating distribution.
Conversion to partnership. A planning opportunity arises when valuations are reduced because the lower the value ascribed to a corporation’s assets at the time of moving to partnership form, the less corporate gain (if any) is generated on the deemed liquidation and less shareholder tax (if any) arises on any assets deemed distributed. Thus, the entity may be able to move to the partnership form if it so chooses at a relatively lower cost.
Conversion to an “S” corporation. Another planning opportunity arises with respect to businesses operating in “C” corporation form as they consider electing to operate in “S” corporation form, provided the change generally is tax-advantageous and the requisite S corporation criteria can be met (e.g., an S corporation can have only one class of stock for tax purposes and certain types and limitations on the number of shareholders). One significant advantage of S corporations is that they generally are subject only to one level of tax, like partnerships. An exception to this is the tax on corporate asset built-in gain at the time of conversion to S status. This gain generally is taxed at the corporate level if the asset is disposed of (or deemed disposed of in certain exit transactions) within five years of the conversion. If a C corporation elects S status while valuations are depressed, this built-in gain can be reduced and thus result in a more tax-efficient near-term future exit.
Taxable spin offs. A planning opportunity may exist if a corporate parent wishes to dispose of a subsidiary but cannot do so under the tax-free spin-off provisions of the Internal Revenue Code. Distributing the stock of a subsidiary when value is low will reduce the corporate gain on such distribution as well as tax on the distribution to stockholders.
Converting the parent corporation to an LLC taxed as a partnership. If a corporate parent of a consolidated group converts to an LLC when valuations are low, the tax impact may be minimal, as described above. Then, when valuations rise, the parent could selectively dispose of one subsidiary, but not another, with only one level of tax. Countervailing factors to such conversion must be considered (e.g., loss of tax consolidation among the group and possible issues with cross-collateralization of debt by subsidiaries), but the exit benefit may prove substantial.
Recognizing capital losses. Individuals who have capital gains may consider exiting devalued investments to recognize capital losses. The losses could be used to offset other capital gains realized in the year to reduce the overall tax burden.
Gift tax planning. Gift tax generally is imposed on larger noncharitable gifts (i.e., noncharitable gifts in excess of $15,000 annually per donor per donee) that, in sum, exceed one’s lifetime exclusion (currently $11.58 million, scheduled to be reduced on January 1, 2026 to $5 million, adjusted for inflation). The current lower values present an opportunity to make gifts of property that is expected to appreciate substantially in the future and use less of the lifetime exclusion. This property also could be sold to family members at the current low values. Techniques such as the creation of a grantor retained annuity trust (GRAT), which benefit from depressed values and (the current) low interest rates also should be considered.
Converting to Roth IRAs. For individuals who are otherwise considering a conversion of their traditional IRA to a Roth IRA this year, the income tax recognition on such a conversion in a period of investment devaluation may result in a lower tax bill in the long run. This is because, in converting a traditional IRA to a Roth IRA, tax is imposed at the time of conversion on pre-tax amounts invested and any earnings; if the Roth holding period is then satisfied, distributions to the individual later are tax-free. If the individual’s traditional IRA investments are currently at a low point, and a Roth conversion makes sense for other reasons, converting now may result in tax on a lower amount. In the best case, the individual’s Roth IRA investments may significantly appreciate after the conversion.
The tax considerations discussed above are general in nature only and are not tax advice to any particular taxpayer. A particular entity or individual’s circumstances will affect the tax impact of planning. If you have further questions or would like to discuss specific facts, please contact Howard Goldberg(firstname.lastname@example.org) concerning business planning or Lisa Petkun (email@example.com) concerning individual planning.
The material in this publication was created as of the date set forth above and is based on laws, court decisions, administrative rulings and congressional materials that existed at that time, and should not be construed as legal advice or legal opinions on specific facts. The information in this publication is not intended to create, and the transmission and receipt of it does not constitute, a lawyer-client relationship.