If the Democrats Win
Science has not established – at least to my knowledge – any correlation between the pre-election year-end activities of individual business owners, on the one hand, and election outcomes, on the other.[i]
If the behavior of business owners were considered an accurate indicator of election results, then one may reasonably conclude – based upon my observations – that tomorrow’s general election will give Democrats not only the Presidency, but the Senate as well, while preserving their control of the House.
But what is the behavior to which I am referring, and why does it point in the direction of a Biden victory?
Over the last few weeks, many business owners – including several who, for years, deferred any estate planning – have suddenly become interested in making substantial gifts of interests in their business to family members or to trusts for their benefit, often up to the full amount of their remaining federal exemption, before the end of the year.
Other business owners, who are already in discussions to sell all or part of their business, are eager to complete their sale before the end of the year, while some are anxiously looking to dispose of real property this year as the first step in completing a deferred like-kind exchange of such property.
Why would business owners give up property even when their taxable estate is expected to fall below the current exemption amount, why would they choose to accelerate, rather than defer, the recognition of taxable gain from the sale of business interests, and why would others rush to start the 45-day identification period for replacement real property of like-kind to the property sold without having first investigated potential acquisition candidates?[ii]
The answer to each of these questions is pretty obvious: Mr. Biden’s tax plan; specifically, the proposed reduction of the Federal exemption amount by at least 50%, the proposed increase (almost doubling) of the income tax rate applicable to capital gain, and the proposed elimination of the like kind exchange for any taxpayer with more than $400,000 of annual income.[iii]
In order for these proposals to be enacted into law, the Democrats have to win the White House and the Senate (and hold on to the House), or they have to win the Senate while also securing a veto-proof majority in both chambers of Congress.[iv]
The effect of a Democratic Party victory will not be limited to the anticipated legislative changes that seem to be motivating the end-of-year transactions by business owners described above. Among the other important factors to be considered in the event of such a victory will be its effect upon the Federal corporate income tax rate, and the impact thereof upon a business owner’s “choice of entity” decision.
Prior to the enactment of the Tax Cuts and Jobs Act in 2017,[v] the maximum Federal income tax rate on corporations was 35%.[vi] The TCJA eliminated the graduated rate brackets applicable to corporations, and replaced them with a flat tax rate of 21%.[vii]
At the same time, the TCJA reduced the maximum Federal income tax rate for individual taxpayers from 39.6% to 37%.[viii]
In addition, the TCJA included a new deduction, intended to provide an income tax benefit to the individual owners of businesses that are operated as tax partnerships or S corporations. This deduction is based upon 20% of an individual taxpayer’s share of a partnership’s or S corporation’s qualified business income.[ix]
Surprisingly, Mr. Biden’s tax plan does not call for a return to the pre-TCJA corporate income tax rates.[x] Rather, it proposes an increase in the rate from 21% to 28% – basically, the midway point between the previous 35% rate and the current rate.[xi]
However, Mr. Biden’s plan does provide for a return to the pre-TCJA maximum income tax for individuals of 39.6%.[xii] It also proposes an increase, from 20% to 39.6%, in the Federal tax rate applicable to the long-term capital gains[xiii] and qualified dividends realized by individual taxpayers with gross income for the taxable year in excess of $1 million.[xiv]
Finally, under Mr. Biden’s plan, the “20% of qualified business income deduction” would be phased out for higher income taxpayers, such that the deduction will be maintained only for those making less than $400,000 during a taxable year.
Assume, in the immediate aftermath of a Democratic sweep, that our hypothetical taxpayer is an owner of a business entity (“Partnership”) that is treated as a partnership for tax purposes.[xv] Our taxpayer and most of their partners expect to be subject to a maximum Federal income tax rate of 39.6% on both their ordinary income, qualified dividends and long-term capital gains. It follows that they will not benefit from the 20% deduction for qualified business income.
How might our taxpayer and their partners respond to the sudden and adverse changes to the tax environment in which they do business?
Following the enactment of the TCJA and its reduction of the federal corporate income tax rate to a flat 21%, many taxpayers considered organizing new business entities as – or converting existing entities, out of which they were already operating their business, into – C corporations.
Although a 28% corporate tax rate, by itself, may not be enough to convince the individual owners of a partnership[xvi] to incorporate their business as a C corporation, the imposition of a 39.6% tax rate on any capital gain resulting from the taxable disposition of an interest in the business should cause them to consider such a conversion, especially where they may qualify to exclude from their gross income all of the gain from the sale of the corporation’s stock.
Qualified Small Business Stock
Under Section 1202 of the Code, a non-corporate taxpayer who holds “qualified small business stock” for more than five years[xvii] may be able to exclude the gain realized by the taxpayer from their sale or exchange of such stock (“eligible gain”).[xviii]
The excluded gain will not be subject to either the income tax or the surtax on net investment income; nor will the excluded gain be added back as a preference item for purposes of determining the taxpayer’s alternative minimum taxable income.[xix]
That being said, the amount of gain from the disposition of stock of a qualified corporation that is eligible for this exclusion is limited in that it cannot exceed the greater of:
- $10 million,[xx]reduced by the aggregate amount of eligible gain excluded from gross income by the taxpayer in prior taxable years and attributable to the disposition of stock issued by such corporation, or
- 10 times the aggregate adjusted bases of qualified small business stock issued by such corporation and disposed of by the taxpayer during the taxable year (with basis being determined by valuing any contributed property at fair market value at the date of contribution).[xxi]
This limitation notwithstanding, where the provision applies, a taxpayer may exclude a significant amount of gain from their gross income.[xxii]
Qualified Small Business Stock
In order for a taxpayer’s gains from the disposition of their shares in a corporation to qualify for the exclusion, the shares must have been acquired directly from the corporation – an original issuance, not a cross-purchase – in exchange for money or other property (not including stock), or as compensation for services provided to the corporation.[xxiii]
If property (other than money or stock) is transferred to a corporation in exchange for its stock,[xxiv] the basis of the stock received is treated as not less than the fair market value of the property exchanged. Thus, only gains that accrue after the transfer are eligible for the exclusion.[xxv]
The corporation must be a qualified small business as of the date of the original issuance of the stock to the taxpayer, and during substantially all of the period that the taxpayer holds the stock.[xxvi]
A “qualified small business” is a domestic C corporation[xxvii] that satisfies an “active business” requirement,[xxviii] and that does not own: (i) real property the value of which exceeds 10% of the value of its total assets, unless the real property is used in the active conduct of a qualified trade or business,[xxix] or (ii) portfolio stock or securities the value of which exceeds 10% of its total assets in excess of liabilities.
At least 80% (by value) of the corporation’s assets (including intangible assets) must be used by the corporation in the active conduct of one or more qualified trades or businesses.[xxx]
As of the date of issuance of the taxpayer’s stock, the excess of (i) the corporation’s gross assets (i.e., the sum of the cash and the aggregate adjusted bases of other property[xxxi] held by the corporation), without subtracting the corporation’s short-term indebtedness, over (ii) the aggregate amount of indebtedness of the corporation that does not have an original maturity date of more than one year, cannot exceed $50 million.[xxxii] For this purpose, amounts received in the issuance of stock are taken into account.
If a corporation satisfies the gross assets test as of the date of issuance, but subsequently exceeds the $50 million threshold, stock that otherwise constitutes qualified small business stock would not lose that characterization solely as a result of that subsequent event, but the corporation can never again issue stock that would qualify for the exclusion.
Pass-Through Entities as Shareholders
Before considering the conversion of a partnership into a corporation, it may be helpful to review how Section 1202 is applied to the gain realized by a shareholder that is itself a pass-through entity.
Gain from the disposition of qualified small business stock by a partnership or S corporation that is taken into account by a partner or shareholder of the pass-through entity is eligible for the exclusion, provided that (i) all eligibility requirements with respect to qualified small business stock are met, (ii) the stock was held by the pass-through entity for more than five years, and (iii) the partner or shareholder held their interest in the pass-through entity on the date the entity acquired its stock, and at all times thereafter and before the disposition of the stock.[xxxiii]
In addition, a partner or shareholder of a pass-through entity cannot exclude gain received from the entity to the extent that the partner’s or shareholder’s share of the entity’s gain exceeds the partner’s or shareholder’s interest in the entity at the time the entity acquired the sock.
It should be noted that any pre-conversion appreciation in the assets of the partnership’s business will not be eligible for the gain exclusion rule; only the appreciation realized after the incorporation will qualify.[xxxiv] Likewise, the required five-year holding period will not start until the conversion date.
Based on the foregoing, a partnership should be able to contribute its business assets to a newly formed corporation in exchange for all of the corporation’s stock. If a new investor is to join the partnership in funding the corporation, the new investor may be part of the control group[xxxv] that transfers property to the corporation in exchange for the corporation’s stock.
Provided the partnership remains in existence, and provided the other requirements described above are satisfied, the gain from the partnership’s subsequent sale of the stock may be excluded from the gross oncome of the partners.[xxxvi]
But what if the partnership ceases to exist for tax purposes following its incorporation?[xxxvii] For example, a new investor – indeed, the one who may have insisted upon the incorporation of the partnership before investing in the partnership’s business – may also have insisted upon having all of the shareholders[xxxviii] residing in the same tier relative to the corporation.
Incorporation and Original Issuance
There are several ways by which a partnership may be incorporated. However, in order for the shares of stock that are acquired by the partners to constitute qualified small business stock, it is important to consider whether the method of incorporation may cause the partners to fail the “original issuance” requirement.
Check the Box
When such an election is made, the partnership is deemed to have contributed all of its assets and liabilities to the association in exchange for stock in the association, and immediately thereafter, the partnership liquidates by distributing the stock to its partners.[xli]
Of all the conversion options, the check-the-box election, strictly speaking, is the simplest and most straightforward.[xlii] That being said, it may be difficult to correlate the applicable state law partnership rules with the corporate tax provisions of the Code.
State Law Conversion
The partnership may also convert into a corporation under a state’s conversion statute. For example, in Delaware, a limited liability company that is treated as a partnership for tax purposes may be converted into a Delaware corporation by filing a certificate of conversion and, simultaneously therewith, a certificate of incorporation.[xliii]
According to the IRS, such a “formless” conversion under state law will be treated, for tax purposes, as though the partnership formally transferred all of its assets and liabilities to the corporation in exchange for stock, and then immediately made a liquidating distribution of the stock to its partners.[xliv]
A state law conversion is a fairly simple method by which to incorporate a partnership, provided it is available under applicable state law; for example, New York does not provide for such a conversion.
Merger into Corporation
A partnership may merge with and into a corporation in accordance with state law, with the corporation surviving. Under New York law, for example, this would require the creation of a corporation, the adoption of a plan of merger,[xlv] and the filing of a certificate of merger.[xlvi]
As in the case of a merger of corporations or a merger of partnerships, the merger of a partnership into a corporation will be treated, for tax purposes, as though the partnership formally transferred all of its assets and liabilities to the corporation in exchange for stock,[xlvii] and then immediately made a liquidating distribution of the stock to its partners.[xlviii]
A partnership may transfer its assets and liabilities to a corporation in exchange for its stock. The partnership can then make a liquidating distribution of the corporation’s stock.[xlix]
Instead of transferring its assets and liabilities to the corporation, the partnership may, instead, distribute them to its partners in liquidation of the partnership. The partners would then contribute these assets and liabilities to the corporation in exchange for its stock.[l]
The partners may contribute all of the outstanding partnership interests to the corporation.[li] All of the partnership’s assets and liabilities remain within the state law entity that was the partnership.
For tax purposes, the partners are treated as contributing their partnership interests to the corporation in exchange for the corporation’s stock.[lii] The partnership ceases to exist for tax purposes when the corporation becomes the sole owner of the partnership.[liii]
Where there many partners, relatively speaking, or if one or more minority partners are reluctant to incorporate, it should be possible to utilize a reverse subsidiary merger to compel the transfer of the partnership interests.[liv]
As indicated earlier, a shareholder will not be permitted to exclude the gain from the sale of their stock in a qualified small business corporation unless such stock was acquired at original issuance – meaning that the shares must have been acquired directly from the corporation.
Among the various partnership-to-corporation “conversions” described above, only two involve the direct issuance of stock by the corporation to the partners in exchange for the latter’s contribution of their partnership’s assets or partnership interests: the “assets-up” and the “interests-over” conversions.
In every other conversion scenario, the stock is either actually or constructively issued directly to the partnership – an original issuance – before being distributed, or deemed distributed, to the partners. Does that prevent the resulting corporation from being treated as a qualified small business corporation, and thereby deny its shareholders the opportunity to benefit from the gain exclusion rule under Section 1202 of the Code?
According to the Code, a partner who receives a distribution of stock from a partnership will be treated as having acquired the stock in the same manner as it was acquired by the partnership, and will be treated as having held the stock during any continuous period that it was held by the partnership, provided such stock was qualified small business stock in the hands of the partnership (determined without regard to the 5-year holding period).[lv]
Thus, the form of partnership incorporation utilized should not, by itself, disqualify the former partners, now shareholders, from potentially benefiting under Section 1202’s gain exclusion rule.
The Weight-Challenged Individual is About to Sing[lvi]
The 2020 campaign for the Presidency is almost over. Perhaps just as important – at least for us tax-types – is the battle for control of the Senate.
Hopefully, before our next post – in one week from today – we’ll know who will be sitting in the White House come January 20, 2021,[lvii] and what their chances will be of enacting any meaningful legislation before the end of 2022, at which point we may once again witness a nasty brawl for control of Congress.
[i] Of course, that is not to say that such a relationship does not exist.
[ii] Like the pun?
[iv] A Presidential veto may be overridden by a two-thirds vote of each chamber. Article I, Section 7 of the Constitution.
In the Senate, that requires 67 votes; the Democrats currently have 47 votes in the Senate, to the Republicans’ 53; thus, they will have to win a net of 20 seats. Thirty-five Senate seats are up this year, of which 23 are held by Republicans.
In the House, 290 votes are needed to override a veto; the Democrats currently hold 232 seats, as compared to the 197 held by the Republicans; thus, they will need to win a net of 58 seats.
Neither of these outcomes is likely.
It should be noted that one seat is held by a Libertarian, and there are 5 vacancies (4 Republicans resigned and one Democrat died).
[v] “TCJA”; P.L. 115-97.
[vi] This applied to taxable income in excess of $10 million. A 34% rate applied to taxable income between $75,000 and $10 million.
[vii] Applicable to taxable years beginning after December 31, 2017.
[viii] Applicable to taxable income in excess of $612,350 in the case of a married couple filing jointly, for taxable years beginning after December 31, 2017. For the immediately preceding taxable year, the 39.6% rate applied to taxable income in excess of $470,700 in the case of a married couple filing jointly.
[ix] IRC Sec. 199A. This provision represented a concession to non-corporate taxpayers following the reduction in the corporate tax rate.
[x] Assuming a Biden presidency, what role will be played by the left wing of the Democratic party?
[xi] Interestingly, no mention has been made of replacing the flat rate, and returning to a graduated rate system based upon rate brackets.
[xii] Again, the plan is silent as to whether this top rate would be made applicable to a lower level of taxable income than under the TCJA.
[xiii] For example, the gain from the sale or exchange of shares of stock in a corporation that have been held for more than one year is treated as long-term capital gain.
[xiv] Of course, one must not forget the 3.8% Federal surtax on the net investment income of individual taxpayers. IRC Sec. 1411.
Stay tuned for the U.S. Supreme Court’s decision in California v. Texas, which is scheduled to be heard later this month. It is possible the Court will determine that the Affordable Care Act is unconstitutional, which would nullify the surtax.
[xv] IRC Sec. 761; Reg. Sec. 301.7701-3.
[xvi] An S corporation cannot qualify for the benefits of IRC Sec. 1202 by converting into a C corporation. See infra.
[xvii] This holding period begins with the day the taxpayer acquired the stock. If the taxpayer contributed property other than cash to the corporation in exchange for stock, the taxpayer’s holding period for the property is disregarded for purposes of the 5-year holding requirement.
[xviii] IRC Sec. 1202(a).
The exclusion rule of Section 1202 applies to the taxpayer’s sale or exchange of stock in a qualified small business.
Obviously, this covers a sale by the shareholders of all of the issued and outstanding shares of the corporation, subject to certain limitations.
It should also cover the liquidation of a C corporation and its stock following the sale of its assets to a third party. In that case, the double taxation that normally accompanies the sale of assets by, and liquidation of, a C corporation may be substantially reduced.
[xix] IRC Sec. 1202(a)(4).
[xx] In the case of a married individual filing a separate return, $5 million is substituted for $10 million.
[xxi] Note that the first of these limits operates on a cumulative basis, beginning with the taxpayer’s acquisition of the stock and ending with the taxable year at issue; the second operates on an annual basis, and depends upon how much stock was disposed of during the taxable year at issue.
[xxii] Moreover, any amount of gain in excess of the limitation would still qualify for the favorable capital gain rate, though it will be subject to the surtax. If Mr. Biden succeeds in taxing long-term capital gain at the rate of 39.6%, this rate will presumably apply to such excess gain.
[xxiii] IRC Sec. 1202(c).
[xxiv] It is assumed for our purposes that any in-kind contribution to a corporation in exchange for stock qualifies under IRC Sec. 351; in other words, the contributor, or the contributing “group” of which the contributor is a part, will be in control of the corporation immediately after the exchange; otherwise, the contribution itself would be a taxable event.
[xxv] IRC Sec. 1202(i)(1)(B).
[xxvi] IRC Sec. 1202(c)(2)(A).
[xxvii] Because the corporation must be a C corporation at the issuance of its stock, an S corporation issuer can never qualify for the benefits under Section 1202 by converting to a C corporation.
[xxviii] IRC Sec. 1202(e)(4).
[xxix] IRC Sec. 1202(e)(7).
[xxx] IRC Sec. 1202(e)(1). Certain trades or businesses are specifically excluded. IRC Sec. 1202(e)(3).
[xxxi] For purposes of this rule, the adjusted basis of property contributed to the corporation is determined as if the basis of the property immediately after the contribution were equal to its fair market value. IRC Sec. 1202(i).
[xxxii] IRC Sec. 1202(d). What’s more, the gross assets of the corporation must not have exceeded $50 million at any time before the issuance of its stock.
[xxxiii] IRC Sec. 1202(g).
[xxxiv] IRC Sec. 1202(i).
[xxxv] For purposes of satisfying the “control immediately after” requirement for tax-free treatment under IRC Sec. 351.
[xxxvi] Note than gain from the sale of a partnership interest does not qualify.
[xxxvii] There are various reasons why a partnership may be eliminated in connection with the incorporation.
[xxxviii] Including the former partners.
[xxxix] Within the meaning of Reg. Sec. 301.7701-3.
[xl] The election is made by filing IRS Form 8832, Entity Classification Election.
[xli] Reg. Sec. 301.7701-3(g).
[xlii] It is assumed herein that every conversion that does not require an actual transfer by individual partners or by the partnership has been approved by the partners in accordance with their partnership agreement.
[xliii] Delaware Code Title 8, Sec. 265. https://codes.findlaw.com/de/title-8-corporations/de-code-sect-8-265.html .
[xliv] Rev. Rul. 2004-59.
[xlv] The terms of the partnership agreement will have to be consulted.
Dissenters’ or appraisal rights may be triggered.
[xlvi] NY LLCL Article 10.
[xlvii] This will happen by operation of law as a result of the merger.
[xlviii] Rev. Rul. 69-6; Reg. Sec. 1.708-1(c)(3).
[xlix] Rev. Rul. 84-111, Situation 1. The transfer of all of the assets of the partnership should require a vote of the partners, whether by majority or supermajority.
[l] Rev. Rul. 84-111, Situation 2. The liquidation should require a vote of the partners. It’s important to follow the terms of the partnership agreement.
[li] Rev. Rul. 84-111, Situation 3. This may present an issue where there are many partners.
[lii] Rev. Rul. 99-6. The corporation is treated as receiving these assets and liabilities.
[liii] IRC Sec. 708(b)(1).
[liv] Though it will also trigger dissenter’s or appraisal rights by which the recalcitrant partners may force the liquidation of their interests at “fair value.”
[lv] IRC Sec. 1202(h)(2)(C).
[lvi] I’m tired of politic correctness, except where it may be used in good humor. No, not the ice cream. Do people still eat ice cream? It’s made from cow’s milk, you know. Cows? Those 4-legged, two-horned, peaceful animals that say “moo,” that sometimes end up as baseball gloves (miss the smell of a new mitt), and that are credited with destroying the earth. No, not almonds or coconuts or soy beans.
[lvii] Inauguration Day.