Don't be Fooled by Phony Arguments

February 22, 2012
by Rick Taylor, CPA
Tax Services
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The Obama Administration is expected to release a provision to reduce the top corporate tax rate to 28% (from 35%).  This will lead to all kinds of “experts” saying this will result in businesses converting from passthroughs to regular C corporations.  This is an inaccurate statement when you factor in all of the disadvantages of C corporations including: 

  1. Double taxation (which will increase significantly if Obama’s proposal to tax dividends as ordinary income and the health care surtax goes into effect in 2013 - dividends will be taxed at a 43.8% top tax rate);
  2. Inability to passthrough losses of the entity (recently I saw a small C corporation go out of business with $950,000 of unused NOLs!); 
  3. Capital gains taxed as ordinary income (C corporations have the worst of all worlds with respect to capital gains and losses; capital losses can only offset capital gains, but capital gains are taxed as ordinary income);
  4. Excess executive compensation (I’ve never had IRS argue that passthrough paid too much to an owner as compensation; had this argument made numerous times in the case of a C corporation);
  5. Inability to give “profits interests” without tax (Treasury generally believes it is impossible to give any corporate interest as compensation without tax (notwithstanding the presence of §83(b)); it is very easy to convey profits interest in passthroughs taxed as partnerships on a tax-free basis);
  6. Inability to use passthrough income to reduce (and generally eliminate if the passthrough is profitable) owner’s exposure to AMT (the easiest way to avoid AMT is to own a profitable passthrough);
  7. Application of the PHC tax;
  8. Application of the excess accumulations tax;
  9. Gain on distribution of appreciated property;
  10. Severe limitations on the use of the cash method (generally corporations with gross receipts in excess of $5 million must use the accrual method);
  11. Inability to make special allocations;
  12. No increase in basis for income of the entity;
  13. No increase in basis for debt of the equity (in the case of passthroughs taxed as partnerships);
  14. Application of the corporate AMT;
  15. Inability to use GRATs and/or defective grantor trusts in an effective manner to transfer ownership to next generation; and
  16. Greater scrutiny of expenses in the case of closely held entities (IRS prefers to disallow the deductions AND hit the taxpayer with dividend income to boot!). 

Bottom line is you are going to see people trying to sound intelligent pontificating on big changes that are in store for taxpayers. Make sure you and/or your tax advisor are thinking all these things through before acting.