Tuesday, May 15, 2018
Many farm and ranch clients (and others) are asking about the appropriate entity structure for 2018 and going forward in light of the Tax Cuts and Jobs Act (TCJA). Some may be enticed to create a C corporation to get the 21 percent flat tax rate. Other, conversely, may think that a pass-through structure that can get a 20 percent qualified business income deduction is the way to go.
But, what is the correct approach? While the answer to that question depends on the particular facts of a given situation, if an existing C corporation elects S-corporate status, passive income can be a problem. The conversion from C to S may be desirable, for example, if corporate income is in the $50,000-$70,000 range. Under the TCJA, a C corporate income in that range would be taxed at 21 percent. Under prior law it would have been taxed at a lower rate – 15 percent on the first $50,000 of corporate taxable income.
Today’s post takes a look at a problem for S corporations that used to be C corporations – passive income.
S Corporation Passive Income
While S corporations are not subject to the accumulated earnings tax or the personal holding company tax (“penalty” taxes that are in addition to the regular corporate tax) as are C corporations, S corporations that have earnings and profits from prior C corporate years are subject to certain limits on passive investment income. I.R.C. §1362. Under I.R.C. §1375, a 21 percent tax is imposed on "excess net" passive income in the meantime if the corporation has C corporate earnings and profits at the end of the taxable year and greater than 25 percent of its gross receipts are from passive sources of income. For farm and ranch businesses, a major possible source of passive income is cash rent.
If passive income exceeds the 25% limit for three years, the S election is automatically terminated, and the corporation reverts to C status immediately at the end of that third taxable year. I.R.C. §1362(d)(3).
How Can Passive Income Be Avoided?
There may be several strategies that can be utilized to avoid passive income exceeding the 25 percent threshold. Here are some of the more common strategies:
Pre-paying expenses. The S corporation can avoid reporting any excess net passive income if the corporation is able to prepay sufficient expenses to offset all passive investment income and/or create negative net passive income.
Distribution of earnings and profits. In addition, another method for avoiding passive income issues is for the corporation to distribute all accumulated C corporate earnings and profits to shareholders before the end of the first S corporate year-end. I.R.C. §1375(a)(1). However, corporate shareholders will always have to deal with the problem of income tax liability that will be incurred upon the distribution of C corporate earnings and profits unless the corporation is liquidated. Generally, distributions of C corporate earnings and profits should occur when income taxation to the shareholders can be minimized. Consideration should be given to the effect that the distribution of earnings and profits will have upon the taxability of social security benefits for older shareholders. In order to make a distribution of accumulated C corporation earnings and profits, an S corporation within accumulated adjustments account (AAA) can, with the consent of all shareholders, treat distributions for any year is coming first from the subchapter C earnings and profits instead of the AAA. I.R.C. §1368(e)(3).
Deemed dividend election. If the corporation did not have sufficient cash to pay out the entire accumulated C corporation earnings and profits, the corporation may make a deemed dividend election (with the consent of all of the shareholders) under Treas. Reg. §1.1368-1(f)(3). Under this election, the corporation can be treated as having distributed all or part of its accumulated C corporate earnings and profits to the shareholders as of the last day of its taxable year. The shareholders, in turn, are deemed to have contributed the amount back to the corporation in a manner that increases stock basis. With the increased stock basis, the shareholders will be able to extract these proceeds in future years without additional taxation, as S corporate cash flow permits.
The election for a deemed dividend is made by attaching an election statement to the S corporation's timely filed original or amended Form 1120S. The election must state that the corporation is electing to make a deemed dividend under Treas. Reg. §1.1368-1(f)(3). Each shareholder who is deemed to receive a distribution during the tax year must consent to the election. Furthermore, the election must include the amount of the deemed dividend that is distributed to each shareholder. Treas. Reg. §1.1368-1(f)(5).
It should be noted that S corporation distributions are normally taxed to the shareholders as ordinary income dividends to the extent of accumulated earnings and profits (AE&P) after the accumulated adjustments account (AAA) and previously taxed income (pre-1983 S corporation undistributed earnings) have been distributed. Deemed dividends issued proportionately to all shareholders are not subject to one-class-of-stock issues and do not require payments of principal or interest.
A 20 percent tax rate applies for qualified dividends if AGI is greater than $450,000 (MFJ), $400,000 (single), $425,000 (HOH) and $225,000 (MFS). In addition, the 3.8 percent Medicare surtax on net investment income (NIIT) applies to qualified dividends if AGI exceeds $250,000 (MFJ) and $200,000 (single/HoH). However, if accumulated C corporate earnings and profits can be distributed while minimizing shareholder tax rates (keeping total AGI below the net investment income tax (NIIT) thresholds and avoiding AMT) qualified dividend distributions may be a good strategy.
The deemed dividend election can be for all or part of earnings and profits. Furthermore, the deemed dividend election automatically constitutes an election to distribute earnings and profits first as discussed above. The corporation may therefore be able to distribute sufficient cash dividends to the shareholders for them to pay the tax and to treat the balance as the deemed dividend portion. This can make it more affordable to eliminate or significantly reduce the corporation’s earnings and profits.
Modification of rental arrangements. Rents do not constitute passive investment income if the S corporation provides significant services or incurs substantial costs in conjunction with rental activities. Whether significant services are performed or substantial costs are incurred is a facts and circumstances determination. Treas. Reg. §1.1362-2(c)(5)(ii)(B)(2). The significant services test can be met by entering into a lease format that requires significant management involvement by the corporate officers.
For farm C corporations that switch to S corporate status, consideration should be given to entering into a net crop share lease (while retaining significant management decision-making authority) upon making the S election, as an alternative to a cash rent lease or a 50/50 crop share lease. Some form of bonus bushel clause is usually added to a net crop share lease in case a bumper crop is experienced or high crop sale prices result within a particular crop year. Net crop leases in the Midwest, for example, normally provide the landlord with approximately 30-33 percent of the corn and 38-40 percent of the beans grown on the real estate.
Since crop share income is generally not considered "passive" (if the significant management involvement test can be met), a net crop share lease should allow the corporation to limit involvement in the farming operation and avoid passive investment income traps unless the corporation has significant passive investment income from other sources (interest, dividends, etc.) such that passive investment income still exceeds 25 percent of gross receipts.
Other strategies. Gifts of stock to children or grandchildren could be considered so that dividends paid are taxed to those in lower tax brackets. However, tax benefits may be negated for children and grandchildren up to the age of 18–23 if they receive sufficient dividends to cause the "kiddie" tax rules to be invoked. In addition, a corporation may redeem a portion of the stock held by a deceased shareholder and treat such redemption as a capital gain redemption to the extent that the amount of the redemption does not exceed the sum of estate taxes, inheritance taxes and the amount of administration expenses of the estate. IRC §303. The capital gain reported is usually small or nonexistent due to step up in basis of a shareholder’s stock at date of death.
The TCJA may change the equation for the appropriate entity structure for a farm or ranch (or other business). If an existing C corporation elects S status, passive income may be an issue to watch out for.