Entity selection in 2026: navigating post-OBBBA

00;00;05;22 - 00;00;26;05

Damien Martin

Welcome back to Elements of Private Tax. This is your co-host Damien Martin, back doing what we do best, breaking down the intricate world of private tax into practical insights you can use today, one element at a time. Now, every element on the periodic table has its own distinct properties, its own weight, its own reactivity, its own role in the larger structure of matter.

 

00;00;26;07 - 00;00;49;10

Martin

Get the right elements and the right combination, and you can build something remarkable. But get it wrong and well, things can get a little unstable. In tax, choice of entity works much the same way. C corporations, S corporations, partnerships, they each carry their own distinct tax properties and react differently when exposed to real-world conditions. The right structure can produce efficient, predictable results.

 

00;00;49;12 - 00;01;09;15

Martin

The wrong one can trigger unintended consequences and long-term traps for the unwary. Joining me today is someone who has spent a career in the lab studying the atomic properties of Subchapters C, K, and S, and it’s none other than my co-host, Tony Nitti.

 

00;01;09;17 - 00;01;24;21

Martin

Hi, Tony, I had the Bunsen burner lit. Let’s get the experiment started by testing a prevalent question following the enactment of the tax bills, popularly and informally referred to as the Tax Cuts and Jobs Act and the One Big Beautiful Bill Act. Why would any family enterprise want to be a C corporation?

 

00;01;24;22 - 00;01;47;18

Tony Nitti

Yeah, I mean, it’s a great question. I think it largely comes down to something we work with a lot, and that is math, right? So the math, what I mean by that D is, you know, C corporations, they were the entity choice of last resort, right, from 1986 until 2017. Why? Because of the math, right? Because C corporations, you know, the hallmark of Subchapter C is double taxation.

 

00;01;47;19 - 00;02;09;03

Nitti

So, the C corp generates income. It pays tax at the corporate rate. It then goes ahead and distributes that income to its shareholders and they get taxed a second time as a dividend at the individual level. And the way the math was unfolding prior to we’ll go back to the Tax Cuts and Jobs Act and then we’ll layer on top the One Big Beautiful Bill.

 

00;02;09;06 - 00;02;31;11

Nitti

But, you know, the way the math worked, you had a 35% corporate rate, and then you had a 23.8% dividend rate. When you put those two things together, the effective tax rate of double taxation was a shade under 50%. So for every dollar a C corporation earned in order to get that dollar out to the shareholders, it was going to cost you $0.50 in just federal taxes.

 

00;02;31;17 - 00;02;52;10

Nitti

Compare that to your pass-through businesses, right? Your S corporations, your partnerships, right? The hallmark of pass-through business is a single level of taxation. So if an S corp or partnership earns income, there’s no tax generally at the entity level. Instead, the income is chopped up, it’s allocated among the owners, and the owners pay tax at the individual level, at individual rates.

 

00;02;52;10 - 00;03;15;09

Nitti

And prior to TCJA in 2017, that top individual rate was 39.6%. So when you say the math has changed prior to 2017, you wanted to be a C corporation, you were looking at about a 49.6% effective tax rate. You wanted it to be a partnership or S corp, you’re looking at a 39.6% rate. So that’s a 10% advantage there

 

00;03;15;09 - 00;03;41;19

Nitti

based on that quick math I just did, but then TCJA came along, right? And what TCJA did is it cut that corporate rate from 35% to 21%. And so the math has now changed, right? Now with the C corporation, even with double taxation, a 21% corporate rate, a 23.8% dividend rate, now that effective double taxation has dropped down to about 39.6%.

 

00;03;41;22 - 00;04;08;20

Nitti

Meanwhile, all the TCJA did with tax rates for pass-through business owners right for individuals was drop that top rate from 39.6% to 37%. So if they had stopped right there, the math would have dramatically changed, right? We would have been looking at a 39.6% rate with double taxation as a C corp vs. a 37% top rate as an S corp or partnership.

 

00;04;08;22 - 00;04;31;14

Nitti

Obviously, Congress didn’t want to do that, right? They didn’t want to pull the rug out from under all the business owners who had carefully set up their businesses as S corps or partnerships by effectively eliminating the tax rate advantage they had over their C corp brethren. And so instead, right, what was the solve? They created Section 199A, right, what we call colloquially, the pass-through deduction.

 

00;04;31;14 - 00;04;52;13

Nitti

It allows owners of S corp or partnerships or sole proprietorships to deduct 20% of their income from the business. And if you’re deducting 20% of your income, you’re not really paying a top rate at 37%, you’re paying a top rate of 80% of 37% or 29.6%. And so if we just pause for a second, we’re like, well, wait a minute, did the math really change?

 

00;04;52;13 - 00;05;22;07

Nitti

Because before the TCJA, we had a 49.6% effective rate for C corps and a 39.6% top rate for pass-through business owners. After TCJA, we had a 39.6% double tax effective rate for C corps and a potential 29.6% top rate for owners of pass-through businesses. So pass-through business owners still, at least at first blush, have that kind of 10% relative rate advantage.

 

00;05;22;07 - 00;05;41;24

Nitti

But we know there’s more to unpack here, right? Number one, we know that not everybody gets the 199A deduction. If you’re a doctor, a lawyer, you’re an accountant, you’re an actor, you’re an athlete, you’re a broker, you’re a consultant, and your taxable income is too high, you don’t get that 20% deduction. So now the math has changed.

 

00;05;41;24 - 00;06;07;04

Nitti

You are comparing a 37% rate as a pass-through business with a 39.6% double-tax rate as a C corp. And then we have to layer on the fact that that C corp double-tax rate, it still sounds kind of high, at 39.6%. That’s only if you’re distributing out every penny of income that you earn. Not every business is going to want to do that.

 

00;06;07;04 - 00;06;33;21

Nitti

And the double-edged sword of life as a pass-through business, as an S corp or a partnership is, OK, great, you get to pay tax once at the owner level, but you’re paying that tax, Damien, whether you distribute the cash out to you or not. And so if you’re a business in a post-TCJA world that wants to reinvest most of their earnings into the business, life as a C corporation,

 

00;06;33;21 - 00;07;14;06

Nitti

when you think about the math having changed, a 21% corporate rate vs. potentially a 37% individual rate, that deserves some attention, right, because now we have penalty provisions like the accumulated earnings tax or the personal holding company tax regimes, where it’s going to force you to take some level of distribution from a C corp. But if you’re minimizing distributions and you’re only subjecting your income to a 21% tax rate as a C corp, that’s noteworthy when that same income would be getting taxed, potentially at rates as high as 37% as a pass-through business.

 

00;07;14;06 - 00;07;39;20

Nitti

And so the math having changed is one piece of the kind of one-two punch that has led to this golden era of C corps. The second piece is something that’s not new, but because that corporate rate has come down, has just made C corp so much more attractive. And that is, right, something that’s near and dear to both of our hearts,

 

00;07;39;25 - 00;08;08;20

Nitti

qualified small business stock, Section 1202, right? And we’re not here to drill into 1202, but on a very high level, 1202 allows a non-corporate shareholder to exclude from federal taxable income up to 100% of the gain from the sale of qualified small business stock. And if you can hold that stock for three years, under, you know, new law, a newly issued stock, you can exclude 50% of your gain; for four years, 75%.

 

00;08;08;21 - 00;08;31;13

Nitti

The big carrot is if you can get to a five-year holding period, you can exclude the 100% up to the greater of $15 million or ten times your investment. And the thing is, Damien, you know, this like qualified small business stock is strictly the domain of the C corporation, right? You can’t exclude gain under 1202 when you sell an S corp or when you sell a partnership interest.

 

00;08;31;13 - 00;09;00;05

Nitti

And so it’s that one-two punch. You’re telling me that as a C corporation, I can pay a 21% rate on my operating income? And then if I play my cards right, potentially when I sell my stock, walk away paying $0 of federal income tax, you parlay those two things together and you can understand why C corporations have and deserve a seat at the table

 

00;09;00;05 - 00;09;23;07

Nitti

now for this choice of entity conversation that, as you mentioned earlier, every time legislation happens, there’s like this resetting where people say, OK, what moved? And how does that change this analysis of what’s best for our clients or if you are the client, what’s best for your business, right? S corp, C corp, partnership, what makes the most sense?

 

00;09;23;09 - 00;09;43;16

Martin

Right, right. And as you often say, Section 1202 is like the best deal in Internal Revenue Code, right? Like if you can qualify for that, if you can get through the requirements, you’re straight excluding gain, that’s going to, you know, really change your math. But obviously you know I guess from the conversations I know that I’m having, you’re having, a lot of folks are having, right?

 

00;09;43;18 - 00;10;05;14

Martin

The math is not the only consideration here. To some degree. I guess you could say that the H.R. 1 was a little anti-climactic and sort of, you know, we got a lot of permanency of these expiring or at the time, expiring individual provisions, right? Now, we sort of have permanency, at least until there’s a, you know, mixed legislative change of the tax rate.

 

00;10;05;14 - 00;10;23;01

Martin

So this analysis becomes at least, you know, there isn’t an expiration date like Section 199A, like we had that would make a big difference in your math. Now at least, we can sort of say, well, all right, I can’t tell you what’s going to happen legislatively, but for the time being, we know what the tax law is.

 

00;10;23;02 - 00;10;43;10

Martin

We know what the rates are. We know what the math is on the federal side, right? But with that in mind, though, right, Tony, I mean, that’s not the only factor, right? It would be incredibly easy then, if you could just say math is the only factor, but it’s not. How do you address that in conversations? How are you seeing that coming up in the conversations that you’re having around this analysis?

 

00;10;43;11 - 00;10;49;17

Martin

You know, again, is it S, is it C, you know, flow-through vs. C corp? What are we doing here, you know?

 

00;10;49;23 - 00;11;12;20

Nitti

All right. Well let’s address those. So first things first, what you just said is 100% accurate in the sense that people always want to ask what changed in the choice of entity analysis after H.R. 1. And the thing is, it didn’t really move the needle. What it did, as you said, is it solidified the inputs, right? Because we were staring down the barrel of that 20% deduction, 199A expiring at the end of 2025.

 

00;11;12;21 - 00;11;38;23

Nitti

That didn’t happen. That’s now permanent. We were staring down the barrel of the 37% top individual rate going to 39.6%. That’s not going to happen, right? So now, when we do the analysis for the first time in years, we can at least say we know what the inputs are. The one thing that did change and does warrant attention, we’ve already kind of addressed this is a bit unexpectedly H.R. 1 expanded Section 1202.

 

00;11;38;24 - 00;12;08;16

Nitti

So that does tilt the pendulum a little bit, you know, towards a C corporation in certain situations, just because they took what you just said, and you’re 100% accurate, you know, is the most unique and powerful exclusion incentive in the code and only made it more accessible and more valuable. But that’s really the only thing that changed in H.R. 1 is this expansion of QSBS aside from just making these inputs known for the first time in years, OK?

 

00;12;08;18 - 00;12;42;29

Nitti

But to your point of it’s not just about math, you know, how do I go about it? Well, the thing is, there is absolutely no one-size-fits-all answer, OK. Even the math is not going to make that. So what I try to do, D, is I try to leverage my practical experience for my role, you know, as a Partner in International Tax here at Ernst & Young LLP (EY), where clients are often coming to me not to talk about choice of entity, right, but to come to me and say, hey, there’s this seminal moment in my business’s life cycle.

 

00;12;42;29 - 00;13;04;19

Nitti

I need you to tell me what the consequences are of this thing that’s happening or that I want to happen. And sometimes I have to give them an answer that they don’t love. And what they’ll say, Damien, they’ll say, well, why is that my consequence? I have, you know, an old college buddy or whatever it may be. They did something similar and they had better consequences.

 

00;13;04;19 - 00;13;31;15

Nitti

And I will have to say, well, you know, choice of entity, you are an S corp. You would have been better off in this situation as a C corp or you or a partnership, you would have had that result you desired had you been an S corp. And when I tell them that, I’m always met with this familiar refrain where they will say, boy, I wish someone had told me then when I was setting up my business what you are telling me now.

 

00;13;31;21 - 00;13;49;13

Nitti

And so I take that to heart, right? And so when I am asked to talk about choice of entity conversations, when I am asked to sit down with somebody who’s at that formative stage where they’re deciding on an entity rather than trying to figure out the consequence of some transaction, I want them to go into that decision, eyes wide open.

 

00;13;49;13 - 00;14;42;23

Nitti

I want to address with them those critical moments that will eventually arise along the life cycle, from eligibility to formation to operation to distribution, to sale and liquidation. I want to identify those critical moments and say, when these critical moments arise, here’s what your consequences will be. Whether you’re a C corp, S corp, partnership, then it is up to you to understand your business, what your needs will be, what your goals will be, and understanding all of these different consequences I’ve told you about at different moments in your life cycle, you can choose what’s best for you with one other piece layered on understanding what flexibility exists through change if we don’t love how we start,

 

00;14;42;24 - 00;15;06;02

Nitti

right? So I’ll always kind of finish with that. And oftentimes I think that’s as important a part of the conversation as the life cycle approach, right? Because I don’t want to jump ahead here, Damien, you and I both know the way the tax law works. It’s pretty easy to go from a partnership to an S corp or a C corp, but boy, is it painful to go from a C corp or an S corp to a partnership.

 

00;15;06;06 - 00;15;27;07

Martin

That’s right, that’s right. I love how you frame it that way. Yeah, I wish you had told me, right? Or what do I need to think about? And sometimes hindsight is 20-20. And so I think that that ability to convert and what that looks like is an important thing because I think now again, I’m having this conversation with a number of people, I know you are as well of, hey, the horse is already out of the barn, so to speak, right?

 

00;15;27;07 - 00;15;44;17

Martin

We are where we are, but do we want to convert? And that answer is going to depend on, well, what are you now, right? But that life cycle is huge because I think that does, you know, the inputs. We lock the inputs on the math, but then some of the inputs of, what are your characteristics. And by you, obviously, I mean you as the entity.

 

00;15;44;18 - 00;16;04;14

Martin

What defines you? What you know, industry, the type of ownership, all that sort of thing. So yeah, to that life cycle factor approach, how do you typically walk through that, Tony? What are the factors that are in that list to sort of start to help to understand, you know, gosh, is this the right fit or not? You know, when I put the math off to the side for a minute.

 

00;16;04;15 - 00;16;11;09

Nitti

Yeah, well, how much time we got? I’m kidding buddy. No, no, I mean, I joke because, you know, I love talking about this stuff.

 

00;16;11;10 - 00;16;15;18

Martin

I know, you know, I was going to tell you I have all day, but, you know, I don’t know.

 

00;16;15;21 - 00;16;37;02

Nitti

Well, let’s move through some of that. And what’s interesting is I like to start with a logical starting point, the beginning. And what I mean by that here is, how does the federal tax law treat you from a default perspective, based on what you might do to organize your business under state law? OK, because that’s also going to dictate what flexibility we have going forward.

 

00;16;37;02 - 00;17;03;08

Nitti

And we do have default treatment under the check-the-box regs, right, at 301.7701-2 and -3. And a lot of people don’t understand this. Like if you don’t take the steps to incorporate under state law, right? You’re a Comma Inc., you default to being a corporate entity, right? A C corporation specifically. And what’s even more interesting is when we talk later about flexibility to use those same check-the-box regs to change your treatment,

 

00;17;03;12 - 00;17;24;21

Nitti

you’re not eligible to use those regs if you’re a Comma Inc., right? So you can’t go from a Comma Inc., to a partnership by simply filing a check-the-box election, you have to get more creative and actually convert under state law. But as we’ll talk about, that usually carries some pretty painful tax consequence. So if you’re a Comma Inc., you default to being a C corp.

 

00;17;24;22 - 00;17;45;24

Nitti

If you’re not a Comma Inc., right, if you don’t incorporate, if you just organize under state law, then you are defaulting into a partnership if you have more than one owner, and you’re defaulting into a disregarded entity if you only have one owner. So we have to start from there. How does the federal tax law treat you based on what you do under state law?

 

00;17;45;24 - 00;18;11;28

Nitti

And you’ll notice something really important there. Nobody’s defaulting into being an S corporation, right? You can default into being a C. You can default into being a partnership. You can’t default into being an S corp. And that’s where I usually start the conversation. The reason you can’t default into being an S corp is because S corps, unlike partnerships, unlike C corps, have strict eligibility requirements.

 

00;18;11;28 - 00;18;34;10

Nitti

And, right, this need to make an actual election to be treated as an S corp. And it’s so fascinating because, just to color our conversation here, you know, I know there are more S corp returns filed every year than any other entity type. And I’m, like, an S corp guy, right? I chair the S corp group at EY.

 

00;18;34;11 - 00;18;54;17

Nitti

I do it for the AICPA TRP. Like, I look at that, Damien, and I go, should that really be the case? And when we talk through this life cycle stuff, I think you’ll see that, boy, there’s a lot of scenarios where it’s like, all right, maybe an S corp isn’t as advantageous here as, for example, an LLC or even a C corp.

 

00;18;54;17 - 00;19;20;07

Nitti

And so I’ll always start there, D. I’ll start with, well, hey, if you have restrictions on being an S corp, you have eligibility requirements that don’t exist for C corps or partnerships, perhaps we should understand that nature of your business first because S corps, right, they are very simple creatures, which may be the best justification for why there’s more S returns filed every year.

 

00;19;20;07 - 00;19;42;24

Nitti

But they’re also very rigid creatures. And so S corps, you know, you can’t have common and preferred stock. You can only have a single class of stock. You can’t have more than 100 shareholders. And then most importantly, right, you’re limited to the nature of your shareholders. Now US citizen or resident individuals, you can have six types of trusts. You can have estates.

 

00;19;42;24 - 00;20;06;11

Nitti

You can have 501(c)(3) organizations. But that’s it. That’s all. So you can’t have a partnership as a shareholder in S corp. You can’t have another corporation as a shareholder in S corp. And so if somebody is thinking about setting up their business and they know that within a couple of years they want to take on money from institutional investors, well, you’re not going to stay an S corp very long, right?

 

00;20;06;11 - 00;20;32;08

Nitti

If they’re going to insist on equity instead of a loan, the minute that that private equity puts money into your S corp, you will cease to be an S corp. So maybe it doesn’t behoove you to start life as an S corp. And so I really start there because there are no restrictions on number or nature of owners in a partnership or a C corp, but there are very strict restrictions as an S corp, so we may as well address that issue first.

 

00;20;32;08 - 00;20;36;06

Nitti

And then from there, I tend to move on to formation.

 

00;20;36;13 - 00;20;59;13

Martin

Yeah. And how you’re going to get into it. But I mean, you don’t accidentally become an S corp, wake up one day, become an S corp, you know, you can certainly wake up one day and accidentally no longer be an S corporation, which I know you spend a good amount of time with and, you know, obviously there’s a lot of thought and process that goes into, you know, maybe if you inadvertently made your S corp, not an S corp anymore, you know, what you need to do about that, the care and feeding and watering.

 

00;20;59;13 - 00;21;17;09

Martin

But yeah, it’s probably like with anything right. I mean like you said, S corps being more rigid. But there’s pros and cons, right? Like and sometimes when you get one thing, maybe you’re giving up another thing. And that’s what’s so interesting about the eligibility component for some people, to your point, it’s just literally not on the table.

 

00;21;17;09 - 00;21;33;26

Martin

And I think the other thing that’s also maybe, I’ll have to make my plug. I know this is one that you make a lot of times too of, you know, someone tells me like, what did you set yourself up as, right? And you say, well, an LLC, well that because of the check-the-box that didn’t tell me enough to know enough as to how you are actually currently taxed.

 

00;21;33;28 - 00;21;54;16

Martin

Exactly. The Comma Inc., it does, right? And so that is a very important distinction. I think if you are somebody that owns an entity, you know, knowing that distinction sometimes is important because there’s a lot here, right? And that’s obviously why we’re talking about it. So to add some clarity, just even around, you know, what can you do? What are the world of possibilities for you?

 

00;21;54;16 - 00;22;07;14

Martin

Because in some cases that’s smaller than others depending on your fact pattern. But formation is an interesting one, particularly if you’re, you know, coming into from another venture or whatnot. So maybe talk a little bit about that. What do we see on the C corp side?

 

00;22;07;15 - 00;22;29;11

Nitti

Yeah, I love what you just said, particularly when you’re coming in from another venture. Because when we talk about formation issues, it’s largely one of nuance, right? And that’s why, like I said, you have to understand, the client has to understand what their specific fact pattern is, because the beautiful thing about the tax law is if you’re just putting in cash, right, we don’t have a lot of concerns upon formation.

 

00;22;29;12 - 00;22;46;11

Nitti

You’re putting cash, you either get back stock or you get partnership interest, no worries. But you’re not always putting in cash, right? Damien, like you said, you might already be engaged in a venture. You might have a sole proprietorship that you want to incorporate or you might have a piece of real estate that you want to drop into a partnership.

 

00;22;46;11 - 00;23;13;23

Nitti

And when you think about situations like that, like you may have property that’s appreciated, that is going into an entity in exchange for an ownership interest. And we know that we have gain or loss recognized when we sell property. But Section 1001 actually says we have gain or loss when we sell or exchange property. And so if I put in my sole proprietorship into a C corp or an S corp in exchange for stock, what word did I just use, right?

 

00;23;13;24 - 00;23;39;28

Nitti

It’s an exchange. And so, barring a rule to the contrary, if those assets that went in were appreciated, I’d have to pay tax on that appreciation. But Congress wants you to be able to incorporate, you know, a sole proprietorship. And so in the corporate context, we have rules under Section 351 that provide for nonrecognition, right? I can take my cash-basis accounts receivable.

 

00;23;39;28 - 00;24;05;28

Nitti

I can take my machinery and equipment for my sole proprietorship. I can drop them into a corporation in exchange for stock and not have to pay federal income tax. The same is true for a partnership, except instead of under 351, it’s under 721. So in S corps, C corps, which are governed by the same rules, and then partnerships, property can go in tax-free, as we’ll learn later,

 

00;24;05;28 - 00;24;32;14

Nitti

one of the biggest distinctions here is good luck getting property out tax-free from a corporate entity. But it can go in tax-free. So when I say the difference is nuance in the C corp and S corp world because they’re governed by 351, you have control requirements, right, where you have to either individually or as part of a simultaneous transfer or group, you have to control 80% of the stock of the corporation in order to get this non-recognition.

 

00;24;32;14 - 00;24;53;14

Nitti

Whereas with a partnership, right, there is no control requirement. So, Damien, you could go to an existing partnership and drop in a building that’s been appreciated by 10 million bucks in exchange for a 1% interest, and it’s still going to be tax-free. You do that in the C or S corp setting, because you don’t have that requisite 80% control, it’s going to be taxable.

 

00;24;53;14 - 00;25;27;29

Nitti

So, it’s easier for a property to go in tax-free into a partnership particularly, and this is a big one, when the property you’re putting in is also subject to liabilities and you’re asking the entity to take over those liabilities. This is where a big distinction comes in. Because in the corporate setting, whether we’re talking about C corps or S corps, if you transfer property subject to a liability and that liability is greater than the tax basis of the property, you’ve contributed,

 

00;25;28;00 - 00;26;04;08

Nitti

Section 357(c) kicks in and it’s purely mechanical. It says you have to recognize gain equal to the excess. So if I put in a building or the basis of a million subject to a $3 million mortgage, I got $2 million of gain, right? Purely mechanical. In the partnership setting, it’s not impossible, but it’s very unlikely that even when you put in leveraged property into a partnership, that it’s going to produce gain, because there is no corollary to 357(c) and so liabilities can go in, we can get allocated back some of the liabilities.

 

00;26;04;08 - 00;26;24;28

Nitti

It’s very, very unlikely, we’re going to have gain, like I said not impossible but unlikely. And so that’s our first big distinction we’re drawing here other than eligibility. If I have property that’s going to be subject to liabilities that needs to go into an enterprise, boy, it’s a lot easier to put that into a partnership than it is either a C corp or an S corp.

 

00;26;24;28 - 00;26;43;28

Nitti

And so we’re setting the stage for something that you hear a lot in this choice of entity conversations, like, never put real estate into, you know, a corporation. Or as my buddy said during a presentation, we did a couple of months ago, friends don’t let friends put real estate in S corporations, same as said for C corporations.

 

00;26;43;28 - 00;27;02;20

Nitti

This isn’t the reason we don’t like real estate in corporate entities. There’s bigger reasons, but you can start to see why. Like if real estate is going to be subject to a mortgage, you drop that thing into a C or S corp, there’s a very real chance that it could be taxable if that, you know, it’s going to be taxable

 

00;27;02;20 - 00;27;11;25

Nitti

if the mortgage exceeds the basis of the asset, that same probability doesn’t really exist if you put it into a partnership instead.

 

00;27;11;27 - 00;27;37;27

Martin

That’s right. Yeah, you know, well, which is, and it maybe gets to another like often-used adage or whatever about not letting the tax tail wag the dog, right? Because you’re driving an additional need for capital because you’ve triggered a recognition event, hopefully not inadvertently, right? But that’s why these factors are so important and knowing that going in, to say, you know, this is what I’m trying to accomplish on formation, is this the right answer or not?

 

00;27;37;29 - 00;28;06;17

Martin

So let’s just say that we figure out who our owners are and check that box. We thought about, you know, what we’re putting in, how we’re getting there. Is it cash? Is it appreciated property? OK, check that box. Now we got to like operate this thing, right? And comparing those two things, so maybe starting with just how we allocate income, because I know there’s obviously some pretty significant detail or differences I should say, between flow-through and, well, I’ll just say S, C and partnership.

 

00;28;06;18 - 00;28;08;07

Martin

What are the relevant factors there?

 

00;28;08;12 - 00;28;27;23

Nitti

Yeah, this one’s nice because you can take C off the table, right? Because C corps, it’s going to be taxed at the corporate level. There is no allocation going out to the owners. But what’s fascinating about comparing S corps to partnerships here is it’s one of those few factors where it’s like, well, I can only tell you what the consequences are.

 

00;28;27;24 - 00;28;50;22

Nitti

You have to tell me which one you prefer, right? Like, there’s not a clear better answer. And it’s based on kind of as we’ll see your appetite as the business owner. And what I mean by that is what did I say earlier, right? S corps, simple but rigid. Well, when we say the rigid, we have zero flexibility, Damien, in how an S corp allocates income out to its owners.

 

00;28;50;22 - 00;29;15;03

Nitti

It is required to go out pro rata on a per share per day basis. So there is no flexibility to say I want to push all the interest income to Damien, I want to push all the depreciation deductions to Tony. It doesn’t exist. I mean, if me and you were 50/50 owners, we’re getting everything 50/50. Compare that to a partnership where within reason, as I like to say, you can make special allocations.

 

00;29;15;03 - 00;29;45;29

Nitti

You can do whatever the heck you want if that’s what you agreed to in the partnership agreement, and those allocations have what we call substantial economic effect. And so yeah, the partnership setting, I can push my interest income to Damien and my depreciation deductions to Tony. I have tons and tons of flexibility. And so the reason I say you would have to tell me which one of those you prefer is because honestly, sometimes businesses with multiple owners, they want to be able to explain what is happening to those owners and investors, right?

 

00;29;46;00 - 00;30;13;18

Nitti

They want everyone that gets, you know, K-1 to say, well, I own 20%, and, hey, my buddy Jim over here owns 20%. Our K-1s look identical. That makes sense to me. And in an S corp you’re going to get that. You could also get it in a partnership. But if in a partnership you decide to start doing special allocations, you can get into situations where, you know, Damien and Tony each own 20% of the partnership, but we have vastly different K-1s and vastly different capital accounts.

 

00;30;13;18 - 00;30;39;01

Nitti

And sometimes, again, it’s just harder to explain to the business owner what they are seeing. And so sometimes people embrace the forced, rigid nature of an S corp because it does afford that simplicity. But obviously, if you need flexibility, if you desire any type of special allocation, then an S corp is simply off the table, right? It’s just not available to you.

 

00;30;39;01 - 00;30;54;24

Nitti

And so your hand could get forced into a partnership situation. But sometimes people just say, I like it as an S corp because I don’t even have the option of any special allocations. And I know that my K-1s are going to make sense to everybody.

 

00;30;54;27 - 00;31;13;26

Martin

Yeah. So OK, so that’s when we have income. Maybe look at like losses and how we utilize those. Again, we’ll put the C corps off to the side here since we know how that’s being handled. Since it’s within the C corp, right? It’s not being allocated anybody but more so on the utilization front, how do I guess, S vs. a partnership,

 

00;31;13;28 - 00;31;15;11

Martin

what are the differences there?

 

00;31;15;16 - 00;31;37;11

Nitti

Well, there is a big difference. Now we’re getting to one of those moments where yeah this isn’t nuanced. Like, this is significant, OK. Because if business passes out a loss to its owners, those owners are going to want to use that loss, right? They want to take advantage of the fact that they had a rough year for, at least from a tax perspective, and use that to offset income from other sources if possible.

 

00;31;37;11 - 00;32;02;21

Nitti

And the tricky thing about our tax law as it’s currently constructed is before you can use a loss from a pass-through business, you have four different hurdles that you have to jump through, right? The loss disallowance provisions. But the first of those hurdles just says that you have to have what we call basis in the entity that is allocating you the loss, and you can only use the loss to the extent of that basis.

 

00;32;02;21 - 00;32;34;09

Nitti

And basis is just this esoteric concept that’s meant to track your tax investment in the entity. So if you put in $100 of cash, basis goes up by 100, if you pay tax on another $50 basis goes up by 50. If you withdraw $70, it goes down by 70. You get the idea. And there is this critical distinction between basis in an S corp and basis in a partnership that makes loss utilization a lot more likely in a partnership LLC context.

 

00;32;34;09 - 00;32;57;29

Nitti

And that distinction is this, in a partnership setting, a partner gets basis for their share, their applicable share of all the partnership’s liabilities. So a partnership takes out bank debt and Damien’s a partner, some of that bank debt gets allocated to Damien and it increases his basis. And that’s a good thing because I said you can only use loss to the extent of basis.

 

00;32;57;29 - 00;33;16;10

Nitti

So the more basis you have, the happier you are when it comes to use and losses. Compare that to an S corporation where you only get basis for liabilities that you loan directly to the S corporation. If Tony is the S corp shareholder, I have to reach in my pocket, pull out some cash and loan it up to the S corp.

 

00;33;16;10 - 00;33;37;09

Nitti

So if the S corp goes out and borrows bank debt, that does nothing for me. And so you could have identical businesses, right? Same balance sheets. And out of an LLC, you’re able to utilize losses that you wouldn’t be able to as an S corp because as an LLC, you’re getting an uptick in basis for your share of liabilities

 

00;33;37;09 - 00;33;59;20

Nitti

that’s not happening on the S corp side. And so when we think about it and we continue to layer on our earlier conversation about this tenant of tax law, don’t put real estate into a corporation, well, real estate tends to be leveraged. And so real estate also tends to produce tax losses sometimes even if it’s cash flow positive.

 

00;33;59;20 - 00;34;24;27

Nitti

And so you put real estate into an S corp and it’s leveraged, you’re not getting any basis bump at the shareholder level for that debt. You take that same real estate and put it into an LLC, now you’re getting that basis bump related to your share of that debt, which if the LLC is allocating losses out to you, become more likely to be utilized at the individual level because of that basis bump.

 

00;34;24;27 - 00;34;46;28

Nitti

That is a big distinction. If someone says, you know, my business is going to be generating losses from a tax perspective for a number of years and is going to be leveraged, it just screams to me partnership over S corp, because you’ll get the added benefit of being able to include those liabilities in your basis.

 

00;34;47;00 - 00;35;08;09

Martin

Gotcha. Yeah, that’s a big deal. And again, a lot of when we’re doing this analysis, right, I was thinking about, you know, are we expecting losses or are we expecting income again to the extent you can plan for these things. You always have variables, right? But that’s one thing about real estate. You’re right. With the depreciation deductions you oftentimes do end up with tax maybe losses despite cash flow positive to your point.

 

00;35;08;09 - 00;35;32;20

Martin

But what about employees, right? Because I know any more sort of equity-type compensation or arrangements or incentives, you know, in terms of incentivizing people, has just become a core focus, really, I think, with business, you know, how do you create the right incentives for your people, right? So with that in mind, you know, what are the differences when you’re granting interests of ownership to employees?

 

00;35;32;24 - 00;35;51;25

Nitti

Man, that’s a great question because going back to what I said to you earlier, of these painful conversations I sometimes have with clients about, you know, I wish you told me then what you’re telling me now, this may be the situation, maybe second most common situation I run into, where I have to have that conversation, and we’ll get to the first later.

 

00;35;51;25 - 00;36;06;14

Nitti

But yeah, business owners will come to me and say, I got these people, they’ve been working hard for me for years. I want to reward. I want to give them an ownership stake in the business, but I don’t want them to have to pay for it, and I don’t want them to have to pay tax on it.

 

00;36;06;15 - 00;36;37;04

Nitti

How can I make it happen? And that’s where my hands are tied, because it completely depends on how you set up your business. If you’re a C corp or an S corp, it’s just not possible because if you grant stock to an owner, right, the way the rules work under Sections 61 and 83, it’s going to value that stock and include in your compensation income the value of that stock less any amount that you paid for it, right?

 

00;36;37;07 - 00;37;02;09

Nitti

And you don’t want them to pay for it. So if you give them stock worth $50,000, right, they’re going to be taxed on ordinary income of $50,000. There’s no way around it. It’s just how things work. Now, you can get creative with phantom stock and things like that don’t give them actual ownership, but if you want them to have outright ownership on a tax-free basis, it’s not happening for a C corp or an S corp.

 

00;37;02;14 - 00;37;19;26

Nitti

So flip over to a partnership. Well, what we have to acknowledge here is there’s two types of ownership you can have in a partnership. The first is kind of what we call a capital interest and in a capital interest, imagine I’ve got a capital account of 100 bucks as a partner. And Damien, you’ve been working hard for me for years.

 

00;37;19;26 - 00;37;43;12

Nitti

I want to give you a partnership interest. And I say, Damien, I’m giving you 10% of my interest, and you’re going to get immediately a $10 capital account in this partnership. Well, because you have a $10 capital account, if the partnership were to liquidate the next day under the 704 rules, you’d be entitled to $10. And so you’ve got something of value.

 

00;37;43;12 - 00;38;06;20

Nitti

And because of that, it’s no different than in the situation where I gave you corporate stock. You got $10 of value. I’m making you pay tax on $10 of value. So if I give you a capital interest, there’s no benefit here relative to a C corp or S corp. You’re in the same situation. But what’s unique, what partnerships can do that the S corps and C corps cannot do is they can grant what we call a pure profits interest.

 

00;38;06;20 - 00;38;32;12

Nitti

And with a pure profits interest. I say to you, Damien, you’ve been working so hard for this partnership for years, I’m giving you a 10% interest. But you’re getting nothing from my capital account. In fact, you’re not getting any capital account at all. You’re getting a 10% interest in future appreciation from this moment on. And because you’re only getting a promise of future appreciation, if the partnership were to liquidate the next day, you get nothing, right?

 

00;38;32;13 - 00;38;53;21

Nitti

You get nothing at all, because there hasn’t been any appreciation, theoretically, overnight. And so you get nothing because you’re not getting anything, the way the law stands, at least currently under Rev. Proc. 2001-43, is there’s nothing to tax you on. There’s no value. And so because there’s no value, you walk away with a 10% interest in future profits,

 

00;38;53;21 - 00;39;20;16

Nitti

but without any current tax bill, it is the only way that you can give an employee an outright ownership interest in an entity without making them pay for it and without it being taxable. And so that’s a huge advantage for partnerships. And like I told you more often than you can imagine, do I have conversations with clients and say, I want to give my S corp employees, my C corp employees an ownership stake,

 

00;39;20;18 - 00;39;36;06

Nitti

how can I do it tax-free? And I have to say, it doesn’t exist. You know, well, my business partner in his business, he’s given out ownership interests tax-free. And he’s like, yeah, he’s set up as an LLC. He’s giving profits interests. We don’t have that capacity here with an S corp or a C corp.

 

00;39;36;12 - 00;39;51;07

Martin

Right. Well, I think you also made a key distinction too between your capital and your profits interest too, right? Is that it’s an interest in future profits. So and I guess if I come to you, you know, we’re planning on selling, you’ve got this great offer, it came out of nowhere, you know, and that’s going to happen soon.

 

00;39;51;08 - 00;40;08;23

Martin

I asked you that question of how do I then get that interest to an employee? I mean, the future profits are not there, right, in that sense. So that becomes a different conversation as well. So that, you know, timing is everything in a lot of things, and particularly when it comes to granting interest — equity interests and probably tax in general, I guess, if I think about it, right?

 

00;40;08;25 - 00;40;29;23

Martin

But how about taking money out or taking assets out, you know, distributions. Maybe we’ll start, we’ll bifurcate, right? Because you’ve got, you know, I could give you cash or I could give you property, but on the cash side, well, again, maybe we’ll dispose of C corps because we know the dividend is a dividend and that’s how that’s taxed.

 

00;40;29;23 - 00;40;34;14

Martin

So what about, you know, differences between our S and our partnerships in that context?

 

00;40;34;17 - 00;40;54;20

Nitti

Sure. Well actually, let’s again, let’s spend five seconds to reiterate what you just said because that’s the whole thing, right? With a C corp is you certainly cash out. It’s going to be taxed and dividend, so to the extent you’re not doing that, C corp starts looking a lot more friendly. But you do run into business owners that say, I want to become a C corp and pay nothing in dividends.

 

00;40;54;20 - 00;41;13;13

Nitti

And just as I alluded to earlier, understand that we do have penalty tax regimes, whether it’s the accumulated earnings tax or the PHC, the personal income tax, that will compel you to take a distribution at some point in time. But yeah, to the extent every dollar of that distribution you need to make goes down, C corp starts to look more friendly.

 

00;41;13;14 - 00;41;41;19

Nitti

But to your point S vs. partnership, we’re going to add two more notches in the column here for partnerships, because from a cash perspective the rules are identical. You can take a distribution of cash tax-free to the extent of your basis. Why? That’s the mechanics that preserves the single level of tax. If you pay tax on $100 of income, that $100 increases your basis and you don’t want to be paying tax on that twice.

 

00;41;41;19 - 00;42;00;24

Nitti

So if I now distribute that cash out, that cash is tax free to the extent of my basis, and if the income just increased my basis, if all I’m doing is distributing the income, it can’t possibly mathematically exceed that basis. And so this is the rule necessary to make sure we only pay tax once as an S corp or a partnership.

 

00;42;00;24 - 00;42;27;22

Nitti

But there’s this critical distinction again that we already learned about, D, which is that partners get basis for their share of partnership liabilities. S corp shareholders don’t and so that means it’s more likely that a distribution of cash out of a partnership will be tax free than it is out of a similarly situated S corp, simply because of the presence of debt on the balance sheet

 

00;42;27;22 - 00;42;42;00

Nitti

that can help the partner in a partnership, but not the shareholders in the S corp. So that is a distinction from a cash perspective. Much easier to get it out of a partnership that’s leveraged than it is out of an S corp that’s leveraged.

 

00;42;42;01 - 00;42;45;29

Martin

Fair. Yeah. All right. So how about the property then? If we’ve, you know, we’ve talked about the cash here.

 

00;42;46;06 - 00;43;05;19

Nitti

This to me is the biggest distinction. This is the conversation where I have to tell people, no, no, no, no, no. The results are not what you’re hoping they were. They’re actually very, very punitive. What I mean by that, we learned earlier today that appreciated property can go into anything tax free, right, if you play your cards right.

 

00;43;05;20 - 00;43;33;10

Nitti

S corps, C corps, partnerships comply with 351 on the corporate side, 721 on partnership side, no tax. What happens when appreciated property wants to come out? Well on the partnership side it’s a big nothing, right? You got two buildings inside a partnership both appreciated by 5 million. Damien and Tony are the only partners. We can’t stomach looking at each other anymore, D, we want to go our separate ways.

 

00;43;33;11 - 00;43;56;16

Nitti

You know, we can push those buildings out to each of us without any tax hit to the partnership, to us, anything. And oftentimes people who either operate partnerships a lot or maybe tax professionals who work with partnerships a lot, they think, well, you know, a pass-through entity is a pass-through entity. So if I can distribute appreciated property tax-free out of my partnership, I’m sure I can do the same thing out of an S corp.

 

00;43;56;16 - 00;44;20;29

Nitti

And S corps, I mentioned this earlier, a lot of times are governed by the same rules as C corps. We saw that with 351. And in this case, we see it with 311B, and 311B says if it’s a C corp or an S corp and it distributes appreciated property, it is treated as if it’s sold that property for its fair market value.

 

00;44;21;00 - 00;44;46;19

Nitti

It is a deemed sale of that property that’s being distributed. And that is, you know, oftentimes very painful because you now have gaining and so let’s do it in the S corp setting, right? Because there’s only going to be a single level of tax in the C corp, there’s two levels of tax for the distribution of appreciated property. In S corp, you only have this deemed gain that arises at the S corp level and flows through.

 

00;44;46;19 - 00;45;26;26

Nitti

But now you’re going to have tax at the individual shareholder level and what don’t you have to pay the tax with, right? There wasn’t an actual sale. You don’t have cash proceeds. You just triggered a sale but have no cash to pay the tax. And yeah, this is a big misconception that’s out there. I spend a decent amount of my time explaining to S corp owners or, you know, tax advisors working with S corps that, no, you cannot just distribute out that plane, or no that building can’t come out tax free to the one shareholder that wants to go their separate ways or, you know, this subsidiary entity you have.

 

00;45;26;27 - 00;45;54;27

Nitti

We can’t just distribute that out unless it’s a tax-free spinoff. Anything you plan to spin or to distribute out that is not cash, that it is appreciated, you have to pretend as if you sold it for its fair market value. And so this is a huge distinction. And this, Damien Martin, we are finally getting to why people say never put real estate in a corporation because God forbid, right?

 

00;45;54;28 - 00;46;14;18

Nitti

It’s time to go your separate ways. It’s time that Damien wants his building out and I want my building out; it can’t be done in the S corp setting. We’re going to trigger all that appreciation. Whereas if we had simply put our two buildings into a partnership, then we can’t stomach looking at each other anymore, we can each take our building, go our separate ways without any tax impact at all.

 

00;46;14;20 - 00;46;23;06

Nitti

So that is why we don’t put real estate into an S corp, because it can go in tax free, cannot come out tax free.

 

00;46;23;07 - 00;46;38;06

Martin

Right. Yeah. You talk about adding insult to a situation, right? If we’re parting ways, Tony, I mean, the next thing I don’t want is a surprise tax bill that, you know, with no cash with which you pay that, you know, surprise tax bill as well. I mean, those are not happy conversations, so that’s to your point.

 

00;46;38;08 - 00;46;48;09

Nitti

They’re the most painful conversations I have when people want to split up a business, want to get something out, and they just can’t do it easily because they’re in an S corp setting.

 

00;46;48;11 - 00;47;06;15

Martin

Yeah. All right. Well, I got to say, for an S corp guy, you know, as we’ve gone through this, like the operating here, right? We’ve kind of been maybe beaten up a little bit on the S corps, if you feel like we’re notching, you know, check marks in different boxes that maybe the partnerships have been outweighing a little bit. So I feel like, you know, the question comes back to me because you said it, right?

 

00;47;06;16 - 00;47;25;00

Martin

There’s more S corp returns filed than anything else here. So why is that? And maybe it’s this last factor or I guess if we think about operating is just the income — self-employment income that’s being generated by the business, why might this put a check in the box for S corps. I’ll tee you up that way.

 

00;47;25;01 - 00;47;54;18

Nitti

No. We haven’t really heard if we’re keeping score at home, right, we haven’t heard many checks in the box for L corps right now, right? You get that basis for liabilities as an LLC. You can get profits interest, you can distribute property. So why the heck are there more S corp returns filed than any other one? You know, some of my people or my, you know, S corp TRP that you know love S corps and work with them may take issue with me, but S corps like I said, they’re simple creatures.

 

00;47;54;19 - 00;48;23;24

Nitti

They’re pretty nice, but we’re not hearing a lot of advantages. So why so many returns? The self-employment tax savings, right? This is clearly an advantage of an S corp. I just don’t know how much of an advantage it is. And what I mean, D, is S corps were added to law in 1958, and in 1959, we got a ruling, 59-221, that interestingly says S corp income when allocated out to its owners, is not subject to self-employment tax.

 

00;48;23;27 - 00;48;51;18

Nitti

You know, compare that to a general partnership or even an LLC, where the IRS has gotten more and more aggressive in saying that type of income has been in the LLC context, I mean clearly in the general partnership context, but the LLC context is subject to self-employment tax. And so this is not an income tax play necessarily. But if you’re an S corp shareholder, you might say, wait, I earned $100,000 of income inside my S corp.

 

00;48;51;25 - 00;49;21;01

Nitti

If that had been subject to self-employment tax, I’d be paying $15,300 in payroll taxes on that $100,000. Because I’m an S corp, I have options. I could pay myself $100,000 salary, reducing my income to zero, but then I’m going to have to pay the $15,300 in payroll taxes between the employer and the employee. Or I could take advantage of Rev. Rul. 59-221, not pay myself any salary,

 

00;49;21;02 - 00;49;48;05

Nitti

let the $100,000 flow through to me, pay income tax on it but completely escape payroll taxes and then distribute that cash tax free. And so there are payroll tax savings to be had by issuing compensation in favor of distributions in the S corp world. That is why S corps are so attractive in a lot of contexts. But the thing is, the IRS knows.

 

00;49;48;05 - 00;50;23;12

Nitti

And soon after Rev. Rul. 59-221 was issued, you saw a spate of taxpayers try to abuse the fact pattern by taking zero compensation out of their S corps while receiving significant distributions. And over the last half century, the IRS has clearly made known their position and been largely triumphant in the court cases of saying that, hey, look, if you’re a shareholder and you’re providing substantial services to an S corp, before you can take any distributions, you have to take out reasonable compensation.

 

00;50;23;12 - 00;50;47;27

Nitti

And so they were going in, in all these cases and saying you didn’t pay yourself any comp. You took out, you know, X amount of distributions. We’re going to call all the distributions comp. And we’re going to get our payroll taxes. And so S corp shareholders that want to benefit from the payroll tax savings, that opportunity is there, right? But you do have to pay yourself reasonable compensation.

 

00;50;47;27 - 00;51;12;17

Nitti

That’s always going to be subjective and open for debate, depending on your facts and circumstances and what role you really play in driving the revenue of that S corporation. But when you just think about it, you know, now, you have to take out reasonable comp. So you have to actually pay payroll, which you’re not doing in the partnership context. And so you really got to pay your payroll provider and you know, like start eating away at some of the savings.

 

00;51;12;17 - 00;51;43;19

Nitti

And I know some of the savings can be significant. But if you’re paying yourself the Social Security wage base, then all you’re really saving, right, is the Medicare tax, right? Another up to 3.8%. And so I’m not trying to, you know, to downplay the advantage here, even though, boy, it certainly sounds like I am. It’s just that I think there’s probably a lot of S corps that are set up as S corps to take advantage of these payroll tax savings, which I don’t, you know, listen, every dollar counts.

 

00;51;43;19 - 00;52;04;12

Nitti

I am just I’m not sure when you compare it to some of the other downsides we see with an S corp that it necessarily makes a ton of sense in a lot of situations, but that is why it’s happening, Damien, because people say, non-income tax play. I can save on payroll taxes by taking out $300,000 of distribution, and only $100,000 in comp,

 

00;52;04;13 - 00;52;11;12

Nitti

hope that that $100,000 satisfies the reasonable compensation requirement, and saves some payroll taxes on the rest.

 

00;52;11;13 - 00;52;32;18

Martin

Right, right. Yeah. No. And again, this is why there’s like no one-size-fits-all, right? And then really understanding what it means for your situation and, you know, are you actually seeing the benefits and whatnot? It can’t just be that conversation, you know, I often say I feel like there’s a lot of tax being discussed on the golf course, based on a lot of the conversations I have after said, people have gone to the golf course, right?

 

00;52;32;19 - 00;52;52;21

Martin

And but like understanding, you know, how your fact pattern may be different is a big one. But all right, you know, you’ve talked about like the beginning, maybe the middle, which is, you know, the operations and all these different allocations, self-employment, you know, treatment distributions and so forth. What about the end, like if I’m going to sell or I’m going to liquidate my business,

 

00;52;52;27 - 00;52;57;02

Martin

what if we look at like the sale of the ownership interest, first and foremost?

 

00;52;57;03 - 00;53;23;01

Nitti

This is probably that life cycle moment that not only, you know, is most important to the person asking the question, but also causes the most confusion because people say, well, you know, my buddy did this, my buddy did that. Why are their consequences different? So with a C corporation, this is where double tax comes in, right? You’ve been paying tax at 21% all along.

 

00;53;23;01 - 00;54;02;05

Nitti

Now you want to sell the stock, you’re going to have to pay tax on that gain on the sale as well without any, you know, adjustment in your basis. So true double taxation and that’s where another 23.8% is going to come home to roost, even if you didn’t pay much in the way of dividends. But as we’ve said several times, what is so unique to certain types of C corporations is if you can benefit from QSBS rules under Section 1202, there is the potential that you walk away from that sale with zero federal income tax debt, and that just doesn’t exist for S corps or partnerships.

 

00;54;02;05 - 00;54;27;24

Nitti

So at worst, you know, you’re paying your 23.8% if you’ve held the stock for more than a year. But at best, you’re paying nothing to Uncle Sam. So that’s pretty amazing. Compare that to an S corp where an S corp, unless you have some kind of collectibles within the S corp that are subject to a look through and a 28% rate, your rate when you sell your S corp stock is going to be capital gains rate, typically 23.8%.

 

00;54;27;24 - 00;54;49;16

Nitti

You might be able to cut that down to 20% if you actively participate in the S corp, but you know, you’re walking away with a 20% rate, 23.8% rate, but no hope of excluding the gain under the QSBS rules. OK. Then we flip over to a partnership, and we have not heard a single negative thing yet today about partnerships other than self-employment tax.

 

00;54;49;16 - 00;55;19;27

Nitti

And now here’s, you know, something that people need to be aware of because the conversation I have constantly is, hey, I’m selling my partnership interest. I’ve sold stock in a corporation before. I got a buddy that sold their S corp business. I assume same treatment as them, right? Long-term capital gains and partnerships are different animals because partnerships adhere to a concept called aggregate theory, where for many purposes of the law, partnership entity doesn’t really exist, right?

 

00;55;19;29 - 00;55;46;11

Nitti

It’s just merely there to aggregate the interests of all of its partners. And that’s never better exemplified than when you sell your partnership interest. Because under an aggregate theory, unlike an S corp or C corp where you’re treated as selling stock, you’re treated as selling your slice of all the assets of the partnership. And the thing about the tax law, right, is that some assets when sold, yeah, they produce capital gains taxed at favorable rates.

 

00;55;46;15 - 00;56;12;11

Nitti

Some assets when sold produce ordinary income tax at ordinary rates as high as 37% under current law. There is no more painful conversation you can have than telling someone who’s about to sell their partnership interest that a decent portion of their gain is going to be recharacterized as ordinary income and taxed at rates as high as 37%, right?

 

00;56;12;17 - 00;56;35;11

Nitti

Because it’s hard to conceptualize, why? I sold my interest in my business no different than my buddy who sold a C corp, and you know my friend that sold her S corp. Why is it different? It’s different because you chose to be a partnership for federal tax purposes. And this is just how it goes, right? You benefit from aggregate theory when you include liabilities in your basis, but then you pay for it on the back end.

 

00;56;35;11 - 00;56;46;15

Nitti

If you have ordinary income producing assets where the sale of — the deemed sale of those assets will cause your exit to be more painful than you realize.

 

00;56;46;16 - 00;57;04;18

Martin

Right, right. And that is to your point, one of those just, it’s admittedly, it can be very confusing to a, you know, a business owner that’s not thinking about the, you know, these differences, right? And, well, why is this different? It can be very surprising. But, you know, it’s also where it’s helpful to be having these conversations on the frontend, really be thinking through all of these components.

 

00;57;04;18 - 00;57;24;11

Martin

The exit I always say is an equalizer. You know, in a lot of respects in these calculations — yes, 100% — when you’re evaluating. And that’s a big, big reason why, you know, I guess I mean, I guess I’ve been when I say like the end without maybe mentioning like death, I guess, right? But you know, if you’re holding an ownership interest, what are the differences there?

 

00;57;24;11 - 00;57;28;27

Martin

And maybe going back to that aggregate theory, I guess, right, and kind of how that ends up applying.

 

00;57;28;29 - 00;57;33;07

Nitti

Yeah. I mean, not to be more of it Damien, but it’s coming for all of us.

 

00;57;33;10 - 00;57;38;01

Martin

So they say death and taxes, right? That’s the only certainty, right?

 

00;57;38;03 - 00;58;03;11

Nitti

So death, if you’re going to be heading towards that white light, your heirs would prefer that you hold an interest in a partnership compared to an S corp or a C corp why? Well, no matter what, when you die, you hold S corp stock, C corp stock, partnership interest, the basis of your stock or your partnership interest will be increased up to fair market value, right, under Section 1014.

 

00;58;03;11 - 00;58;27;18

Nitti

So that if your heirs were to sell the ownership interest, there’s going to be no, you know, no gain; that appreciation will escape gain forever. But what’s unique about partnership — or maybe I should start with S corps and C corps — is for S corps and C corps, while the basis of the stock is increased, nothing changes inside the entity. There’s no basis increase for the assets inside.

 

00;58;27;20 - 00;59;04;13

Nitti

And so if the business has to sell its assets, you’re still going to recognize that gain. Whereas with a partnership under Section 754 and as you alluded to, aggregate theory, when you die, if you have a 754 election in place under 743, not only does your basis outside the partnership step up in your interest, but you actually get to step up the basis of the assets attributable to the deceased owner inside the partnership so that if those assets are sold and not the partnership interest, you don’t have that gain inside the partnership to be allocated out.

 

00;59;04;13 - 00;59;12;11

Nitti

And so that really is an attractive attribute of partnerships as you’re nearing end of life.

 

00;59;12;13 - 00;59;27;27

Martin

Yeah. OK. So maybe you’re not going to die, but maybe the business dies. Maybe we’re going to liquidate instead. The last bucket here, just like sale, the exit. How do those stack up between our, you know, our pass-through and our C corp or S corp?

 

00;59;27;28 - 00;59;48;02

Nitti

Well, we can make quick work of partnerships, right? Because it’s just largely a big fat nothing. I mean, not guaranteed. If the cash distributed exceeds your basis, that’s going to be taxable upon liquidation. But the point is you could be passing out all types of property. Damien and Tony can go their separate ways by liquidating the partnership by passing out to buildings.

 

00;59;48;04 - 01;00;09;23

Nitti

None of that gain is going to be triggered. So 731 is very, very friendly to partnerships. But as I said, don't lose touch. If, you know, if cash comes out greater than your basis, that’s going to be taxable. But any non-cash property, it’s not going to be triggered. In the C corp or S corp setting through Section 336, which is akin to Section 311(b) that we talked about earlier,

 

01;00;09;23 - 01;00;30;00

Nitti

you try to liquidate an S corp or C corp, you treat it as if you sold all of the assets for fair market value. So there is real pain involved, particularly on the C corp side, because you’re going to pay tax once at the corporate level and then again at the shareholder level. At the S corp level, at least, it’s only one level of tax at the owner level,

 

01;00;30;00 - 01;00;53;00

Nitti

but that could have been avoided entirely had you been a partnership. But I do want to reiterate that, because I think I know where we’ll probably go next with this when we think about converting. But a liquidation of a corporate entity, C or S, whether real or deemed, is treated as if that company sold all of its assets. tangible and intangible.

 

01;00;53;02 - 01;01;11;02

Nitti

So it doesn’t matter that you might have value you can’t see and touch like an accounting firm or something like that. You’re treated as having sold that intangible value. And so liquidating either a C or S is usually going to be a very, very painful event if you’ve been accumulating value over the years.

 

01;01;11;04 - 01;01;27;07

Martin

Right, right. Yeah. And so, and maybe like, pull on a thread a little bit and go back to a comment you made earlier, right, about just, you know, maybe I’m sitting here maybe not going to liquidate, but think about maybe I decide, I want to I want to convert because again, I’m already out of the gate on where I am,

 

01;01;27;07 - 01;01;50;15

Martin

but talk through some of these factors and maybe things have changed because that also can happen. Tax law changes, we talk about that, right? But then also maybe facts have changed or whatnot. The ability to convert, like you basically, you know, you teed it up and then you supported it here a bit, you know, your thesis here that you know, converting from an S or a C to a partnership can be pretty painful, right?

 

01;01;50;19 - 01;02;04;17

Martin

You were just talking about like on the liquidation and for that reason, but what would you say, you know, if you’re going to kind of walk through or think about these conversions and maybe flip from one form to another, that being the most painful, maybe, you know, how do you rate those?

 

01;02;04;18 - 01;02;24;28

Nitti

It’s a huge deal, Damien, because sometimes we do change midlife, right? Maybe somebody’s been listening into this podcast and saying, I think I can benefit from QSBS. I want to flip from LLC to C. Or somebody says, boy, those LLCs sound pretty good. I want to move, you know, from an S or C to an LLC. But what flexibility do we have?

 

01;02;25;00 - 01;02;50;02

Nitti

Well, first of all, you can always formally do anything you want, right? So if you have a C corp, you can formally liquidate it and convert it under state law into an LLC, right? You have that option even though you can’t use the check-the-box regs for a C corporation. But what word did we just use? If you want to go from a C corp or an S corp to an LLC, whether it’s through a check-the-box regs because you could have a C corp that’s taxed as a C.

 

01;02;50;05 - 01;03;07;23

Nitti

That’s an LLC under state law, right? So you might have checked the box to become a C. And now you want to check the box again to become a partnership. Anytime you convert a C or an S to an LLC, whether it’s done through check-the-box, whether it’s done through a state law conversion, however fancy you try to get with it,

 

01;03;07;29 - 01;03;31;17

Nitti

it is going to be treated as a liquidation of the C or S corp. And what do we just get done saying? Liquidations trigger all the appreciation in the assets of the corporation, tangible or intangible. And so what we’re learning here is I always feel bad doing this, Damien, because I spend the whole conversation, you know, selling LLCs.

 

01;03;31;17 - 01;03;53;00

Nitti

And then I have to break it to people that if you’re currently a C or S, it’s going to be awfully hard to get into an LLC, unless you have a very unique and probably less than ideal set of facts, because it means you haven’t accumulated any real value in your S or C corp. Unless you want to pay tax on all the appreciation you’ve accumulated over the years, you can’t get there.

 

01;03;53;01 - 01;04;16;20

Nitti

You can’t get from a C or an S to an LLC. And so I think this should factor into choice of entity analysis, because what if you start life as an LLC and now you want to go to C or S? Well, that is a deemed incorporation, LLC transfers its assets to a corporation, gets back stock, LLC liquidates by passing the stock out to its partners.

 

01;04;16;20 - 01;04;38;28

Nitti

That is taking this conversation full circle, right? When we talk formation, that is a deemed 351 incorporation and generally will be tax-free. When wouldn’t it be tax-free? What did we talk about earlier? If the liabilities of the partnership exceed the tax basis of the assets, you always have to be wary of 357C, but we can pull this off.

 

01;04;38;28 - 01;05;24;23

Nitti

We can go from LLC to S or LLC to C tax-free. You can’t go the other direction tax-free. So knowing that, doesn’t it kind of make sense to say if I’m not sure if I’m weighing all these options and I don’t know what’s best for me, and I have some, you know, hesitancy about one or vs. the other and what might be best, if you know that you can go LLC to S or C tax-free, but you got no prayer of going S or C to LLC tax-free, might it behoove business owners to start life as an LLC and then see how things go from there?

 

01;05;24;24 - 01;05;32;06

Nitti

Because like I said once, if you choose S or C, just know that you’re really not getting back into a partnership.

 

01;05;32;08 - 01;05;46;17

Martin

That’s right. Yeah. Your flip is if you know, you think that you want your 1202, I guess, right? And that’s when you know you want to start with a C. But again, there is no one-size-fits-all here, I think it’s like the biggest takeaway, right? But yeah, you get just so much more flexibility, which I think anymore,

 

01;05;46;18 - 01;06;04;29

Martin

and a lot of times what I see is if you have different ventures going on or different investments, it’s sort of aligning the right tool for the job maybe. You know, all right, well, this fits well with this fact pattern. You know, maybe this venture fits well with this fact pattern. And so maybe I’ve got different options, right? I don’t have to go all one way or all another way

 

01;06;05;01 - 01;06;06;28

Martin

to find the right tool for the job.

 

01;06;07;01 - 01;06;28;14

Nitti

You see that all the time in practice, right? A business owner just had this conversation yesterday with our buddy, Josh Peifer at Ernst & Young LLP (EY), where, you know, you have a business that wants to form and it’s going to need real estate, but when they sell the business, they don’t know that they necessarily want to sell the real estate. They might want to continue on as landlords.

 

01;06;28;16 - 01;06;53;12

Nitti

OK. Well let’s make sure then, right, that we can put the business into whatever entity we think makes sense. But what did we learn here today, Damien? With real estate, right, where should we probably be parking that real estate? What type of entity? We should be putting it into a partnership. And so we could end up in a situation where we have a partnership renting property over to a C corp or an S corp that conducts the business.

 

01;06;53;12 - 01;07;05;08

Nitti

Very common to have different choice of entity within your structure is what I would say. You know, there’s no, like I said, one-size-fits-all, even for any one taxpayer.

 

01;07;05;10 - 01;07;34;11

Martin

Yeah. I think that’s right. And that’s really where we’re at this inflection point, if you will, I guess, right? Because we’ve had recent tax legislation. Maybe we know the levers are going to kind of stay where they are. At least, you know, nothing happens, absent legislative change on a lot of areas and a lot of fronts on the tax rate side of things, at least, I guess, you know, one thing we didn’t talk about, maybe some differences in state and local tax deductibility perhaps in, you know, flowing through the individual side or trust side vs., you know, a corporation.

 

01;07;34;11 - 01;07;53;07

Martin

But perhaps, Tony, I can think of maybe no better way to kind of go full circle with the conversation than to think about, you know, what I know was a very popular conversation coming out of the Tax Cuts and Jobs Act of saying, well, maybe I’m an S corp and I want to go to a C corp because I think it helps to frame the whole conversation of, you know, what are the factors they should think about.

 

01;07;53;07 - 01;08;07;11

Martin

We’ve talked a lot about these, about the life cycle, right? But maybe what are some other things in particular with this, you know, one maybe S to C or whatnot or choosing between the two, would you consider when you’re stacking these things up together?

 

01;08;07;12 - 01;08;26;06

Nitti

So that’s a great point. You know, I spent that time talking about going from S to C to LLC or vice versa. And as I often did, do I get distracted and forget to touch on some of the other basics? Like, you can also move from C to S or S to C generally without any immediate tax consequence, I should say.

 

01;08;26;14 - 01;09;03;05

Nitti

But you know, it doesn’t mean there’s not a lot of things to consider. And as you point out right now, what we’re getting a lot of is, hey, I’ve been an S corp, but 21% rate, that sort of thing, a potential for QSBS. Yeah, maybe I’m better off as a C corporation. Should I make the move? I’ll hit you with kind of a quick bullet list of what I always look at when I kind of do this analysis, but I start by telling people, that’s not a pool you can dip your toes into, right?

 

01;09;03;06 - 01;09;23;08

Nitti

If you revoke your S election to become a C corporation, which you’re entitled to do, you can’t go back to being an S corporation for at least five years. And so that’s important, right? It’s not like you can try it out for a year and if you don’t like it, just make a new S election. You’re committed for five years.

 

01;09;23;12 - 01;09;41;13

Nitti

In a way, you’re committed for ten years because if you wait five years and make a new S election, then you’re subject to built-in gains holding period for five years. And it’s like you really want to go into this eyes wide open. And so when I talk to people about what factors they should consider, I always start with this,

 

01;09;41;13 - 01;10;04;14

Nitti

Damien, right? If there is any possibility you’re going to sell this business in the next 8 to 12 years, it probably doesn’t make sense because at 21% corporate rate is nice as it can be, unless you’re going to benefit from QSBS upon the sale and that’s tricky to do when you revoke an S election to make your stock QSBS eligible,

 

01;10;04;16 - 01;10;31;26

Nitti

a lot of those savings, and in most cases within a ten-year window, all of those savings are going to be reversed when you sell your ownership interest. And so I really get more excited about this S vs. C analysis when someone can tell me we are not listening to any offers, I can promise you, we’ve been family owned for 30 years, and we’re going to be family owned for the next 30 years because the sale is usually going to reverse any benefit. From there,

 

01;10;31;27 - 01;10;51;22

Nitti

you know, I’ll say, well, we talked about this today, C corps going to look more attractive as you’re making fewer and fewer distributions to the shareholders that are causing a second level of tax. So if you planning on distributing all your cash out every year after paying corporate-level taxes, C corp, you know, the math is not going to be nearly as attractive.

 

01;10;51;22 - 01;11;13;08

Nitti

But if you’re saying, hey, we’re entering a ten-year period here where we intend to reinvest as much of our income into our business as possible, then all of a sudden I say, OK, well, the math is going to look pretty nice as a C corporation, as long as you acknowledge that you’ll have to pay some dividends. Then there’s some more esoteric things, Damien, S corps might have accumulated an adjustment account.

 

01;11;13;08 - 01;11;35;11

Nitti

And while few people really understand what that does, is it represents the amount of income the S corp has earned that can be distributed to shareholders without being a dividend. And if you leave S status and become a C corp, you’re given a one year grace period to distribute that triple A balance in cash. And if you don’t, that attribute simply disappears.

 

01;11;35;11 - 01;12;04;12

Nitti

And now when you distribute that income as a C corp, it’s going to be taxed as a dividend. That’s a painful hit. Distributing income that would have been tax-free and instead voluntarily paying 23.8% on it, that’s a bitter pill to swallow. And so oftentimes someone will come to me and say, thinking about converting from an S to C and I look at their most recent return and see $200 million of AAA, I’ll say, OK, tell me what your plan is to encourage that AAA balance within one year of revoking the election.

 

01;12;04;12 - 01;12;25;14

Nitti

Because if we don’t have a plan, this may not be worth pursuing because we’re going to be giving away this valuable attribute. And then there’s math involved too. Like if you’re not benefiting from 199A, right, if you’re a doctor, lawyer, accounting actor, athlete, then the math is different. Like we talked about earlier today, you’re comparing 37% to 39.6% on the C corp side

 

01;12;25;14 - 01;12;53;04

Nitti

even with double taxation. That’s why we have seen a lot of personal service firms jump ship to become C corporations over the last eight years. Because if you’re not benefiting from a 20% pass-through deduction, your math is very different from someone who is. And so those are the biggest things that I look at. But probably the real takeaway there is not a decision to be made lightly, because if you revoke your S election, you’re not getting back into S corp life for five years.

 

01;12;53;06 - 01;12;58;29

Nitti

And even if you do, you’re going to have to wait out a five-year built-in gains holding period.

 

01;12;59;01 - 01;13;21;09

Martin

Right. I mean, you know, we’ve highlighted a little bit of like on the flexibility side, right? But I mean, there is a lot of value to flexibility to your earlier point of, you know, maybe we stay an LLC than tax the partnership if we’re not sure, because yeah, it gives us a little more flexibility. But yeah, I mean, this is not to be taken lightly because you said you can’t un-ring the bell once you’ve rung the bell there, at least for a period of time, you’re on the sidelines, I guess, if you will.

 

01;13;21;10 - 01;13;39;11

Martin

But you’ve also made another great point of, yeah, the exit. I mean, that’s the equalizer, right? It’s the great equalizer in this conversation. So you can’t always predict tomorrow when you have to make some of these decisions based off of what your best look at your crystal ball is, I guess, right? But I mean, that is certainly one that really tips the scales, if you will, I guess, right?

 

01;13;39;12 - 01;14;02;16

Martin

So gosh, I mean, I know I always love talking about this stuff with you, Tony because — there are so many considerations and it is, it’s a process as a conversation. It’s not a one-size-fits-all, to kind of overuse that phrase, because I think that’s the best way of describing is you can’t just look at somebody and say, on the surface, whether they’re a form of business or there’s a choice of entity, is the right one

 

01;14;02;16 - 01;14;12;26

Martin

without digging in and actually understanding and doing a proper analysis for my take. I mean, I don’t know, would you agree with that? Is that overstating it? I mean, I feel like you’d agree based on our conversation here.

 

01;14;12;28 - 01;14;29;26

Nitti

Yeah, we have done a thorough analysis here today, but not nearly thorough enough, right, for someone to pull the trigger. I mean, think about this, right? Someone might be listening right now and going, well, wait a minute. You know, I’m a law firm or accounting firm and I’m not benefiting from 199A. Maybe I should incorporate in five years from now

 

01;14;29;27 - 01;14;56;24

Nitti

benefit from QSBS, well guess what, right? Certain businesses are ineligible for the QSBS 1202 exclusion under 1202E. Those businesses are going to sound awfully familiar for people who are pass-through businesses benefiting from 199A or not benefiting, I should say. It’s just a matter of sitting down with somebody you know, talking about your goals, your expectations, your hopes, your dreams, and hopefully they lay out on a life cycle approach like this, the different considerations.

 

01;14;56;24 - 01;15;23;17

Nitti

And remember, you wish you could pick and choose. You wish you had the self-employment tax savings of an S corp, but the debt basis of a partnership, but also the QSBS exclusion of a C corp. You can’t have it that way. So you got to just weight what works best for you. And as we said, consider the flexibility or lack of flexibility depending on which way you choose to start life.

 

01;15;23;19 - 01;15;43;29

Martin

Ah, you see, this is what I love about the study of choice of entity. On the surface, it looks like a simple question, but careful study demonstrates that you can have a whole series of reactions that you didn’t anticipate. And really, that’s the point. Just like in chemistry, the outcome isn’t determined by what something is called, but how it’s put together and how it behaves when real world pressures are applied.

 

01;15;44;02 - 01;16;02;12

Martin

We’re out of time in the lab today, but you can find more insights on the topics we covered today and some of those that we didn’t at EY.com. As a reminder, this podcast is intended for informational and educational purposes only. It’s not tax, legal or financial advice, so please always consult with your own advisor, which of course we’re happy to become

 

01;16;02;12 - 01;16;19;11

Martin

if we don’t currently work with you. Please let us know what you think of the podcast and help others find it by leaving us a rating and review. And finally, don’t forget to follow Elements of Private Tax, so you don’t miss our upcoming episodes, as we’ll be right back in your feed soon. Until then, I’m Damien Martin and thank you for listening.