2020 Year-End Tax Guide

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THE MARCUM 2020 YEAR-END TAX GUIDE

Qualified Small Business Stock

Example: Taxpayers A and B form a new entity, investing $2,000,000 (50/50 members). The business is expected to earn $100,000 each year over the next five years, and the owners will receive distributions of the same amount. After five years, the value of the entity has increased to $5,000,000 and will be sold for that amount. How would the choice of entity impact the taxation to the members? For simplicity purposes, state taxes have been ignored for this example but should be considered in the final decision. If the entity is formed as a limited liability company (taxed as a partnership), both members would be allocated 50% of the profits, or $50,000 each year. Assuming both taxpayers are in the highest tax bracket, and qualify for the full qualified business income deduction, the tax on this would be $14,800 each year at a tax rate of 29.6%. The distribution of the funds would be a tax-free event since there is sufficient basis available. When the entity is ultimately sold for $5,000,000, the members would each recognize gain of $1,500,000 and would incur tax of $300,000 at the highest 20% capital gains rate. Instead, what if the entity was formed as a C Corporation? The entity itself would pay tax on the annual income of $100,000, which would be $21,000 each year at a rate of 21%. After payment of corporate level income tax, income of $79,000 will remain to distribute. The members will be taxed on the annual distributions of $39,500 each, which would be $9,401 at a rate of 23.8% (20% on the dividend distribution plus the 3.8% net investment income tax). Upon sale of the stock, the taxpayers will be able to exclude the full gain of $1,500,000 each.

The tax calculations for each type of entity are as follows:

Partnership C Corporation

Entity-level tax

$0

$105,000

Member-level tax on earnings

$148,000

$0

Member-level tax on distributions

$0

$94,010

Member-level tax on sale

$600,000

$0

Cumulative Taxes

$748,000

$199,010

Comparing the two scenarios above, the C Corporation structure will save $548,990 in total taxes. However, the tax savings ultimately depend on the sale of the entity. Without the sale and Section 1202 exclusion, the C Corporation structure would actually result in additional taxes. Choice of entity is still a relevant decision to make and you should consult with your tax advisor to determine the best course of action.