Entity Selection for Attorneys

Recent Tax Law Changes

Ordinary Income Tax Hike

The ATRA was enacted on Jan. 1, 2013 to replace the expiring Economic Growth, Tax Relief and Reconciliation Tax Act of 2001 (EGTRRA), Public Law 107-16. The EGTRRA was a temporary tax reduction act passed into law during the second Bush administration.

In sum, ATRA makes permanent the EGTRRA 10, 15, 25, 28, 33, and 35 percent tax rate structure and adds a 39.6% tax bracket applicable to high income earners.

Self-Employment Tax Applies To LLC Interests

The Federal Insurance Contributions Act (FICA), 26 U.S.C '3101, imposes a tax on both employees and employers to fund Social Security and Medicare. A tax akin to FICA is imposed on the earnings of self-employed individuals by the Self-Employment Contributions Act (SECA) of 1954. SECA defines partnership income as the earnings of self-employed individuals. SECA fails to address, however, the income of Limited Liability Companies (LLCs). As a result, for over three decades uncertainty lay as to whether LLC income was subject to or exempt from SECA.

In a recent line of cases culminating in Renkemeyer, Campbell & Weaver, LLP v. Comm'r, 136 T.C. 137 (2011), the United States Tax Court answered the lingering question. In Renkemeyer , the court held LLC members who perform services for LLCs are subject to self-employment taxes, notwithstanding the fact that LLC income is not mentioned in SECA. The court also changed the focal point for determining when SECA tax attaches to the earnings of all entities taxed as partnerships. Before Renkemeyer, the focus was on whether an owner bore personal liability for the obligations of the company. After Renkemeyer' we look to the extent to which an owner provides services for the company.

Additional Medicare Tax

Under FICA and SECA, employees, employers and self-employed individuals are obligated to pay Medicare taxes. A 2.9% tax obligation is evenly split between employees and employers. See, 26 U.S.C. '3101(b)(1). Self-employed individuals are responsible for the full 2.9%. See, 26 U.S.C. '1401(b)(1).

Effective Jan. 1, 2013, the ACA imposes an additional Medicare tax (i.e., Medicare surcharge) of .9% on salaries and self-employment income earned by individuals in excess of $250,000 for married taxpayers who file jointly, and $125,000 for married taxpayers who file separately and $200,000 for all other taxpayers. See, 26 U.S.C '1401(b)(2).

Net Investment Income Tax

The ACA introduces a tax of 3.8% on net investment income. The tax, effective Jan. 1, 2013, applies to estates and trusts, and individuals whose modified adjusted gross income exceeds $200,000 for single filers, and $250,000 for married filing jointly. Included in the category of net investment income are interest, dividends, capital gains, rental income, royalty income and income from passive activities. See, Pub. L. 111-152, title I, Sec. 1402(a)(1), Mar. 30, 2010, 124 Stat. 106.

Cafeteria Plans

The ATRA makes having a cafeteria plan more affordable for small businesses. For qualifying companies, it eliminates the need for discrimination testing, provided certain minimum contribution and eligibility tests are met. With an ATRA Simple Cafeteria Plan, like a regular plan, employer and employee contributions are deductible, exempt from FICA and non-taxable to plan participants. Generally, companies with an average of 100 or fewer employees during either of the two preceding years qualify to set up a Simple Cafeteria Plan. See, 26 U.S.C. '125(j).

Limitations on Itemized Deductions

The ACA raises the threshold for itemized medical deductions. Starting in 2013, taxpayers are permitted itemized deductions for medical expenses only to the extent they exceed 10% of adjusted gross income. Before 2013, the threshold was 7.5%. What does this change mean in dollar terms? The average taxpayer now spends $2,500 more per $100,000 of income before medical expenses are deductible. Taxpayers age 65 or older are exempt from this increased AGI threshold through 2016. See, 26 U.S.C. '213.

Through a law named for its sponsor, the Pease Amendment of the AFTA reduces the deductibility of itemized deductions for individuals whose income exceeds a certain threshold. Effective tax year 2013, itemized deductions are reduced by the lesser of 3% of adjusted gross income or 80% of a taxpayer's itemized deductions. The threshold for 2013 is $250,000 for single filers, and $300,000 for joint filers. See, 26 U.S.C. '68.

Reduction of the S Corp. Built-in Gains Tax Recognition Period

The Protecting Americans from Tax Hikes Act of 2015 (PATH Act), H.R. 2029, reduces the period an S Corporation must hold built-in gains property to avoid triggering built-in gains tax. Prior to PATH, if a C Corporation made an S Corporation election at a time when the C Corporation had appreciated assets, the corporation would hold the assets 10 years to avoid built-in gains tax. The holding period is now five years.

Entity Types

General Partnerships

Whenever two or more persons join together to own and operate a business a general partnership (GP) comes into existence. Partnerships are taxed based on the pass-through method. They do not pay tax at the entity level. They pass through a distributive share of partnership income, gain loss, deduction or credit, which partners report on their individual tax returns. See, 26 U.S.C. '706(a).

Limited Partnerships

A limited partnership (LP) is a business entity that requires at least one limited partner and one general partner. The limited partner is typically not liable for the obligations of the LP and restricted from participation in the management of the company. The general partner is responsible for management of the LP and bears personal responsibility for its liabilities. A general partner is taxed essentially as a partner in a GP. The limited partner is taxed differently. A true limited partner who refrains from active involvement in the partnership's business is exempt from self-employment tax and the Medicare surcharge.

Limited Liability Company

A limited liability company (LLC) is a hybrid entity. It is treated like a corporation for limited liability purposes, but, for tax purposes can choose to be taxed either as a corporation, partnership, or disregarded entity. Like corporate shareholders, LLC members are exempt from personal liability for the obligations of the entity. Their exposure is limited to their financial investment in the LLC. Unlike an LP, all members of an LLC have limited liability. The taxation of LLC members resembles that of either a general partner or limited partner depending upon the member's level of involvement in the affairs of the LLC.

Limited Liability Partnerships

A limited liability partnership (LLP) is similar to a LLC. They differ in the protection from liability they provide to the owners of the entity. LLPs are often utilized by licensed professionals who find themselves in jurisdictions that prohibit professional LLCs.

LLPs are taxed essentially like LPs and LLCs.

Professional Service Corporations

A professional service corporation (PSC) is a unique form of entity. It was created to give professionals a business structure with the tax advantages of a C Corporation without allowing them to escape professional liability. It is available to those in the fields of law, engineering, architecture, accounting, actuarial science, the performing arts or consulting. See, 26 U.S.C. '448(d)(2).

PSCs are taxed essentially like regular C corporations. Like C Corporations, PSCs are subject to double taxation. They are taxed at the entity level and again at the shareholder level if profits are distributed out to the shareholders. Also, like a regular corporation, if a PSC has operating expenses that exceed its revenues, i.e., a net operating loss (NOL), certain restrictions on the timing of the use of the NOLs apply.

Generally, PSCs carry NOLs back two years or forward 20 years to offset income from other periods. See' 26 U.S.C. '172(b)(1)(A).

As a corporation, PSCs are also allowed to provide tax free Cafeteria plan benefits to employees, including to more than 2% shareholders. Such benefits include: 1) accident or health insurance (26 U.S.C. '106); 2) adoption assistance (26 U.S.C. '137); 3) Group term life insurance coverage limited to $50,000 (26 U.S.C. '79(a)); 4) dependent care assistance plan coverage (26 U.S.C. '129); 5) participation in a qualified cash-or-deferred arrangement that is part of a profit sharing or stock bonus plan (26 U.S.C. '125(b)(2)); and 6) other benefits allowed under the IRC, including vacation days.

If a PSC retains earnings beyond its reasonable business needs, an accumulated earnings tax is imposed on the company. This tax is assessed at a rate of 20% of the amount of the retained earnings deemed excessive.

One notable difference between PSCs and regular C Corporations is the tax bracket that applies to each. A graduated rate structure applies to regular C Corporations, while PSCs are taxed at a flat 35%.

S Corporations

An S corporation is a U.S. corporation with a maximum of 100 shareholders.

Taxed based on the pass-through method, S Corporations generally do not pay tax at the entity level. An S Corporation that sells assets subject to built-in gains tax serves as one exception. (IRC '1374(a) provides: “If for any taxable year beginning in the recognition period an S corporation has a net recognized built-in gain, there is hereby imposed a tax (computed under subsection (b)) on the income of such corporation for such taxable year.”) The potential for built-in gains is present whenever a C Corporation with appreciated assets elects S Corporation status, or is acquired by an S Corporation in a tax-free reorganization.

If an S Corporation has profits a reasonable salary must be paid to its active shareholders. These wages are subject to Social Security tax and the Medicare surcharge. Otherwise the income of S Corporations is exempt from SECA and FICA tax.

Sole Proprietorships

A single-owner business is taxed by election as either a corporation or a disregarded entity. See, Treas. Reg. '301.7701-3(a).

Entity Choice

Tax Rate Factors

One drawback of the PSC form is the prospect of double-taxation of its income. PSC income is taxed once at the entity level and again at the individual level if income is distributed out to the shareholders. LPs, GPs and LLCs are taxed only once, at the individual level. S Corporations are generally taxed once, at the individual level, but can be subject to an entity level built-in gains tax as well.

PSC double taxation can be minimized, if the PSC pays out most or all corporate earnings as deductible salary to shareholders. However, the effectiveness of this tax strategy has been curtailed somewhat, because taxes on employee wages are now higher for some as a result of the individual income tax increase brought about by the AFTA.

If a company with high income shareholders has plans for expansion or growth, the PSC may be the clear entity of choice, at least from a tax standpoint. To understand why, consider a few above-mentioned points. PSC shareholders do not pay taxes on corporate profits, unless earnings are paid out to them as salary or dividends. While the highest individual tax bracket is now at 39.6%, PSCs flat rate remains at 35%. Thus, retaining PSC earnings creates a tax advantage. It defeats double-taxation, permitting earnings to be taxed at a 4.6% lower rate. It also keeps income off of the individual returns of the shareholders thereby reducing their exposure to the Net Investment Income Tax and Medicare Surcharge.

Tax Eligibility Factors

The income of different types of entities is subject to different types of tax. The income of S Corporations and PSCs is exempt from SECA tax. Generally, the income of GPs, LPs, LLPs and LLCs is not. However, S Corporations are required to pay a reasonable officer salary out of profits, which income is subject to FICA and the additional Medicare tax.

One tax disadvantage of the PSC is attributable to the tax on accumulated earnings beyond reasonable needs. Whether a PSCs needs for retaining earnings are reasonable is determined case-by-case based on the facts and circumstances. The only certainty is that that the tax does not apply to the first $150,000 of retaining earnings. S-Corporations, GPs, LLCs, LPs and LLPs can retain income without risk of accumulated tax consequences.

A relative disadvantage of the S Corporation is its vulnerability to built-in gains taxation. When S Corporation built-in gains tax applies the affected income is taxed twice. (Companies that acquire the assets of a professional services company in a tax-free reorganization should be aware that accounts receivables of a cash bases taxpayer are subject to built-in gains tax. Professional service companies often use the cash basis of accounting.) The PATH does provide some relief by reducing the period required to hold appreciated assets to avoid built-in gains tax. See, PATH Act.

Net Operating Loss Factors

The ability to pass-through NOLs is an advantage pass-through entities have over PSCs. LLCs, LPs, LLPs, GPs and S Corporations can all pass through NOLs, which can be utilized to offset the individual taxable income of the entities' owners (provided the owners' have sufficient basis to absorb them). PSC NOLs can only be carried forward 20 years or back two years. They cannot be passed down to shareholders.

As time value of money concepts relate, deductions are most valuable the sooner they are taken. Thus, a NOL that can be used today is more valuable than one that must remain on the shelf for another day.

Moreover, applying the mirror image of the argument for retaining earnings in a PSC, today, losses that pass-through may be more valuable notwithstanding time value of money concepts. To understand, recall, for some individual taxpayers recent legislation has capped itemized deductions, introduced new taxes, and raised the top tax bracket to 39.6%. PSC earnings remain taxed at 35% and the new taxes do not apply to PSC income. Therefore, by passing losses through the type of income bearing the higher taxes may be reduced. Of course the tax implications of PSC dividends must be factored into the analysis for companies issuing them.

Employee Benefits Factors

PSCs have the edge over LLCs, LPs LLPs, GPs and S Corporations on employee benefits. Under the doctrine of constructive receipt if a taxpayer is offered the choice between cash and a nontaxable benefit, the taxpayer is deemed to have received income. This rule does not apply to cafeteria plan offers of benefits.

If a company offers its employees cash or benefits under a Cafeteria plan, the employees take the benefits tax free and the company takes a deduction for the benefits provided to its employees. See, 26 U.S.C. '125. The reason PSCs are advantageous is that all of their employee-shareholders are deemed eligible employees for cafeteria plan benefits. Partners, members and more than 2% S Corporation shareholders are deemed self-employed and thus forbidden to take a bite of the tax free cafeteria plan fruit.

It should be noted; partners, LLC members and 2% shareholders are eligible to receive some employee benefits, notably health care and employee fringe benefits. Their eligibility depends on how the benefits are administered by their companies.

The new Simple Cafeteria plan makes the PSC even more beneficial for professional services companies with less than 100 employees. Simple plans entail fewer restrictions making them less costly to operate.

Conclusion

Making the most of the entity choice is often a challenge for a law practice. To make matters worse, lawmakers have a tendency to change the laws upon which decisions are made. Nevertheless, a few broad guidelines can be offered based on the federal tax laws currently in place. PSCs may be best if a practice has partners taxed at a rate in excess of 35%, and the company has plans to expand or its profits will be zero. An LLC, LP, LLP or GP may be optimal if a company has no plans for expansion and more than 100 partners. An S Corporation has allure if a company has high profits and less than 100 shareholders. That said, before selecting an entity a full evaluation of all factors relevant to the decision is critical.

Marcus E. Dyer, CPA, Esq., is a Tax Manager in Withum's Law Firm Industry group. He and the firm's Law Firm Industry Group serves the needs of middle market law firm's addressing all of their accounting, tax and consulting needs. He can be reached at [email protected].