Effects of Tax Rate Changes After Extension to Bush Tax Cuts End

Published: April 21st, 2011

By: Stephen R. Looney

Since the Tax Reform Act of 1986,[1] almost all entities have been formed as, or converted to, pass-through entities such as S corporations, limited liability companies (LLCs) or limited partnerships.  Evidence of this trend can be seen in the chart set forth below as Exhibit 1 published in June of 2010 by the IRS.[2]  The chart additionally points out that despite the tremendous popularity of LLCs over the last decade, the number of entities filing returns as S corporations still exceeds the number of entities filing returns as partnerships and it is expected to stay that way for the foreseeable future.

 Exhibit 1 Statistics Regarding Choice of Entity

 

2009

 

2010

(Projected)

2014

(Projected)

2017

(Projected)

Form 1065

3,564,630

3,719,500

4,439,800

4,856,300

Form 1120S

4,495,685

4,472,200

5,068,200

5,553,800

Form 1120

2,148,339

2,042,100

1,968,300

1,941,100

 Because the Bush tax cuts have been temporarily extended through December 31, 2012, the tax rates are not scheduled to change until 2013.  Exhibit 2 shows the various tax rates for 2011 and 2012, as well as the estimated tax rates for 2013.  The rates in Exhibit 2 also apply to ordinary income that flows through an S corporation, LLC or partnership to its shareholders, members or partners.  Exhibit 3 shows the corporate income tax rates for the 2011 through 2013 tax years.

Exhibit 4 shows the tax rate on long-term capital gains and dividends for 2011 and 2012, as well as the scheduled tax rates on long-term capital gains and dividends for 2013.

 

EXHIBIT 2

2011-2012 and 2013 Income Tax Rates

 

 

                            Individual Income Tax Rates (2011 and 2012)

 

Tax Bracket

Single

Married Filing Jointly

10% bracket

$0 – $8,375

$0 – $16,750

15% Bracket

$8,375 – $34,000

$16,750 – $68,000

25% Bracket

$34,000 – $82,400

$68,000 – $137,300

28% Bracket

$82,4000 – $171,850

$137,300 – 209,250

33% Bracket

$171,850 – $373,650

$209,250 – $373,650

35% Bracket

$373,650 +

$373,650 +

                           Estimated Individual Income Tax Rates – 2013

 

Tax Bracket

Single

Married Filing Jointly

15% Bracket

$0 – $34,850

$0 – $58,200

28% Bracket

$34,850 – $84,350

$58,200 – $140,600

31% Bracket

$84,350 – $171,850

$140,600 – $214,250

36% Bracket

$171,850 – $382,650

$214,250 – $382,650

39.6% Bracket

over $382,650

over $382,650

             

 

EXHIBIT 3

Corporate Income Tax Rates (C Corporations – 2011 through 2013 (No Changes)

 

Tax Bracket

Amounts

15% Bracket

$0 – $50,000

25% Bracket

$50,000 – $75,000

34% Bracket

$75,000 – $100,000

39% Bracket*

$100,000 – $335,000

34% Bracket

$335,000 – 10,000,000

35% Bracket

$10,000,000 – $15,000,000

38% Bracket**

$15,000,000 – $18,333,333

35% Bracket

over $18,333,333

* The 39% tax bracket applies until the benefit of the 15% bracket and 25% bracket have    been “given back,” and the average rate is 34%.

 

**The 38% tax bracket applies until the benefit of the 34% has been “given back,” and the average rate is 35%.

 

     

 

EXHIBIT 4

2011-2012 and 2013 long-term capital gains, dividends, and maximum marginal combined tax rates.

 

 

Tax Rate on Long-Term Capital Gain (Non-Corporate Taxpayers)

 

2011-2012

2013

15% maximum rate

20% maximum rate

These rates also apply to net long-term capital gain that flows through an S corporation, LLC, or partnership to its shareholders, members or partners.

 

Tax Rate on Dividends (Non-Corporate Taxpayers)

 

2011-2012

2013

15% maximum rate

39.6% maximum rate

Maximum Marginal Combined Federal Tax Rate on a C Corporation’s Income or Gain that is Distributed as Dividends to its Shareholders

 

2011-2012

2013

44.75%

60.74%

     

The potential change in tax rates, occurring after this latest extension of the Bush tax cuts ends, will result in the maximum marginal tax rate applicable to individuals exceeding the maximum marginal tax rate applicable to corporations for the first time in a number of years.  As a result of the potential for the maximum marginal tax rate for individuals exceeding the maximum marginal tax rate for corporations, some commentators have predicted a resurgence of C corporations.  However, if such C corporations desire to distribute their earnings out to their shareholders, even the current 44.75% maximum marginal combined tax rate applicable to corporations and shareholders should be enough of an incentive for such corporations to be formed as, or to remain, a passthrough entity.  If the rates are increased in 2013 as scheduled, the maximum marginal combined tax rate will rise to an onerous 60.74%.  Additionally, C corporations, unlike passthrough entities, will still be subject to double taxation on the sale of their assets.

A number of considerations should be taken into account by the tax practitioner in connection with tax rates scheduled to change in 2013.  First, because of the substantial increase in the maximum marginal combined tax rate on a C corporation’s earnings distributed as dividends to its shareholders, this will likely provide added incentive for the IRS to make unreasonable compensation attacks on C corporations.

Additionally, to the extent that a taxpayer has an opportunity to make a sale subject to the 15% capital gain rate in effect before the rate increases to 20%, the taxpayer should make such sale and do so on a cash basis, because if the taxpayer utilizes the installment sales method any future installments will be taxed at the capital gain rate in effect at the time such installment is received.  Similarly, a taxpayer who has the opportunity to engage in a like-kind exchange under Section 1031 may elect to forego the like-kind exchange and recognize gain at the current 15% capital gain rate.  If a taxpayer currently holds an installment sales obligation, such taxpayer may want to take some action to accelerate the gain inherent in the installment sales obligation in order to recognize gain at the current 15% capital gain tax rate.[3]

Finally, for S corporations having accumulated subchapter C earnings and profits which are potentially subject to the tax on excess passive investment income imposed under Section 1375,[4] a common method of avoiding such tax (and possible termination of the corporation’s S election under Section 1362(d)(3)),[5] is for the S corporation to make an election to distribute its accumulated subchapter C earnings and profits first (before its accumulated adjustments account)[6] or to make a deemed distribution of its accumulated subchapter C earnings and profits first as provided for under the regulations.[7]  Although any such distribution results in the taxpayer-shareholder paying tax on such distribution at the current 15% tax rate on dividends, most taxpayers have found this an acceptable cost of avoiding the tax imposed under Section 1375 or losing their S elections under Section 1362(d)(3).  If, however, the dividend rate returns to the tax rate imposed on ordinary income, the maximum marginal tax rate on dividends will increase to 39.6%, and will make this planning tool much less attractive to taxpayers.  Consequently, tax practitioners representing S corporations having accumulated subchapter C earnings and profits potentially subject to the tax on excess passive investment income should consider making a distribution or deemed distribution of the corporation’s accumulated subchapter C earnings and profits prior to the tax rate on dividends increasing.

Despite the trend evidenced in Exhibit 1 above, it is interesting to note that a number of practitioners and clients have remained or been formed as C corporations, especially in the professional service corporation context, based on the premise that they can successfully avoid the double tax on earnings by payment of all of the earnings of the corporation as deductible compensation to their shareholder-employees, and on the premise that such corporations can avoid payment of the double tax on the sale of their assets by allocating the bulk of the sales proceeds to so-called “personal goodwill.”  Both of these tax avoidance mechanisms are questionable, in light of recent cases in the reasonable compensation area emphasizing the independent investor test[8] (as well as prior decisions of the Tax Court in Pediatric Surgical Associates[9] and Richlands Medical Association[10]), and the Howard[11] and Kennedy[12] cases in which the courts denied allocations to personal goodwill on the sale of professional practices.

 


[1] Pub. L. No. 99-514, 100 Stat. 2085 (1986).

[2] Document 6292, Office of Research, Analysis and Statistics, Fiscal Year Return Projections for the United States: 2010-2017, Rev. 6/2010.

[3] Section 453B(a) provides that if an installment obligation is satisfied at other than its face value or distributed, transmitted, sold, or otherwise disposed of, gain or loss will result to the extent of the difference between the basis of the obligation and (1) the amount realized, in the case of satisfaction at other than face value or a sale or exchange; or (2) the fair market value of the obligation at the time of distribution, transmission, or disposition, in the case of a distribution, transmission or disposition other than by sale or exchange.  In such event, any gain or loss will be considered as resulting from the sale or exchange of the property with respect to which the installment obligation was received.

[4] Section 1375 imposes a tax on S corporations having accumulated subchapter C earnings and profits and gross receipts more than 25% of which are passive investment income.  The tax is imposed on the excess net passive income of the S corporation at the highest rate of tax specified under Section 11(b) applicable to C corporations.

[5] Section 1362(d)(3) provides for the termination of a corporation’s S election where it has accumulated subchapter C earnings and profits at the close of each of three consecutive tax years and has gross receipts for each of such tax years more than 25% of which are passive investment income.

[6] Section 1368(e)(3).

[7] Reg. 1.1368-1(f)(3).

[8] See Menard, Inc. v. Commissioner, 560 F.3d 620 (7th Cir. 2009) and Multi-Pak Corp. v. Commissioner, TCM 2010-139.  For a discussion of the Multi-Pak case, see Klein and Looney, “Multi-Factor and Independent Investor Tests Used to Determine Reasonable Compensation,” 12 BET 37 (September/October 2010)

[9] Pediatric Surgical Associates, P.C. v. Commissioner, TCM 2001-81.

[10] Richlands Medical Association v. Commissioner, TCM 1990-66, aff’d without published opinion, 953 F.2d 639 (4th Cir. 1992).

[11] Howard v. U.S., _____ F.Supp. 2010-2 USTC ¶50,542 (E.D. Wash. 2010).

[12] Kennedy v. Comm’r, 671 F.2d 167, 82-1 USTC ¶9186 (6th Cir. 1982), rev’g and remanding, 72 TC 793 (1979).