Roger Royse's presentation on the choice of entity under the Tax Reform Act of 2017 (presented by the Partnerships and Limited Liability Companies). This is part 1 of 1.

1. Business Law Section
Partnerships and LLCs Committee
Choice of Entity under the Tax Reform Act
of 2017 (presented by the Partnerships and
Limited Liability Companies)
November 15, 2018

2. LLC (not taxed as corp) S Corporation C Corporation
Entity Level Federal
Income Taxes
No federal tax at LLC level. Generally no tax at S
corporation level; some excise
taxes, and built in gains taxes
may apply.
Income tax on earnings at
corporate level.
Eligibility
Requirements of
Owners and Equity
No restrictions. US citizens or resident
individuals, certain trusts, and
certain tax exempt entities.
100 max (generally).
One class of stock limitation.
No restrictions.
Entity Level
California Taxes
Gross receipts fee, unlike state
law partnerships. $800 minimum.
Minimum franchise tax of $800
or 1.5% taxable income.
8.84% corporate rate
applies, or $800 minimum
franchise tax.
Option Plans, NSOs,
ISOs
Employees & consultants can be
given options to acquire LLC
interests, but such options are
generally more complex, and
cause §704(b) challenges. ISOs
not available, but profits interests
generally superior to ISO.
ISOs commonly granted to
employees. NSOs may be
granted to employees,
consultants, and advisors.
ISOs commonly granted to
employees. NSOs may be
granted to employees,
consultants, and advisors.
1. Choice of Entity (Assuming Domestic Entity)
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3. LLC (not taxed as corp) S Corporation C Corporation
Status Change on
Transfer of Interests
If taxed as partnership, LLC terminates for
tax purposes on transfer of 50% or more
of capital and profits in 12 months.
Can convert between DRE and
partnership on transfer
No termination of entity on
transfer of interests, except for
election termination on transfer
to ineligible shareholder.
No termination of entity on
transfer of interests.
Treatment of Foreign
Owners
Foreign members subject to US tax on
their share of effectively connected
income of LLC; branch profits tax may
apply.
Foreigners cannot be
shareholders of S corporation.
Foreigners are subject to
withholding tax on dividends
from US corporation, subject to
treaty rate or exemption.
Foreign Individual
Owners - Transfer
Taxes
Unclear. N/A. Foreigners cannot be
shareholders of S corporation.
Corporate stock may be gifted tax
free. U.S. corporate stock will be
part of taxable estate, however.
Conversion to Another
Entity
May generally be incorporated tax free,
but see discussion herein.
Conversion between partnership and DRE
can cause tax (e.g., investment company
rules).
Can convert tax-free to C
corporation by revoking election;
likely to be taxed on converting to
LLC.
Can convert to S corporation by
making election (built in gains tax
may apply to later dispositions of
appreciated property).
Conversion to LLC likely taxable.
Taxes on Sale or
Liquidation
One level of tax, generally capital gain
except for amount allocable to certain
assets.
“Flowthrough” of international tax
characteristics to foreign seller (including
ECI).
One level of tax on sale of stock
or assets, generally capital gain
on stock sale.
No 754 election, decreasing
desirability of stock sale to buyer.
Potential double tax. Corporate
tax on sale of assets. Shareholder
level tax on sale of stock or
liquidation.
Sales by foreign shareholder likely
not U.S. taxed.
1. Choice of Entity (Assuming Domestic Entity)
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4. 199A Deduction
• 20% deduction for certain income of pass-through
entities including sole proprietorships through
2025.
• Maximum deduction is 20% of the “qualified
business income” (QBI”).
• The 199A deduction amount is equal to the lesser
of the following:
– (1) the taxpayer’s “combined qualified business
income amount,” or
– (2) 20% of the excess of (i) the taxpayer’s taxable
income for the taxable year, over (ii) the taxpayer’s net
capital gain for such taxable year.
• This calculation is subject to a number of exclusions and limitations, which has
added a great deal of complexity to this provision.

5. Qualified Small Business Income
• QBI is the net amount of qualified income, gain deduction and
loss with regards to a qualified trade or business.
– Must be effectively connected to US trade or business
– Included or allowed in determining taxable income.
Qualified Business Income does not include the following:
• Investments-dividends, interest capital gains.
• Compensation paid to an owner for services rendered with
respect to the trade or business.
– Guaranteed payments
– Reasonable Compensation
– Payment to a partner for services rendered
– W-2 Income

6. Limitations to 20% Deductions
• The 20% deduction is limited to a cap equal to the greater of:
– 50% of W-2 wages paid, or
– 25% of W-2 wages paid plus 2.5% of the original basis of “Qualified
Property”
• W-2 wages could have a larger effect on S-Corps as opposed to
partnerships.
– Partnerships do not pay W-2 Wages to partners.
– Guaranteed payments under IRC Section 707(c), if paid, are not
included (until otherwise stated by IRS) as W-2 wages, but also not
included in QBI. Payments for services covered by IRC Section 707(a)
are also not included as W-2 wages or QBI.
• Taxpayers whose taxable income is less than the “threshold
amount” do not have to follow the wage limits.
• Threshold amount is defined in Section 199A(e)(2) as $157,500 or
200% of such amount ($315,000) in the case of a joint return.
• For taxpayers with QBI falling in between $207,500 and $415,000,
there is a phase out of the wage limits which must be calculated in
order to determine the proper deduction.

7. Reasonable Compensation
S-Corporation must pay shareholders who provide services to the
company as an employee, in a reasonable amount.
Concern that reasonable compensation could have been applied to
partnerships.
Regulations provide that reasonable compensation will continue to
only be applied, in the context of Section 199A to entities taxed as S-
Corporations.
If the S-Corporation fails to pay its shareholder employees a salary, the
amount of reasonable compensation that would be applicable will still
be deducted from QBI.

8. 8
Specified Services
Section 199A(d) excludes “specified service trade or businesses”
from the definition of “qualified trade or business” for purposes of
Section 199A. That includes the following industries:
• Health Providers
• Legal
• Accounting-includes services provided by enrolled agents.
• Actuarial Science
• Performing Arts
• Financial Services
• Brokerage Services
• Other service professionals where the business is based upon a
specialized skill of one or more of the owners.

9. Specified Services Business
• For owners of excluded businesses with income less than
$157,500 for single taxpayers, or $315,000 for taxpayers filing
joint returns, the specified services exclusion does not apply and
they are entitled to full 20% deduction.
• There is a phase out for owners with income between $157,000
and $207,500 for single taxpayers, and $315,000 and $415,000
for married taxpayers filing jointly.
• Owners in excess of $207,500 for single taxpayer and $415,000
for joint taxpayers are not entitled to claim the 20% deduction.
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10. 10
What Qualifies as a Law Firm
• Law firms are included within the definition of “specified service
business.”
• What is included in the actual trade or business of a law practice?
— Performance of the services of the field of law
— Includes not just services from lawyers, but also paralegals,
legal arbitrators, mediators and other similar professions.
— Exclusions from regulations “printers, delivery services or
stenography services.”

11. 11
What is a Legal Service
• Real estate attorney who do not just practice real estate law, but
also offer title insurance etc.
• Tax lawyers who provide services that can also be offered by
other professionals cannot escape because of the accounting
services exemption.
• Attorney who provide collection services-look to the service
provided.

12. 12
Financial Comparison of C-Corp and Pass Through
C Corp. C Corp. (No
distribution)
Pass Through
(Active)
Pass-thru (No
199A)
Taxable income $1000.00 $1000.00 $1000.00 $1000.00
Entity level tax ($210.00) ($210.00) ($0.00) ($0.00)
Net distribution $790.00 $790.00 $1000.00 $1000.00
20% deduction ($200.00)
Individual tax ($180.80) ($0.00) ($290.60) ($370.00)
After-tax cash $609.20 $790.00 $709.40 $630.00
Effective tax rate 39.8% 21.0% 29.6% 37.0%

13. TEN TAX ADVANTAGES OF A C CORPORATION
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1. Operating Agreements
2. S Elections
3. Suspended Losses
4. 704(c) Allocations
5. Venture Capital
6. QSB Stock
7. Stock Option Plans
8. LLC Debt
9. Reorganizations
10. Fringe Benefits
11. Audits and Liabilities
12. Contingent Allocations

14. C Corporation
(If Qualifying for QSB Stock)
• 21% corporate income tax
• 0% on shareholders if qualifies
for QSB stock treatment
• Subject to limitations ($10
million or 10 times the taxpayer’s
adjusted basis)
• Exit: QSB stock treatment not
available in asset sale
S Corporation
• Not subject to corporate income
tax
• Up to 37% on shareholders
• Exit: can choose between stock
vs. asset sale
• Possible capital gains rates
2. Qualified Small Business Stock
GENERAL REQUIREMENTS
 Original issue
 Five-year holding period
 100% post- Sept. 27, 2010
 $50 million Gross Assets Test
 Active Business Test
 No significant redemptions
Note: California does not follow federal income tax treatment of QSB stock under I.R.C. § 1202.
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15. 2. Qualified Small Business Stock – Better than S Corp?
Qualified C-Corp S-Corp
Assets Assets
VS.
(From seller’s view)
Answer: Depends!
Compare qualified tax savings
to S-corp asset sale’s higher
pre-tax FMV
Tax Savings Favor QSB Stock
•0% rate for QSB stock sold (unless gain
exceeds threshold)
•20% rate for capital assets from S corp
(likely no SECA, NIIT)
•37% rate on OI assets from S corp
Pre-Tax FMV Favors S corp
•Buyer should pay extra to buy S corp assets;
get value of cost recovery
•Value of cost recovery can be high, if fast
rate, low future value discount
•S corporations generally have only one layer
of tax in asset sale, unless there are
ordinary income or BIG-tax assets
Note: California does not follow federal income tax treatment of QSB stock under I.R.C. § 1202.
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