Corporations have been used as business organizational structures for a very long time. Therefore, the laws regarding corporations are deep and comprehensive. And, because LLCs were not available as organizational tools in the 1980s and before, many older businesses have been and remain corporations.
Independent from the legal liability protections offered by corporations, corporations have some tax advantages as well. These advantages have become more pronounced with Congress’s tax law changes over the last few years.
When it comes to corporations and taxes, the shareholders (owners) of a corporation can choose the tax treatment of the corporation. There are primarily two tax treatments for corporations. The first treatment of taxation is known as “c” treatment. The second treatment of taxation is known as “s” treatment. A for-profit corporation cannot be both a c-corp and an s-corp at the same time, and the process of changing after the corporation is established is not simple or immediate.
Although there are numerous differences between c-corps and s-corps, the biggest differences that arise among my clients in contrasting c-corps with s-corps concerns income tax and capital gains tax.
The shares (but not the assets themselves) in c-corps are subject to a step-up in the tax basis when the shareholder dies. The tradeoff of that benefit is that the annual income in c-corps is taxed before it is distributed to the shareholders as earnings. Then, the shareholders personally pay income tax again on those earnings. This is the traditional “double taxation” trap that many people want to avoid.
To avoid double taxation, corporations may choose to be treated as s-corps, in which instances there is no “double tax” on the annual earnings of the corporation. The trade-off of getting out of double-tax on earnings is that there is no increase in the tax basis of shares (or assets) in an s-corp when the shareholder of an s-corp dies.
Many corporation clients of mine are shareholders in family corporations that own land, including farmland. As family members get older, some family members may no longer want to own real estate as an investment (or own shares in a corporation that owns real estate) and would rather invest their inheritances in other investments, such as the stock market.
The bigger struggle is that removing assets from a corporation (including exchanging shares for corporation assets) is considered a sale of the assets (at fair market value), so the transaction becomes a taxable event, usually subject to at least capital gains tax. Although technically complex, in c-corp asset distributions, the corporation and shareholder can both have some tax liability. In s-corps, shareholders have tax liability.
Some corporation shareholders are removing assets from corporations right now for two primary reasons. First, farmland and real estate prices are somewhat softer right now (in the midst of the pandemic and low farm commodity prices) vs. recent years. Second, the current, federal capital gains tax rate is low, historically speaking (15% or 20%). Thus, this may present an opportune time to review corporations’ statuses with tax and legal professionals.
Lee R. Schroeder is an Ohio licensed attorney at Schroeder Law LLC in Putnam County. He limits his practice to business, real estate, estate planning and agriculture issues in northwest Ohio. He can be reached at Lee@LeeSchroeder.com or at 419-659-2058. This article is not intended to serve as legal advice, and specific advice should be sought from the licensed attorney of your choice based upon the specific facts and circumstances that you face.