The Impact of Tax Reform on the Choice of Small Business Legal Form

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ABSTRACT: IMPACT DES REFORMES FISCALES SUR LE CHOIX DE NATURE JURIDIQUE DES PETITES ENTREPRISES

La reforme fiscale de 1986 aura un impact profond sur toutes les entreprises. Les petites entreprises, en particulier, devraient penser serieusement a changer leur nature juridique afin de s'assurer un statut fiscal plus avantageux, Le "Subchapter S" du formulaire des corporations permettra a de nombreuses entreprises de conserver un impot sur les societes qu'elles trouvent avantageux, tout en evitant une augmentation impoortante des taux reguliers, et une double imposition.

The Tax Reform Act (TRA) of 1986 provides for the most drastic restructuring of income taxes since that tax was first imposed in 1913..sup.1 "This new Act manifests the intention of Congress and the President that investment prospects stand on their own"; that is, in the future, investment should be directed to economically productive uses, rather than to take advantage of tax breaks..sup.2 Furthermore, the intent was to force business to pay a larger proportion of the total tax bill and to eliminate the public perception of inequality that arose as many large businesses paid little or no income tax..sup.3

By eliminating many investment incentives as well as capital gains, and by greatly changing the tax rate structure, the TRA has had a major impact on the choice of entity for conducting business. A recent survey of small business owners whose firms are organized as corporations indicates that 25 percent are contemplating switching to another form of ownership..sup.4 Provisions such as the imposition of a strengthened alternative minimum tax, repeal of the General Utilities doctrine, and the limitation on use of the cash method of accounting make the C Corporation a less attractive form of doing business. As a result, small business taxpayers should now reevaluate the appropriateness of corporations as their legal form.

This article provides an updated view of the income tax consquences of TRA changes on the choice of a business form. In addition, tax planning opportunities are analyzed to illustrate how to maximize the potential of various forms.

FORMS CONSIDERED

The business forms to be considered are the "regular" or C corporation, the partnership (including the master limited partnership), and the Subchapter "S" corporation. Unless otherwise stated, general and limited partnerships are treated together, as their tax treatment is virtually identical.

S corporations are corporate entities that elect to be taxed like partnerships, while retaining their corporate status for other purposes. Only certain corporations are eligible to elect this federal tax status. Generally, the requirements are: (1) 35 or fewer shareholders; (2) all shareholders are individuals who are either United States citizens or residents; (3) issuance of common stock only; and (4) unanimous election by the original shareholders.sup.5

Ten states do not have a counterpart to the federal "S" Status.sup.6 Corporations in these states must use two reporting systems if they elect federal Subchapter "S" status, and they are subject to double taxation for state tax purposes.

ORIGINAL INVESTMENT

The exchange of property for other property can generate taxable income to the transferor unless a deferral section is provided by the Internal Revenue Code..sup.7 For example, if an individual exchanges an automobile that costs $4,000 for stock that is worth $5,000, that person has a taxable gain of $1,000..sup.8

To alleviate this problem on the formation of a business, several mandatory Internal Revenue Code Sections require that any taxable gain be postponed if appreciated property.sup.9 is contributed to a corporation.sup.10 or a partnership.sup.11 in exchange for stock or ownership interest in a partnership.

The application of these sections to the above example would be as follows: if an individual exchanges an automobile for stock in a corporation or interest in a partnership worth $5,000, there is no current tax liability. …