What if Congress really does lower the corporate income tax rates?

Lowering the federal corporate tax rate - I suspect a tough sell. But, it could happen within the guise of job creation. I'm not going to comment on the wisdom (or, lack thereof) of such a move. Beyond me to be sure. However, it started me thinking about how some of my clients might react.

I suspect your business customer portfolio is similar to mine - closely held 'C' and 'S' corporations, limited liability companies and partnerships. Throw in the occasional sole proprietorship as well.

Corporate tax rates should be viewed in relation to alternative tax rates. Doing so introduces intriguing present and future tax options.

Here's the corporate and personal maximum tax rate structure today and what it might look like in the future.

Corporate                                        Personal*

35 Percent          TODAY                   35 Percent

-----------------------------------------------------------

< 35 Percent      FUTURE              > 35 Percent

*Includes taxable income from pass through entities (S corporations, partnerships, multiple member LLCs taxed as partnerships, and sole proprietorships (including one owner LLCs as disregarded entities)

Notice the maximum corporate and individual tax rates are the same - 35 percent. That doesn't happen often, but it's true today. If the corporate rate drops and the personal rate is unaltered (or goes up), it's a major change.

Think of yourself as the owner of a profitable closely held business. It creates a taxable income subject to the maximum tax rate. Refer to the diagram below.

A regular 'C' corporation pays an income tax as an entity. That tax rate may be 35 percent. If the corporation creates free cash flow (meaning cash over and above what's needed to operate) and the owner extracts that cash in the form of a dividend, it's taxed to the owner as a dividend via the personal tax return. Another tax - maybe as high as 35 percent. It's called 'double taxation' and it's a truism associated with our corporate tax law.

Some will argue the second taxable event (dividend) can be avoided by simply taking the free cash flow in the form of compensation. Compensation is deductible to the corporation in arriving at taxable income, dividends are not. True - but with a caution. The compensation must be 'reasonable' in the eyes of the IRS based on the value of the services rendered the employer corporation by the owner / employee. If not 'reasonable' (a moving target to be sure), the IRS might reclassify some of the compensation as a non deductible dividend.

Others will suggest a rental activity between the 'C' corporation and some related non corporate entity (LLC comes to mind). The LLC chooses non corporate taxation. The rents paid by the lessee ('C' corporation) to the lessor (LLC) are deductible by the 'C' corporation in calculating its taxable income. The rents are income to the LLC, a pass through, or disregarded entity. No tax calculated at the entity level. 'Rents greater than market' are often used to shift taxable income away from the 'C' corporation. This technique is of interest to the IRS. No guaranty it will prevail.

Today, there is some relief afforded the dividend tax rate. If it's a 'qualifying dividend', the maximum personal tax rate is 15 percent. That rate is good for the next two years. Then, it's up for review by Congress.

A profitable 'S' corporation, partnership (including a multiple member LLC taxed as such), sole proprietorship (including a one owner LLC as a disregarded entity) pays income taxes at the personal level only. That rate might be as high as 35 percent. Same as the 'C' corporation, but it's the only tax income tax. Hard to beat.

If the corporate tax rate drops relative to the personal tax rate

Let's assume the corporate maximum rate drops to 25, maybe 20 percent. What are CPAs going to tell the owners of pass through entities?

• Start up business, additional tax losses expected - remain as pass through entity. Losses used to offset other taxable income at personal tax rates (assuming the losses are non passive).
• Growing business, creating a taxable income, all after tax profits retained to further growth, no dividends - if 'S' corporation, drop election and revert back to 'C' status (can't go back to 'S' status for five years); if non corporate pass through, change to corporate taxation if available (subject to 'case by case' review). Taxable income subject to lower corporate rate; more after tax dollars to reinvest.
• Mature business, profitable, creates a taxable income, has a lot of free cash flow, owner wants that cash - remain a pass through entity. Exception would be if the combined corporate and dividend rate is less than the personal rate (not likely). Usually two taxes will be greater than one.

Obviously, I'm making the assumption the entities can change the way they are taxed. (See article 'I'm confused - just how is a limited liability company taxed for federal purposes?' this blog)

Banker's concerns

Okay, you're a banker, not a purveyor of tax advice. What does this all mean to you in the relationship?

If your business customer is an 'S' corporation or other pass through entity type, the financial statements issued will change once they become a taxable 'C' corporation. I'll give yon an example.

Deferred income tax liability

If the business has two sets of books, one for financial statement presentation, the other for tax return preparation (common and legit), an issue develops. An aggressive tax posture may result in a taxable income on the tax return substantially less than income before taxes reported on the financials.

The 'C' corporation, as a taxable entity, will record its provision for income taxes on the financials. It has to under GAAP. That amount may well be greater than the amount actually payable when the tax return is filed; the difference increasing the deferred income tax liability on the financials. The liabilities on the financials will rise as long as the provision is greater than the actual tax due. I'll leave it to you to determine if you think it's a real liability; one that will require other assets to discharge in the future.

Loan agreement language

I suspect you might want to change language in the loan agreement once the pass through chooses corporate taxation. This is particularly true if you're using the tax return as your main documentation source; financials non existent, or lacking in credibility.

Example: With an 'S' corporation, both terms dividend, distribution are accurate; an 'S' corporation can have both in some instances. A 'C' corporation declares and pays dividends; distributions is not the applicable term.

If your 'S' loan agreement places restrictions on the customer's ability to declare, pay distributions while the loan is outstanding, that language may not work once a 'C' corporation. You'd want to change the term.