Year-end tax guide: Business taxes

2015 Year-end tax guideYou don’t need to own a business to worry about one. Whether you’re a shareholder, a partner, a manager or an executive, you’re concerned about not only your individual taxes, but also your business’s tax return. The key to planning for your business’s tax burden starts with understanding business tax structures.

Q: What’s the major tax difference between a pass-through and a C corporation?
Pass-through entities effectively pass taxation through to individual owners, so the business income is generally taxed only at the individual level. C corporation income is taxed first at the corporate level and again at the shareholder level when it is distributed to shareholders as dividends.  

Q: If my business isn’t publicly traded, should it be a pass-through?
There are many considerations with entity choice, but some of the tax advantages of pass-throughs are compelling enough that most privately held C corporations should seriously consider an S election to become an S corporation if eligible.

Q: What’s the difference between a stock sale and an asset sale?
A stock sale allows a C corporation owner to be taxed only on one layer of gain. An asset sale allows buyers to have depreciation write-offs. For a C corporation, an asset means the seller would be taxed twice — first at the corporate level when the assets are sold to the buyer, and then at the individual level when the proceeds are distributed.

Understanding business tax rates
In choosing a structure, there are many considerations, but one of the biggest differences is that C corporations are taxed at two levels. So how do the tax rates on pass-through entities and C corporations compare now? Pass-through businesses pay tax on all income, regardless of whether it is distributed, so the top rate on pass-through entities is 39.6% if you are not passive (not including any self-employment taxes), and 43.4% if you are. That’s higher than the 35% corporate rate, but only if no corporate earnings are distributed. If all earnings are distributed, the combined rate of corporate and dividend tax is actually 50.5%. See the table for a comparison of the top rates of pass-through entities and C corporations, depending on how much of the earnings are distributed.

If you plan on reinvesting your earnings in the business without distributing them, the top C corporation rate of 35% can be very appealing. But remember, unless you plan to die without ever receiving a dividend or selling the stock, the earnings will eventually need to come out of the business. So the single level of tax enjoyed by pass-through entities still provides a distinct advantage, especially when exiting the business.

C corporation income tax brackets
(click to view chart)
Rate comparison by entity
(click to view chart)

Planning tip: Erase gain with a QSB
While there are obvious tax benefits to being a pass-through, there is one almost unbeatable benefit available for smaller C corporations.

If you invest in a qualified small business (QSB), you may be able to eliminate your gain entirely when selling the stock. QSB stock must be original issue stock in a domestic C corporation meeting active business requirements with aggregate assets not exceeding $50 million when the stock is issued.

If you follow the rules and hold the stock for more than five years, you can sell the stock with little or no capital gain. Under current law, you can exclude up to 50% of the gain for QSB stock acquired in 2015 against a 28% rate, resulting in a 14% rate. But Congress is working on extending a provision that allows you to exclude all the gain. This has been available for stock issued from late 2010 through the end of 2014 and is likely to be extended again. Check with a Grant Thornton professional for the latest information.

The exclusion provides an obvious opportunity for a business already established as a C corporation, but the opportunity doesn’t end there. Under QSB tax rules, partnerships may perform a conversion into a C corporation in which the converted partnership interests are treated as stock acquisitions that can qualify for the QSB stock gain exclusion. S corporation stock cannot be converted to QSB stock, but any new stock issued after a revocation of S status or a C conversion can be eligible for the exclusion.

But be careful before acting on this strategy because there are many reasons the pass-through structure may still offer a better result. The benefit will be reduced significantly if Congress doesn’t extend the full gain exclusion. QSB stock must be held for five years, and the ongoing earnings of the business in the meantime will be subject to tax both at the corporate level and, to the extent it is distributed, at the individual level.

Tax law change alert: Business expensing and credits disappearing?
It may take longer to deduct your business investments this year unless Congress acts, and you could also be missing valuable credits like the alternative fuel credit, the R&D credit and the work opportunity credit. As this guide went to print, Congress had not extended more than 50 provisions that expired at the end of 2014, including bonus depreciation and the increased limits for Section 179 expensing.

If extended for 2015, bonus depreciation will allow you to deduct half the cost of qualified property you placed in service this year. Congress is also proposing to extend the $500,000 limit for Section 179 expensing and the $2 million phaseout threshold. There is a good chance Congress will extend these provisions later this year, so check with a Grant Thornton professional for the latest information. But remember, you cannot account for any of these benefits for financial statement purposes until they are actually enacted, and you should be very cautious in assuming any extension when making estimated tax payments.

Tax consequences when buying or selling
When you do decide to sell your business — or acquire another business — the tax consequences can have a major impact on your transaction’s success or failure.

Buyers will be looking for an asset sale so they can use future depreciation or amortization write-offs, assuming the assets have built-in gain. So C corporation owners typically have to either accept a potentially big tax bill on an asset sale or insist on a stock sale, which isn’t as valuable to the buyer and will reduce the selling price. When selling a pass-through entity, an asset sale results in only one layer of tax.

Sellers could also consider a tax-deferred transfer. The transfer of ownership of a corporation can be tax-deferred if made solely in exchange for stock or securities of the recipient corporation in a qualifying reorganization, but the transaction must comply with strict rules. Although it’s generally better to postpone tax, executing a taxable sale offers these advantages:

  • The seller doesn’t have to worry about the quality of buyer stock or other business risks that might come with a tax-deferred sale.
  • The buyer receives a stepped-up basis in the acquisition’s assets (in an asset sale) and doesn’t have to deal with the seller as a continuing equity owner, as it would in a tax-deferred transfer.
  • The parties don’t have to meet the stringent technical requirements of a tax-deferred transaction.

Planning tip: Consider an employment tax review after buying a business
If you bought the business assets of another employer within the past three years, you may have an employment tax refund opportunity.

Social Security taxes and state and federal unemployment taxes are all capped based on each employee’s wages. When you acquire someone else’s employees in an acquisition, you get to count the wages paid by the prior employer. Many payroll departments and third-party payroll companies overlook this fact and treat transferred employees as new hires. If they reset their wages to zero for the year, it takes longer for employee wages to reach the wage caps and you end up overpaying tax.

An employment tax review can uncover large refund claims. If you’ve acquired a business in the past three years, consider having a specialist review your employment tax filings.

Classifying your workers
Many businesses, especially startups or growing companies, rely heavily on independent contractors. The decision to hire a contractor rather than an employee is a business decision, but there may be tax benefits in some cases. For independent contractors, you don’t pay the employer share of payroll taxes, include them in benefit plans or face excise taxes for failure to offer health coverage. The IRS understands that these benefits can cause companies to misclassify employee-employer relationships as independent contractor relationships and has recently cracked down on the practice.

Misclassifying your workers can be costly. The IRS has an ongoing voluntary reclassification program that allows taxpayers to correct improper classification with greatly reduced back taxes and penalties. If the IRS discovers an issue outside of this program, it is unlikely to be lenient.

To prove the independent contractor relationship, documentation is imperative. You need to establish detailed policies, procedures and systems that employees responsible for hiring contractors can easily understand. To help establish a solid foundation for classifying workers as independent contractors, consider these suggestions:

  • Develop a checklist that must be completed before hiring an independent contractor and that includes a mandatory questionnaire asking about factors that indicate the worker’s relationship to the company.  
  • Use a contract with specific language about the worker’s relationship to the organization.
  • Avoid using contract language that establishes the “right of direction and control,” including noncompete agreements, restrictions on hiring subcontractors and payment of liability or workers' compensation insurance.  
  • Create a formal internal policy document that clearly defines the required documentation and procedures, and lists the departments responsible for implementing the procedures.

Dealing with health care reform
The Supreme Court decision in King v. Burwell upholding IRS regulations on individual premium assistance credits removes the last major judicial hurdle for the new employer excise taxes for failing to meet Affordable Care Act (ACA) health coverage requirements. The IRS transition relief is also ending.

In 2016, the ACA will generally impose excise taxes, also called shared-responsibility payments, on all employers with at least 50 full-time and full-time equivalent employees if they do not offer health care coverage to at least 95% of full-time employees or if they offer coverage, but it does not meet minimum value and affordability requirements. The lower thresholds available in 2015 are disappearing.

All employers with at least 50 employees should understand what it means to meet the 95% coverage threshold, how to determine who is considered a full-time employee and whether a worker is an independent contractor. Inadvertently falling below the 95% threshold or having another coverage failure can be costly.

In addition, new reporting requirements on health coverage are taking effect. Employers will need to capture and report various information for 2015, including the following:

  • For self-insured plans, the name, address and Social Security number of each full-time employee plus dependents enrolled in the employer’s health benefits plan (many employers don’t currently collect Social Security numbers for dependents, but they must do so under the regulations)
  • The coverage level offered to the employee
  • The coverage level at which the employee is enrolled
  • The months for which the individual is covered during the calendar year
  • Each full-time employee’s share of the lowest-cost monthly premium (for the employee only) for coverage providing minimum value, by calendar month
  • A statement concerning which affordability safe harbor was used for each employee per month
  • Total employee and full-time employee counts for each month

This information must be reported to employees on Form 1095-C by Feb. 1, 2016. The information is reported to the IRS on Form 1094-C by Feb. 29 in 2016 if using paper and March 31 if filing electronically. If the employee’s coverage is through a fully insured plan, the employee will also receive a Form 1095-B from the insurance company.


Mel Schwarz T +1 202 521 1564

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