In May, as the last of the cherry blossoms fall in our nation’s capital, Congress will begin its final session before recessing in early August and retreating to the open waters of Nantucket Sound. Charting much of their course this summer— while eliciting serious discussion and debate among senior business leaders—is tax reform.
At the helm, business owners now find themselves in a state of ambiguity as they reflect upon their current business entity structures and preferred financing methods – which were originally designed to yield optimal savings and long-term growth, based on then-current tax legislation. The potential overhaul to the current business/corporate tax regime, however, has left some business leaders paralyzed with anxiety as they imagine a multitude of possible outcomes that may make their past choices less desirable going forward. As income tax reform continues to pick up speed, senior business leaders are becoming more willing to adjust their business structures to better align with proposed tax changes, a Friedman LLP recent study* reveals.
When asked if the removal of the business interest expense deduction would encourage senior business leaders to change their source of financing in terms of debt vs. equity, almost three-fourths (72%) of survey respondents indicated they would consider changing their finance model. On the other hand, 17% of respondents said the removal of the deduction would not impact their current finance plan at all, and 11% of respondents remain undecided.
The question is: why would senior business leaders willfully relinquish equity control in exchange for less debt, and how are they measuring the perceived benefits of equity-based financing?
Businesses seem to recognize the negative ramifications that come with surrounding dilution of ownership interest. For this reason, many business owners see debt as the preferred option. But, with the changing tides, senior business leaders are beginning to appreciate how swapping equity control for cash may provide more than just an accounting entry on the books. This perspective may influence future decisions and overall company culture. For instance, when equity financing is used in place of debt, businesses are no longer required to dedicate a percentage of revenue to pay down loans. This enhances the purchasing power of businesses in need of new equipment, talent, inventory and project funding. And by forgoing bank debt, businesses can eliminate restrictive bank covenants, thus allowing for greater external opportunities.
Still, over 25% of respondents felt either, (i) that they would not be compelled by the removal of the interest deduction, or (ii) that they would need a bit more convincing prior to making a major shift in their overall finance structure. Perhaps this is because they have placed a greater value on percentage of ownership, or perhaps more likely, they simply need concrete information before drawing any conclusions. A comprehensive study of changing incentives could help to create a more compelling argument in time.
Making the transition from debt- to equity-based financing could lead to added benefits, including:
- Fresh business ideas with the admittance of new investors
- Increased cash availability, previously used for debt service
- Removal of restrictive bank covenants
- Higher bottom line levels
- Greater risk diversification among investors
Another question posed to senior business leaders revolved around their business structure and the tax imposed on those businesses. Currently, C corporations pay tax on net income while pass-through entities, such as partnerships and LLCs, pass the income along to the owners, allowing only one level of taxation. This disparity has caused a boom in the formation of LLCs and partnerships— making them the favored business structures over the past several decades.
One of the main focuses during the latest presidential campaign, and a primary feature of the recent tax reform proposal, centered on corporate tax rates, which rank among the highest of all industrialized countries. The prevailing idea to level the international playing field for American businesses would impose one tax on all business income, including pass-through entities, at a rate much lower than both personal and corporate/business rates. The tax burden for pass-through income would no longer fall on the individual owners as they would continue to pay at a rate higher than the proposed business/corporate rate.
Would this change in business tax rates accompanied by taxation on pass-through entities resonate enough with business owners to cause them to change the structure of their businesses? Of the businesses that were not pass-through entities, more than half of those surveyed (60%) said they would consider reorganizing their business if business income were to be taxed at a lower rate than ordinary income while 20% said no— and 14% were unsure. If almost three-quarters of those surveyed would consider the change, then we need to be asking a better question: are they currently in the correct structure regardless of tax rates?
The decision to operate as a C corporation is made with the knowledge of accepting the burden of double taxation— once on the corporation and another on the shareholders when dividends are distributed. There are many other reasons a corporation may choose this formation including shareholder protection, debt vs. equity financing and plans to go public, to name just a few. If switching to a pass-through entity is still the desire of management and the shareholders then two options exist: S corporation or LLC/partnership. The conversion into a subchapter S corporation, which is also a pass-through entity, is straightforward if the company fits the stringent requirements of operating as an S corporation. If the S corporation option is not available, then conversion to an LLC or partnership is not as simple as filing a form. It requires the liquidation of the C corporation — which can be a lengthy and expensive proposition ending with a potentially significant tax liability for both the company as well as the shareholders.
Switching from a C corporation to a pass-through entity may save taxes, but allowing taxes to steer the corporate vessel may cause some businesses to miss the Sound all together and unknowingly veer into darker water.
While great questions remain, we can be certain that before woolen pinstripes are traded in for cotton chinos and top-siders, Congress’s summer session is sure to bring more insight and give business owners plenty to think about.
Check out other tax reform insights in this series:
- Business leaders favor sweeping tax reform proposals, with some hesitancy towards international proposals
- A majority of businesses would offer the same or more health benefits if ACA repealed
- Mixed Reaction to International Tax Reforms, Impact Remains Uncertain
- Companies using independent contractors may be at risk for taxes and penalties
- Survey Finds Businesses with Online Sales May Not Be Prepared for States’ Broader Interpretations of Nexus Rules
*Friedman LLP conducted the web-based survey in early 2017 among companies across the United States, with a focus on the New York, New Jersey, Pennsylvania, and Connecticut areas. The survey compiles responses from 483 senior leaders of companies across industries including technology/computer services, manufacturing/distribution/wholesale, healthcare, retail, real estate, financial services, architecture/engineering, marketing and advertising, nonprofits, law, and more. The size of the companies surveyed ranged from below $10 million in annual revenue to over $500 million. The respondents include business owners, company presidents, chief executive officers, partners, directors, chief financial officers, controllers, and managing directors. All insights in this series are based upon the specific responses of the business leaders who participated in our survey.