Most modern tax practitioners equate corporations with double taxation and seek to avoid using the corporate form of business entity (save for Subchapter S corporations). However, for those practitioners who have been around awhile, the calculus involved in choosing the corporate form might not be so straight forward. This is not because the old geezers are experiencing a cognitive deceleration but rather they likely recall a time when operating in corporate solution was sought after for its tax benefits – Prior to 1982, there existed periods where the top tax rates applicable to individuals were 22% to 65% higher than the top corporate rate.
Currently, the top federal tax rates for individuals are 39.6%, but when one adds the net investment income tax (3.8%), Pease limitations, personal exemption phase outs and such, the effective tax rate can quickly exceed 45%. Moreover, if you live in a high tax state, like New York, your total tax hit can easily exceed 50%. Compare that to a corporate tax hit of 35% in the U.S. and, with respect to certain types of income (e.g., investment income), the state tax can be eliminated. Consider a New York City hedge fund investor who currently receives a mixture of ordinary income and short term capital gains from her investment and has an effective combined state, local and federal tax rate of 53%. That investor might establish a Nevada corporation and hold her investment through such entity. The tax rate at the corporation level is approximately 35% (while Nevada does not have a corporate income tax it does have certain initiation and maintenance taxes but these are not substantial). That is a savings of 18%.
The “old-timers” may also recall that Congress caught on to this trick and enacted several rules to limit this deferral technique. Section 531 of the Internal Revenue Code subjects most corporations to surtax of 20%, where attempts are made to unnecessarily accumulate income rather than distribute it to shareholders. Likewise, Section 541 imposes a 20% surtax on the undistributed income of certain closely held companies. And, for a time, Section 341 existed to deter people from creating a corporation to build ordinary income producing assets or businesses and then liquidating the corporation in order to capture the income at the lower long-term capital gains tax rate (the so-called “collapsible corporation rule” which is now unnecessary and has been repealed). The anti-abuse measures that remain in the Code are considered antique relics and haven’t been used or tested in over thirty years. It will be interesting to see taxpayers revive this type of corporate tax planning given the current rate environment.
The contemporary apprehension about utilizing corporations for tax planning also extends beyond the U.S. borders. Most tax practitioners seek to avoid corporations for off-shore planning as well as domestic. An additional technical issue with off-shore corporations is that U.S. individuals cannot make use of foreign tax credits if their investment is held via a foreign corporation. This limitation is often a non-starter for tax planners. However, let’s examine a present day hedge fund manager living in New York City. Manger is the sole limited partner in a management company (domestic partnership) which earns a 2% management fee from an off-shore master fund under an investment management contract and the current AUM is $1 billion. Thus, the annual management fee is $20 million. If earned in the U.S. directly by the management company, the income would be allocated to the manager on an individual basis (assume 100% for our example), and the resulting tax would be $8.566 million (ignoring state and local taxes for the moment and using a tax rate of 42.83% to reflect a 39.6% federal rate plus self-employment tax net of federal benefit). Now, let’s assume that the management company is reorganized as an Irish Limited Company. The same $20 million fee is earned. The company pays Irish tax of 12.5% or $2.5 million, and then distributes the remainder as a dividend to the manager, as an individual shareholder, in the United States. The U.S. manager is not entitled to a foreign tax credit for the Irish tax so this results in a pure double tax. The net dividend received by the manager should be eligible to be treated as qualified dividend income taxable in the U.S. at 23.8% (20% QDI rate plus 3.8% net investment income tax), resulting in a U.S. tax of $4.165 million. The QDI treatment hinges on the Irish management company being eligible for treaty benefits which is a factual question. Thus, by utilizing a taxable off-shore corporation, the New York City investment manager was able to lower his effective tax rate from 42.83% to 33.325% for a net savings of 9.5% (or $1.9 million on these numbers). Plus, there may be an added benefit to this off-shore structure known as deferral. The management business should be considered an active business and thus, the income earned at the Irish company level need not be repatriated to the U.S. Stopping the cash flow at Ireland simply results in a 12.5% Irish tax. There are no U.S. or state tax consequences until the cash is repatriated.
Given the current tax rate environment in the United States we all need to rethink the way we look at tax planning and our use of corporate vehicles. Personally, I’m not old enough to have practiced during times of severe corporate inversions but I am savvy enough to recognize the opportunities. I’m sure many practitioners in my generation will soon be noticing this funny thing that has happened along the way and the need to rethink all the tax planning we were taught.
If you have any questions regarding this or any other type of tax planning you should contact your normal WithumSmith+Brown partner.